Transcript Multiplier and the Mystery of the Magic Money

Multiplier and the Mystery
of the Magic Money
By
Lisa Herman-Ellison
econoedlink.org. 23 Mar 2009
http://www.econedlink.org/lessons/index.php?lesson=348&pag
e=teacher
Objectives





Define inflation and explain the rate that the
quantity of money plays in inflation rates.
Explain the purpose of the reserve requirement.
Calculate the money multiplier.
Calculate the potential money creation from a
deposit, given the multiplier.
Evaluate what the Federal Reserve should do to
the reserve requirement to correct inflation or
recession.
Introduction

In Yugoslavia “between October 1, 1993
and January 24, 1995 prices increased by
5 quadrillion percent. This number is a 5
with 15 zeroes after it.” (Thayer Watkins, Professor
of Economics at San Jose State University).

The uncontrolled creation of money causes
a quick decrease in the value of currency
and very rapid hyperinflation (in annual
price increases of hundreds or thousands
of percent), which can destroy an
economy.
Introduction
The United states central bank—the
Federal Reserve—can protect against such
a calamity by controlling the supply of
money.
 One technique the Federal Reserve uses
for controlling how fast (or how slow) the
money supply can grow is through a
reserve requirement for bank deposits.

Introduction
By making changes in that reserve
requirement, the Fed can “create” or
“destroy” money in an attempt to prevent
hyper inflation or correct serious instability
in the economy.
 The Federal Reserve also has two other
primary tools of monetary policy, the
discount rate and open market operations,
through which it can control the money
supply.

Activity

Read: “The Worst Episode of
Hyperinflation in History: Yugoslavia
1993-94”
Federal Reserve System
Although the Yugoslav economic crisis was
largely caused by the physical printing of
money, the uncontrolled creation of
money by any means can have a
devastating effect on an economy.
 The U.S. Federal Reserve System was
created in 1913 with a primary purpose of
controlling the US money supply and the
value of money.

Federal Reserve System
The reserve requirement is one of the
most important tools the Fed uses to
control the money supply.
 Under the reserve requirement, banks are
required to hold a percentage of their
deposits on account with the Fed or in
their own vaults.
 Banks are prohibited from lending this
money out to customers.

Federal Reserve System
In this way, the Fed puts a limit on the
growth of the money supply.
 The Monetary Control Act of 1980 allows the
Fed to set the reserve requirement at 814% of deposits, based on economic
conditions.


As of 1/1/09 Reserve Requirement:
$0 to $10.3 million = 0%
More than $10.3 to $44.4 million = 3%
More than $44.4 million = 10% (“Reserve Requirement”)
Federal Reserve System
“Magic money” is able to grow from our
fractional reserve system because money
deposited at the bank is largely loaned
back out to other customers.
 The reserve requirement places a limit on
the bank’s ability to do so.


For example, if Tamika enters town with
$1,000 to deposit into the local bank, the
bank’s actual reserves increased by $1,000.
Federal Reserve System

Because of the reserve requirement, those
reserves will be divided into two separate
funds:



Required reserves – which the bank must hold
Excess reserves – which the bank can lend to
other customers.
If the Fed sets the reserve requirement at
10%, the bank is required to hold onto
$100 of Tamika’s deposit, and it can then
lend the remaining $900 to another
customer.
Federal Reserve System


If that customer uses the money to buy
something from Mariluz, who then deposits that
money back into the bank, the money supply
grows to $1,900.
This “magic money” is created because the sum
of the same dollars are being used twice:


Tamika holds papers saying that she has$1,000 in her
bank account, and Mariluz holds papers saying that she
has $900 in her bank account.
What will the bank do with Mariluz’s $900?
In accordance to the 10% reserve requirement, the
bank must hold $90 and is free to lend the remaining
$810 to another customer. This process can continue
until the last penny has been loaned.
Federal Reserve System
In addition to placing a limit on money
creation, the Federal Reserve can make
changes in the reserve requirement to try
to correct problems of inflation or
recession in the economy.
 If the economy were starting to
experience serious inflation, the Federal
Reserve could increase the reserve
requirement, limiting the banks’ ability to
lend funds and reducing the money
supply.

Federal Reserve System
The reduced money supply would increase
interest rates. Making consumers and
firms less likely to want to borrow funds,
thereby reducing their demand for
products and slowing down the economy.
 To see how this would work, remember
with a 10% reserve requirement, $10,000
could be created from an initial $1,000
deposit.

Federal Reserve System
Now use the interactive table to increase
the reserve requirement to 12 percent.
 At that rate, only $8,333.33 can be
created from that same deposit.
 The Fed can also reduce the reserve
requirement to increase the money supply
in the event of a recession, lowering
interest rates and enticing consumers and
firms to borrow more, to increase their
spending.

Federal Reserve System
But because the reserve requirement is so
powerful, the Federal Reserve board of
Governors only makes changes in the
reserve requirement in case of serious
economic problems.
 As precise as the use of the reserve
requirement may seem, several factors
limit its effectiveness in correcting
economic problems.

Federal Reserve System



During a recession, reducing the reserve
requirement only allows banks to make more
loans available; the Fed cannot force banks to
lend the money nor force consumers to take out
loans.
In addition, those who receive the loaned funds
may choose not to redeposit those funds, holding
them in cash instead.
Also, money may leave the country through the
purchase of imports or foreign investments, and
money may enter the country through foreign
purchases of out exports or investment in
American assets.
Federal Reserve System
Although its effectiveness may be limited
by several factors, the reserve
requirement remains the most powerful
single tool in the Federal Reserve’s arsenal
to combat economic instability.
 More importantly, the reserve requirement
stands as one important protection
against the hyperinflation that has
seriously crippled economies around the
world.

Conclusion



Because of the potential for hyperinflation, the
Federal Reserve uses reserve requirements to
limit the growth of the money supply.
If the Board of Governors sees inflation as a
serious economic problem, the reserve
requirement can be increased to further limit the
ability of banks to make loans and create money.
The Fed can also reduce the reserve requirement,
to make more money available to stimulate the
economy during a recession, while some factors
limit its effectiveness, the reserve requirement
remains a very powerful tool of the Federal
Reserve.
The Multiplier
The size of the multiplier, 1/(1 − MPC), depends on the
marginal propensity to consume, MPC: the larger the
MPC, the larger the change in real GDP for any given
autonomous (independent) increase in aggregate
spending.
Multiplier Formulas and Terms
MPC = ∆ in consumption divided by ∆ in
income
 MPS = ∆ in savings divided by ∆ in income


Final outcome for (GDP):


Multiplier = 1/(1 MPC)
Potential GDP income = Multiplier x income
(deposit)
Activity

Calculate the federal reserve
requirement, money multipliers, and
evaluate what the Federal Reserve should
do to the reserve requirement to correct
inflation or recession.
Activity
1.
2.
3.
If the reserve requirement is 20% and a
$1,000 deposit was made in the bank,
how many dollars of the deposit must the
bank hold in required reserves? $200
If the reserve requirement is 20% and a
$1,000 deposit is made in the bank how
many dollars of the deposit can the bank
lend back out to a customer? $800
If the reserve requirement is 20% and a
$1,000 deposit is made in the bank, what
is the multiplier (1/(1-MPC) or 1/MPS?
(1/0.20) = 5
Activity
4.
5.
If the reserve requirement is 20% and a
$1,000 deposit is made in the bank, how
much money potentially can be created
from the initial deposit (multiplier x
income)?
(5 x $1,000) = $5,000
If the reserve requirement is 5% and
$1,000 deposit is made in the bank, how
many dollars of the deposit must the
bank hold in cash? $50
Activity
6.
If the reserve requirement is 5% and
$1,000 deposit is made in the bank, how
many dollars of the deposit can the bank
lend back out to a customer? $950
7.
If the reserve requirement is 5% and
$1,000 deposit is made in the bank, what
is the multiplier?
(1/0.05) = 20
Activity
8.
If the reserve requirement is 5% and
$1,000 deposit is made in the bank, how
much money potentially can be created
from the initial deposit?
$1,000 x 20 = $20,000
9.
If the Fed is trying to reduce the inflation
rate, should the Fed increase or decrease
the money supply? Decrease
Activity
10.
If the Fed is trying to reduce the inflation
rate, should the Fed increase or decrease
the reserve requirement? Increase
11.
If the Fed is trying to reduce the inflation
rate, will this policy result in higher or
lower interest rates? Higher
Activity
12.
If the Fed is trying to reduce the inflation
rate, will this policy lead consumers and
firms to borrow more or less? Less
13.
If the Fed is trying to reduce the inflation
rate, will this borrowing change lead
consumers and firms to buy more or
less? Less
“Reserve Requirement”. Federal Reserve
Board, The. 25 Mar 2009.
http://www.federalreserve.gov/monetary
policy/reservereq.htm