Transcript File

Chapter 16 Section 3
By: Layne Cumby
Lee Johnson and
Dakota Hisle
5-24-10
Vocabulary
• Money multiplier formula-amount of new
money that will be created with each demand
deposit calculated as 1 divide RRR.
• Excess reserves-reserves greater than the
required amounts.
Vocabulary
• Money creation-the process by which money
enters into circulation.
• Money creation is carried out by the Fed and
by banks all around the country.
Vocabulary
• Required reserve ratio-(RRR) ratio of reserves
to deposits required of banks by the Federal
Reserve.
• The RRR is the fraction of deposits that banks
are required to keep on reserve.
Vocabulary
• Open market operations are the
buying and selling of government
securities to alter the supply of
money
• Omo’s involve the circulation of
bonds and the money supply
Prime Rate
• Prime rate is the rate of interest banks
charge on short term loans to their
best customers
• These loans are usually made to large
companies with good credit ratings
Monetary Policy Tools
•As you read, one of the Feds roles is to help
stabilize the macro economy.
•Monetary policy refers to the actions the Fed
takes to control the money supply, influencing
the level of real GDP and the rate of inflation
in the economy.
Money Creation
• The Department of the Treasury is responsible
for manufacturing money.
• Federal Reserve is responsible for putting
dollars into circulation..
Money Creation Contd.
• Recall from Chapter 15 the multiplier effect of
government spending.
• The multiplier effect of government in fiscal
policy holds that every one dollar in fiscal
policy creates a change greater than one dollar
in the economy.
How Banks Create Money
• Money creation does not mean the printing of
money.
• Banks create money not by printing it, but by
simply going about their business.
How Banks Create Money
• For example, suppose you take out a loan of
1,000.
• You decide to deposit the money in a checking
account.
• Once you have deposited the money, you now
you have a balance.
How Banks Create Money
• Suppose in our example that the RRR is 0.1, or
10 percent.
• This means that your 1,000 dollar demand
deposit balance, the bank is allowed to lend
900 dollars.
• Let’s say the bank lends that 900 dollars to
Elaine, and she deposits it in her checking
account.
The Money Multiplier
• This process will continue until the loan
amount, and hence the amount of new money
that can be created, becomes very small.
• The amount of new money that will be created,
in the end, is given by the money multiplier
formula, which is calculated as 1divide RRR.
The Money Multiplier
• In our example the RRR 0.1, so the money
multiplier is 1 divided by 0.1 = 10.
• This means that the initial deposit 1,000
dollars will ultimately lead to a 10,000 dollar
increase in the money supply.
U.S. banks
• As of 1999 in the United States, banks were
required to hold three percent reserves against
demand deposit assets up to 49 million dollars
and ten percent on all demand deposit assets
exceeding 49 million dollars.
Real world
• In the real world however people hold some
cash outside of the banking system meaning
that some funds leak out of the money
multiplier process. Also banks sometimes hold
excess reserves which are reserves greater than
the required amounts.
Federal reserve
• The federal reserve has three tools for
adjusting the amount of money in the
economy. These tools are reserve
requirements, the discount rate, and open
market operations.
Reserve requirements
• the simplest way for the fed to adjust the
amount of reserves in the banking system is to
change the required reserve ratio. It is not,
however the tool most used by the fed.
• A reduction of the RRR would free up
reserves for banks, allowing them to make
more loans.
Increasing reserve requirements
• The process also works in reverse. Even a
slight increase in the RRR would force banks
to hold more money in reserves. This would
cause the money supply to contract or shrink.
Although changing reserve requirements can
be an effective way of changing the money
supply.
Cont. from last.
• The fed does not use this tool often because it
is disruptive to the banking system. Even a
small increase in the RRR would force banks
to call in significant numbers of loans that is
to require the borrower. For this reason the fed
rarely changes reserve requirements.
Discount rate
• The discount rate is the interest rate that the
federal reserve charges on loans to financial
institutions. Banks borrow from the fed to
maintain reserves at the required level.
Changes in the discount rate affect the cost of
borrowing from the fed.
Cont.
• In turn changes in the discount rate can affect
the prime rate. Which is the interest rate of
banks charge on short term loans to their best
customers usually large companies with good
credit rating could be those customers.
Changes in the discount rate are reflected in
the prime rate.
Reducing discount rate
• If the fed wants to encourage banks to lend
more of their reserves it may reduce the
discount rate. With a lower discount rate banks
can reduce their excess reserves by lending
them out. They wont have to worry about their
reserves falling too low. They can add to their
reserves by borrowing from the fed at a low
rate.
Open Market Operations
• The most important monetary policy
tool is open market operations
• Open market operations are by far
the most-used monetary policy tool
Bond Purchase
• When the Federal Open Market Committee
chooses to increase the money supply, it orders
the trading desk at the Federal Reserve Bank
of New York to purchase a certain amount of
government securities on the open market
• The Federal Reserve bank buys these
securities with a check drawn on federal
reserve funds
Bond Purchases (cont.)
• The bond seller then deposits the money
from the bond sales in its bank
• In this way, funds enter the banking
system, setting in motion the money
creation process described earlier
Bond Sales
• If the FOMC chooses to decrease the
money supply, it must make an open
market bond sale.
• In this case, the Fed sells government
securities back to bond dealers, receiving
from them checks drawn on their own
banks
Bond Sales (cont.)
• After the Fed processes these checks, the
money is out of circulation.
• This operation reduces reserves in the
banking system
• Banks will reduce their outstanding loans
in order to keep reserves at the required
levels
Using Monetary Policy Tools
• Open market operations are the most used
of the Federal Reserve’s monetary policy
tools.
• They can be conducted smoothly and on
an ongoing basis to meet the Fed’s goals
• The Fed changes the discount rate less
frequently
Using Monetary Policy Tools (cont.)
• It usually follows a policy of keeping the
discount rate in line with other interest
rates in the economy in order to prevent
excess borrowing by member banks from
the Fed.
• Today the Fed doesn’t change reserve
requirements to conduct monetary policy.
Using Monetary Policy Tools (cont.)
• Changing reserves requirements would
force banks to make drastic changes in
their plans
• Open market operations or changes in the
discount rate do not disrupt financial
institutions however.
Question 1
What is money creation?
Question 2
What is required
reserve ratio (RRR)?
Question 3
State the money
multiplier formula.
Question 4
If the discount rate rose,
would you expect the prime
rate to rise or fall?
Question 5
What are Open Market
Operations?
Question 6
What are excess reserves?
Question 7
What is the Prime Rate?
Question 8
When Bonds circulating are
up, the Money supplies are
________?
Question 9
If you deposit $1,000 in your checking account,
then your $1,000 deposit minus the $100 in
reserves is loaned to Elaine, who gives it to
Joshua. Joshua’s $900 deposit minus $90 in
reserves is loaned to another customer. By this
point the money supply has increased to
________?
Question 10
If reserve requirements go
up, then the total money
supply reacts how?