1

Money Creation

©2006 South-Western College Publishing

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 arerequired reserves?The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed

8

What is arequired reserve ratio?The percentage of deposits that the Fed requires a bank to hold in vault cash or on deposit with the Fed

Money Creation

When a bank makes a loan from its reserves, the money supply increases.

10

What are the three steps in the

creation of money?• Accepting a new deposit• Making a loan• Clearing the loan check

11

Accepting a new deposit, what conclusion?

Transferring currency to a bank and moving deposits from one bank to another do not affect the money supply (M1)

12

Making a loan, what conclusion?

When a bank makes a loan, it creates deposits, and the money supply increases by the amount of the loan because the money supply includes checkable deposits

13

Clearing the loan check, what conclusion?

Now the money can be used for new purchases

14

What is themoney multiplier?

The maximum change in the money supply due to an initial change in the excess reserves banks hold

15

What is the money multiplier equal to?

1 / required reserve ratio

The Money Multiplier

How much money is eventually created in this economy?Original deposit = $ 100.00First National lending = $ 90.00 [=0.9 x $100.00]Second National lending = $ 81.00 [=0.9 x $90.00]Third National lending = $ 72.90 [=0.9 x $81.00]

Total money supply = $1,000

17

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

18

What would the Fed with inflation?Decrease the money supply

What would the Fed do with unemployment?Increase the money supply

19

What ismonetary policy?

The Fed’s use of - • open market operations in discount rate in required reserve ratio

20

What are open market operations?

The buying and selling of government securities by the Federal Reserve System

Open-Market Operations

• The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: When the Fed buys government bonds, the

money supply increases. The money supply decreases when the Fed

sells government bonds.

22

What is thediscount rate?

The interest rate the Fed charges on loans of reserves to banks

Changing the Discount Rate

• The discount rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the

money supply. Decreasing the discount rate increases the

money supply.

24

What would the Fed do if we have inflation?

A higher discount rate discourages banks from borrowing reserves and making loans

25

What would the Fed do if we have

unemployment?

A lower discount rate encourages banks to borrow reserves and make more loans

26

What is the federal funds market?

A private market in which banks lend reserves to each other for less than 24 hours

27

What is the federal funds rate?

The interest rate banks charge for overnight loans to other banks

28

What would the Fed do if we had inflation?

A higher federal funds rate discourages banks from borrowing reserves and making loans

29

What would the Fed do if we had

unemployment?A lower federal funds rate encourages banks to borrow reserves and make more loans

30

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

31

What is the required reserve ratio?

That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement

Changing the Discount Rate

• The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. Increasing the reserve requirement

decreases the money supply. Decreasing the reserve requirement

increases the money supply.

33

If the reserve ratio is one tenth, what is the multiplier?

1 1/10 = 10

34

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

35

Is changing the reserve ratio a popular

monetary tool?No, changing the reserve ratio is considered a heavy-handed approach and is thus infrequently used

36

What are the shortcomings of monetary policy?

• Money multiplier inaccuracy• Nonbanks• Which money definition should the Fed control?

• Lag effects