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Chapter 25

Money Creation
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1

In this chapter, you will
learn to solve these
economic puzzles:
Exactly
What how
areisthe is
major money
tools the
Why
created there
in the nothing
economy?
Federal Reserve
‘federal’ about uses
the to
That
control is, how
the supply does
of the
money?
federal funds rate?
money supply increase?
2

In the Middle Ages, what
was used for Money?
Gold was the money
of choice in most
European nations

3

Who were the Founders of our Modern-day Banking? Goldsmiths. people who would keep other people’s gold safe for a service charge 4 .

What was the first Currency? People would use the receipts they received from goldsmiths as paper money 5 .

How did the early Goldsmiths act as the First Banks? Some goldsmiths made loans and received interest for more gold than the actual gold held in their vaults 6 .

What is Fractional Reserve Banking? A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed 7 .

What are Required Reserves? The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed 8 .

What is a Required Reserve Ratio? The percentage of deposits that the Fed requires a bank to hold in vault cash or on deposit with the Fed 9 .

What are Excess Reserves? Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves 10 .

11 . Typical Bank .Balance Sheet 1 Assets Liabilities Required $5 million Checkable $50 million Reserves Deposits Excess 0 Reserves Loans $45 million Total $50 million Total $50 million Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

What are Total Reserves? Total Reserves = required reserves + excess reserves 12 .

p.$46. Table 1.15.5 million 10% Source: Federal Reserve Bulletin.5 million 3% Over $46. April 1999. A8 13 .Required Reserve Ratio of the Fed Required Reserve Type of Deposit Ratio Checkable deposits 0 .

000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve. 14 .000 Total $100.Best National Bank .Balance Sheet 2 Assets Liabilities  in M1 Required $10.000 0 Reserves Account Excess Reserves +$90.000 Brad Rich $100.000 Total $100.

000 Loans +$90.Balance Sheet 3 Assets Liabilities  in M1 Required $19.000 Reserves Account $90.000 Connie Jones +$90. 15 .000 Brad Rich $100.000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.000 Reserves Account Excess $81.000 Total $190.Best National Bank .000 Total $190.

000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.000 Total $100.Balance Sheet 4 Assets Liabilities  in M1 Required $10.000 Brad Rich $100.000 $100. 16 .Best National Bank .000 0 Reserves Account Excess 0 Connie Jones 0 Reserves Account Loans $90.

Yazoo Bank .000 Reserves Span Account Excess +$81.000 Reserves Total $90.Balance Sheet 5 Assets Liabilities Required +$9. 17 .000 Better Health +$90.000 Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.000 Total $90.

000 $100.100 72.290 65. Expansion of the Money Supply Increase in Increase in Increase in # Bank Deposits Required Excess Reserves Reserves 1 Best Nat’l Bank $100.000 $10.000 8.144 7 Bank E 53.000 $900.000 81.049 5.000 9.830 430.830 Total all other banks 478.314 47.000 2 Yazoo Nat’l Bank 90.610 5 Bank C 65.000 18 .905 53.000 3 Bank A 81.297 47.000 $90.049 6 Bank D 59.144 5.900 4 Bank B 72.610 6.000.561 59.467 Total increase $1.900 7.

What is the Money Multiplier? The maximum change in the money supply due to an initial change in the excess reserves banks hold 19 .

What is the Money Multiplier equal to? 1 / required reserve ratio 20 .

Actual money supply change  M1 = ER x m Initial change in excess reserves Money multiplier 21 .

Can the Multiplier be smaller than indicated? Yes. because of cash leakages and the chance that banks will not use all of their excess reserves to make loans 22 .

What would the Fed do if we had Inflation? Decrease the money supply What would the Fed do if we had unemployment? Increase the money supply 23 .

What is Monetary Policy? The Fed’s use of - • open market operations •  in discount rate •  in required reserve ratio 24 .

What are Open Market Operations? The buying and selling of government securities by the Federal Reserve System 25 .

Federal Reserve System - Balance Sheet 6
Assets Liabilities
Government Fed notes
securities $472 $492

Loans to banks Deposits 34
1
Other liabilities
Other assets 75 and net worth 22

Total $548 Total $548

Source: Federal Reserve Bulletin, April 1999, Table 1.18, p. A10
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Federal Reserve Bank - Balance Sheet 7
Assets Liabilities Initial 
in M1
Government +$100,000 Reserves of +$100,000 +$100,000
securities Best Nat’l
bank

Note: The Fed conducted open market
operations in order to increase the
money supply by purchasing $100,000
in government securities.

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Federal Reserve Bank - Balance Sheet 8
Assets Liabilities Initial 
in M1
Government -$100,000 Reserves of -$100,000 -$100,000
securities Best Nat’l
bank

Note: The Fed conducted open market
operations in order to decrease the
money supply by selling $100,000 in
government securities.

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Fed $ Fed buys government Fed sells government $ securities and banks securities and banks gain reserves loose reserves Banks $ $ Public 29 .

What is the Discount Rate? The interest rate the Fed charges on loans of reserves to banks 30 .

What would the Fed do if we have Inflation? A higher discount rate discourages banks from borrowing reserves and making loans 31 .

What would the Fed do if we have Unemployment? A lower discount rate encourages banks to borrow reserves and make more loans 32 .

What is the Federal Funds Market? A private market in which banks lend reserves to each other for less than 24 hours 33 .

What is the Federal Funds Rate? The interest rate banks charge for overnight loans to other banks 34 .

What would the Fed do if we had Inflation? A higher federal funds rate discourages banks from borrowing reserves and making loans 35 .

What would the Fed do if we had Unemployment? A lower federal funds rate encourages banks to borrow reserves and make more loans 36 .

What is a Required Reserve Requirement? The Fed determines how much a financial institution must keep in reserve as a percentage of its total assets 37 .

What is the Required Reserve Ratio? That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement 38 .

what is the multiplier? 1  1/10 = 10 39 .If the Reserve Ratio is one tenth.

If the Reserve Ratio is one twentieth. what is the multiplier? 1  1/20 = 20 40 .

What would the Fed do if we had Inflation? Increase the reserve ratio What would the Fed do if we had Unemployment? Decrease the reserve ratio 41 .

changing the reserve ratio is considered a heavy- handed approach and is thus infrequently used 42 . Is changing the Reserve Ratio a popular Monetary Tool? No.

What are the Shortcomings of Monetary Policy? • Money multiplier inaccuracy • Nonbanks • Which money definition should the Fed control? • Lag effects 43 .

Key Concepts 44 .

Key Concepts • Who were the Founders of our Modern- day Banking? • What is Fractional Reserve Banking? • What are Required Reserves? • What is a Required Reserve Ratio? • What are Excess Reserves? • What are Total Reserves? • What is the Money Multiplier? • What is the Money Multiplier equal to? 45 .

• What is Monetary Policy? • What are Open Market Operations? • What is the Discount Rate? • What is the Federal Funds Rate? • What is a Required Reserve Requirement? • What is the Required Reserve Ratio? • What are the Shortcomings of Monetary Policy? 46 . Key Concepts cont.

Summary 47 .

banks create money by making loans. originated with the goldsmiths in the Middle Ages. 48 . Fractional reserve banking. the basis of banking today. Because depository institutions (banks) are not required to keep all their deposits in vault cash or with the Federal Reserve.

49 . Required reserves are the minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. The percentage of deposits that must be held as required reserves is called the required reserve ratio.

Money is reduced when excess reserves are reduced and loans are repaid. Excess reserves allow a bank to create money by exchanging loans for deposits. Excess reserves exist when a bank has more reserves than required. 50 .

As a formula: $ multiplier = 1/required reserve ratio. The money multiplier is used to calculate the maximum change (positive or negative) in checkable deposits (money supply) due to a change in excess reserves. 51 .

Monetary policy is action taken by the Fed to change the money supply. (2) changes in the discount rate and (3) changes in the required reserve ratio. The Fed uses three basic tools: (1) open market operations. 52 .

53 . thereby expanding the money supply. Open-market operations are the buying and selling of government securities by the Fed through its trading desk at the New York Federal Reserve Bank. Selling government securities reduces bank reserves and loans. Buying government securities creates extra bank reserves and loans. thereby contracting the money supply.

Fed $ Fed buys government Fed sells government $ securities and banks securities and banks gain reserves loose reserves Banks $ $ Public 54 .

Raising the discount rate discourages banks from borrowing reserves from the Fed and contracts the money supply. 55 . Changes in the discount rate occur when the Fed changes the rate of interest it charges on loans of reserves to banks. Dropping the discount rate makes it easier for banks to borrow reserves from the Fed and expands the money supply.

If the Fed increases the required reserve ratio the money multiplier and money supply decrease. 56 . if the Fed decreases the required reserve ratio the money multiplier and money supply increase. Changes in the required reserve ratio and the size of the money multiplier are inversely related. Thus.

such as insurance companies. finance companies. or another money supply definition. M3. and Sears. (4) Time lags occur. 57 . Monetary policy limitations include the following: (1) The money multiplier can vary. can offer loans and other financial services not directly under the Fed’s control. (3) The Fed might control M1 while the public can shift funds to M2. (2) Nonbanks.

Chapter 25 Quiz ©2000 South-Western College Publishing 58 .

its required reserve ratio is a. 1 percent. Required reserve ratio = required deposits  total deposits x 100 = $10.000  $100.000 set aside to meet reserve requirements of the Fed.1 percent. c.1.000 x 100 59 . b. $10. 0. d.000. 10 percent.000 with $10. B. If a bank has total deposits of $100.

$7. $3. Excess reserves can be loaned. b. Excess reserves = total reserves .$3.000.000. d. c.000 .000 60 . $30. Assume a simplified banking system in which all banks are subject to a uniform required reserve ratio of 30 percent and demand deposits are the only form of money.000. B.000 - (0.000) = $10. $10.000 is able to extend new loans up to a maximum of a.required reserves = $10. A bank that receives a new deposit of $10.000.000 = $7.3 x $10.2.

One day a depositor withdraws $400 from his or her checking account at the bank. B.10 x $400) = -$400 + $40 = -$360 61 . b. c. Excess reserves = total reserves - required reserves = -$400 .(0. d. fall by $400. the bank’s excess reserves a. The Best National Bank operates with a 10 percent required reserve ratio.3. fall by $40. As a result. fall by $360. rise by $400.

5 percent. $ multiplier =  in bank deposits  initial  in excess reserves = 400  $100 = 4 = 1  required reserve ratio = 1  money multiplier x 100. 62 . 400 percent. e. 4 percent. 25 percent. the required reserve ratio must be a. 40 percent. b. 2.4. If an increase of $100 in excess reserves in a simplified banking system can lead to a total expansion in bank deposits of $400. c. d. C.

decrease by $1.000.000 open sale by the Fed would cause the money supply to a. c. increase by $4.  M1 = $1.000 x 4 = -$4.000. Money supply change ( M1) = initial  in excess reserves x money multiplier (MM). C.000. d. a $1. 63 . In a simplified banking system in which all banks are subject to a 25% required reserve ratio. decrease by $4. b.000. increase by $1.000. MM = 1  required reserve ratio = 1  25/100 = 4 .5.

000. b.000. Money supply change ( M1) = initial change in excess reserves x money multiplier (MM) MM = 1  required reserve ratio = 1  20/100 =5  M1 = $1.000 open market purchase by the Fed would cause the money supply to a. a $1. d. D. increase by $100.000 x 5 = $5. 64 . c.000. decrease by $200. In a simplified banking system in which all banks are subject to a 20% required reserve ratio. increase by $5.6. decrease by $5.

d. The Fed provides a discount window at each of the Federal Reserve districts banks to make loans of reserves to banks and change an interest rate called the discount rate. reserve requirement. price of securities in the open market. b.7. The cost to a member bank of borrowing from the Federal Reserve is measured by the a. c. 65 . yield on government bonds. discount rate. C.

000 Required Reserves deposits Excess Reserves Loans 80.000 Total $100.000 66 .000 Total $100. Exhibit 5 Balance Sheet of Best National Bank Assets Liabilities $ Checkable $100.

C. c. 15%.000 Required reserve ratio = required deposits  total deposits = $20.000 x 100 = 20% 67 . The required reserve ratio in Exhibit 5 is a. 25%. 20%. 10%. d.000  $100. b.8.000 = $100.000 - required reserves = $20. Excess reserves = total reserves - required reserves = $80.

000.20 x $100.000. d. B. its new required reserves would be a.000 in new deposits. b.000. If the bank in Exhibit 5 received $100.9.000 68 .000. Required reserves = required reserve ratio x new deposits = . $30. $20. $40. $10. c.000 = $20.

a $200 increase in excess reserves. Required reserves = required reserve ratio x new deposits = . zero change in required reserves.000 = $200 69 . Suppose Brad Jones deposits $1. b. c. a $200 increase in required reserves. B. The result would be a. d.10.200 increase in required reserves.20 x $1. a $1.000 in the bank shown in Exhibit 5.

Money multiplier = 1  required reserve ratio = 1  20/100 = 5 70 . 20. 5. c.11. d. A. b. If all banks in the system are identical to Best National Bank in Exhibit 5. 15. 10. A $1.000 open market sale by the Fed would a.

contract the money supply by $1.000.000.000. 71 . contract the money supply by $5.000 open market sale by the Fed would a. b.000. A $1. d. Money supply change ( M1) = initial change in excess reserves x money multiplier (MM) MM = 1  required reserve ratio = 1  20/100 =5  M1 = $1. D. Assume all banks in the system are identical to Best National Bank in Exhibit 5. expand the money supply by $15.000.12.000 x 5 = -$5. expand the money supply by $1. c.

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