Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 16 Money Creation, the Demand for Money, and Monetary Policy

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 16

Money Creation, the Demand for Money, and Monetary Policy


16-2

Banks and Money

• As early as 1000 B.C., uncoined gold and silver were being used for money in Mesopotamia.

• Later, goldsmiths started issuing paper notes indicating that the bearers held gold or silver of given weights and on deposit with the goldsmith.

• These notes could be exchanged for goods and were the first paper currency.


16-3

Banks and Money (cont’d)

• Reserves

– deposits held by Federal Reserve + the bank’s vault cash

• Fractional Reserve Banking– A system in which depository

institutions hold reserves that are less than the amount of deposits

• Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand


16-4


• Required Reserve Ratio

– The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed

Required reserves = Transactions deposits Required reserve ratio


16-5


• Excess Reserves

– The difference between actual reserves and required reserves

Excess reserves = Actual reserves – Required reserves


16-6

The Relationship Between Legal Reserves and Total Deposits

• Balance Sheet– Statements of assets (what is owned) and

liabilities (what is owed)

• How a single bank reacts to an increase in reserves– We will examine the balance sheet of a single

bank.


16-7

Reserve Ratio = 10%

Balance Sheet 16-1 Typical Bank

Now: What if someone makes a deposit of $100,000 in Typical Bank?


16-8

Typical Bank lends $990,000………

Balance Sheet 16-3 Typical Bank


16-9

The Relationship Between Total Reserves and Total Deposits (cont'd)

• What do you think?– Did this loan expand the money supply?


16-10

Money Expansion by the Banking System (cont'd)

What do you think?• Could Banks 4, 5, 6, etc. create even more money?• How much can be created?

$100,000 New Deposit90,000 Loan by Bank 181,000 Loan by Bank 272,900 Loan by Bank 3

$343,900 Total


16-11

Table 16-1 Maximum Money Creation with 10 Percent Required Reserves


16-12

The Money Multiplier (cont'd)

Actual changein the money

supply= Actual money

multiplierChange in

total reserves

Potential money multiplier = 1

Required reserve ratio


16-13


• Example

– Fed buys $100,000 of government securities

– Reserve ratio = 10%

Potential changein the money

supply= $100,000 = $1,000,000x

1

.10


16-14

Monetary Policy

Ways in Which the Federal Reserve Changes the Money Supply

• Open market operations

• Reserve requirement

• Discount rate

• Hint: Monetary policy involves the money supply and interest rates


16-15

Money Expansion by the Banking System (cont'd)

• Open Market Operations

– The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System

• The Federal Open Market Committee (FOMC)

– Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds


16-16


– Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.

• Discount Rate

– The interest rate that the Federal Reserve charges for reserves it lends to depository institutions


16-17

The Money Multiplier (cont’d)

• Changes in the reserve requirements

– An increase (decrease) in the required reserve ratio

• Makes it more (less) expensive for banks to meet reserve requirements

• Reduces (expands) bank lending


16-18

Reserve Ratios


16-19

Why is the money supply important?

• There are links between changes in the money supply and changes in GDP (short run) and the rate of inflation (long run).


16-20

Myth #16: As for money, the more the better

• The more money we have, other things being equal, the more you will spend only in dollar terms (not more in quantity) -- inflation

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 16 Money Creation, the Demand for Money, and Monetary Policy