chapter 16 money creation and deposit insurance. copyright © 2008 pearson addison wesley. all...
TRANSCRIPT
Chapter 16
Money Creation and Deposit Insurance
Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16-2
Introduction
Smart cards permit people to use digital cash, which consists of funds contained in software programs called digital algorithms.
By the time you finish this chapter, you will understand how the use of digital cash may affect the quantity of money in circulation.
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Learning Objectives
• Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions
• Understand why the money supply is unaffected when someone deposits in a depository institution funds transferred from a transactions account at a another depository institution
• Explain why the money supply changes when someone deposits in a depository institution funds transferred from the Federal Reserve System
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Learning Objectives (cont'd)
• Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities
• Discuss the ways in which the Federal Reserve conducts monetary policy
• Explain the essential features of federal deposit insurance
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Chapter Outline
• Links Between Changes in the Money Supply and Other Economic Variables
• Depository Institution Reserves
• The Relationship Between Reserves and Total Deposits
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Chapter Outline (cont'd)
• The Fed’s Direct Effect on the Overall Level of Reserves
• Money Expansion by the Banking System
• The Money Multiplier
• Federal Deposit Insurance
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Did You Know That…
• Through actions initiated by a central bank such as the Federal Reserve, depository institutions together create money?
• In this chapter, we shall examine the money multiplier process, which explains how an injection of new money into the banking system leads to an eventual multiple expansion in the total money supply.
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Links Between Changes in the Money Supply and Other Economic Variables
• There are links between changes in the money supply and changes in GDP.
• There are links between changes in the money supply and the rate of inflation.
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Figure 16-1 Money Supply Growth versus the Inflation Rate
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Links Between Changes in the Money Supply and Other Economic Variables (cont'd)
• Fractional Reserve Banking
A system in which depository institutions hold reserves that are less than the amount of depositsOriginated when goldsmiths issued notes that
exceeded the value of gold and silver on hand
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Depository Institution Reserves
• What do you think?
Can banks pay off all of their depositors?
How is it possible that they can pay them off eventually but not pay them off simultaneously?
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Depository Institution Reserves (cont'd)
• In a fractional reserve banking system, banks do not keep sufficient reserves on hand to cover 100% of their depositors' accounts.
• There are three distinguishable types of reserves: legal, required and excess.
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Depository Institution Reserves (cont'd)
• Reserves
In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash
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Depository Institution Reserves (cont'd)
• Legal Reserves
Anything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash
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Depository Institution Reserves (cont'd)
• Required Reserves
The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed
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Depository Institution Reserves (cont'd)
• Question Do banks set their own reserve rate?
• Answer No, the Federal Reserve sets the
reserve requirementCurrently it is 10% on most transactions
deposits
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Depository Institution Reserves (cont'd)
• 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
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Depository Institution Reserves (cont'd)
• Excess Reserves
The difference between legal reserves and required reserves
Excess reserves = Legal reserves – Required reserves
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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.
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
• We assume1. Reserve ratio is 10%
2. Transactions deposits are the bank’s only liabilities and loans are the bank’s assets
3. An individual bank can lend as much as legally allowed
4. Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn)
5. Zero excess reserves are kept
6. Banks have zero net worth
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
• Net Worth
The difference between assets and liabilities
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
Description of a Balance Sheet
Assets Liabilities
What is owned Reserves Loans
What is owed Deposits
Net Worth = Assets – Liabilities
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Reserve Ratio = 10%
Balance Sheet 16-1 Typical Bank
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
Assets Liabilities
Balance Sheet: Typical Bank
Assume a depositor deposits in Typical Bank a $100,000 debit-card payment drawn on a transactions account at another depository institution.
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Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million.
Balance Sheet 16-2 Typical Bank
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Required reserves = .10 $1,100,000 = $110,000
Excess reserves = $200,000 – $110,000 = $90,000
The Relationship Between Legal Reserves and Total Deposits (cont'd)
• Following the deposit What are the required reserves of
Typical Bank?
Does Typical Bank have excess reserves?
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Balance Sheet 16-2 Typical Bank (cont'd)
Typical Bank has required reserves of $110,000 and excess reserves of $90,000.
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
• Following the deposit
What will Typical Bank do with its excess reserves?Loan them out
Could Typical Bank safely loan out more than its excess reserves?By law holds a certain amount of
required reserves
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Typical Bank lends $90,000, but the borrowers do not leave this amount on deposit at Typical Bank.
Balance Sheet 16-3 Typical Bank
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
• What do you think? Did this loan expand the money supply?
• Hints Have the reserves of the banking
system changed?
What happened to the loan balance at the bank where the deposit came from?
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The Relationship Between Legal Reserves and Total Deposits (cont'd)
• Effect on the money supply
New reserves for the banking system as a whole are not created when debit-card or check payments are transferred from one bank and deposited in another bank.
The Federal Reserve System can however, create new reserves—the subject of our next section.
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The Fed’s Direct Effect on the Overall Level of Reserves
• The Federal Open Market Committee (FOMC)
Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds
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The Fed’s Direct Effect on the Overall Level of Reserves (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
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The Fed buys $100,000 ofU.S. government securities.
Balance Sheet 16-4
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The reserves and the money supply increase by $100,000.
Balance Sheet 16-4
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Now the Fed sells $100,000 of U.S. government securities.
Balance Sheet 16-5
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The bank’s reserves and money supply both fall by $100,000.
The Fed’s Direct Effect on the Overall Level of Reserves (cont'd)
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Money Expansion by the Banking System
• Consider the entire banking system; for practical purposes, we can look at all depository institutions taken as a whole.
• To understand how money is created, we must understand how depository institutions respond to Fed actions that increase reserves in the entire system.
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This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security.
Balance Sheet 16-6 Bank 1
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Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000.
Balance Sheet 16-7 Bank 1
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Figure 16-8 shows Bank 1 expands its loans by $90,000.
Balance Sheet 16-8 Bank 1
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The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out.
Balance Sheet 16-9 Bank 2 (Changes Only)
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Bank 2 makes a loan for $81,000, the amount of its excess reserves.
Balance Sheet 16-10 Bank 2 (Changes Only)
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Money Expansion by the Banking System (cont'd)
• Recall
The Fed bought a bond and deposited it at Bank 1, immediately increasing the money supply by $100,000.
The deposit creation process (in addition to the $100,000) occurs because of the fractional reserve banking system.
Banks will lend out any excess reserves as they can earn interest income on new loans.
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Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3.
Balance Sheet 16-11 Bank 3 (Changes Only)
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We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900).
Balance Sheet 16-12 Bank 3 (Changes Only)
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E-Commerce Example: Remote Capture Speeds the Check Clearing Process
• Traditional check-clearing typically takes one to three days to complete.
• Internet based institutions pioneered a concept called remote capture.
• Remote capture cuts the time to just an hour.
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Money Expansion by the Banking System (cont'd)
• Question
Looking over our balance sheets, how much do you think the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?
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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 Purchase by the Fed90,000 Loan by Bank 181,000 Loan by Bank 272,900 Loan by Bank 3
$343,900 Total
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Table 16-1 Maximum Money Creation with 10 Percent Required Reserves
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Figure 16-2 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent
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Money Expansion by the Banking System (cont'd)
• Only when additional new reserves and deposits are created by the Federal Reserve System does the money supply increase.
• The reverse process occurs when there is a decrease in reserves because the Fed sells $100,000 in government securities.
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The Money Multiplier
• Money Multiplier
Gives the maximum potential change in the money supply due to a change in reserves
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The Money Multiplier (cont'd)
Actual changein the money
supply= Actual money
multiplierChange in
total reserves
Potential money multiplier = 1
Required reserve ratio
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The Money Multiplier (cont'd)
• Example
Fed buys $100,000 of government securities
Reserve ratio = 10%
Potential changein the money
supply= $100,000 = $1,000,000x
1
.10
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The Money Multiplier (cont'd)
• Forces that reduce the money multiplier
LeakagesCurrency drains
Excess reserves
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The Money Multiplier (cont'd)
• Real-world money multipliers
M1 multiplier = 2.5–3.0
M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s
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Ways in Which the Federal Reserve Changes the Money Supply
1. Open market operations
2. Reserve requirement
3. Discount rate
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Ways in Which the Federal Reserve Changes the Money Supply (cont'd)
• Discount Rate
The interest rate that the Federal Reserve charges for reserves it lends to depository institutions
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Ways in Which the Federal Reserve Changes the Money Supply (cont'd)
• Federal Funds Market A private market in which banks can
borrow reserves from other banks that want to lend them
• Federal Funds Rate The interest rate that depository
institutions pay to borrow reserves in the interbank federal funds market
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Ways in Which the Federal Reserve Changes the Money Supply (cont'd)
• Today’s discount rate policy is to set discount rate above the federal funds rate.
• Question Why would the Fed do this?
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Ways in Which the Federal Reserve Changes the Money Supply (cont'd)
• Question What if the Fed changes reserve
requirements it imposes?
What if reserve requirements go from 10 to 20%?
• Answer Then the money multiplier changes from
10 to 5.
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Table 16-2 Required Reserve Ratios in Selected Nations
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Sweep Accounts and the Decreased Relevance of Reserve Requirements
• Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed.
• This feature allows banks to hold fewer reserves as savings deposits are exempt from reserve requirements.
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Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd)
• Sweep Account
A depository institution account that entails regular shifts of funds from transactions deposits that are subject to reserve requirements to savings deposits that are exempt from reserve requirements
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Figure 16-3 Sweep Accounts and Reserves of U.S. Depository Institutions at Federal Reserve Banks
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Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd)
• Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments.
• Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.
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Federal Deposit Insurance
• When businesses fail, they create hardships for creditors, owners and customers.
• When a depository institution fails even greater hardship results as many individuals and businesses depend on the safety and security of banks.
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Source: Federal Deposit Insurance Corporation
Figure 16-4 Bank Failures
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Federal Deposit Insurance
• Federal Deposit Insurance Corporation (FDIC) A government agency that insures the deposits
held in banks and most other depository institutions; all U.S. banks are insured this way.
• Bank Runs Attempts by many of a bank’s depositors to
convert transactions and time deposits into currency out of fear that the bank’s liabilities may exceed its assets
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Federal Deposit Insurance (cont'd)
• How deposit insurance causes increased risk taking by bank managers
Lack of correlation between risk taking and insurance premiums.
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Federal Deposit Insurance (cont'd)
• Deposit insurance, adverse selection, and moral hazard
Adverse selection arises when there is asymmetric information. Information possessed by one side of a
transaction but not the other
The side with more information will be at an advantage.
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Federal Deposit Insurance (cont'd)
• Deposit insurance, adverse selection, and moral hazard
Moral hazard arises as a result of information asymmetry after a transaction has occurred.
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Federal Deposit Insurance (cont'd)
• The results of moral hazard
The S&L crisis of the mid-1980s
More than 1,500 savings and loan associations failed.
The estimated taxpayer cost was $200 billion.
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Issues and Applications: Smart Cards, Digital Cash, and the Money Supply
• The microchips embedded in smart cards give them a technical edge over debit cards.
• At present, about 300 million smart cards are used around the globe.
• In a world in which people widely use digital cash the money multiplier would be larger.
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Figure 16-5 The Distribution of the World’s Smart Cards
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Summary Discussion of Learning Objectives
• How the Federal Reserve assesses reserve requirements Establishes a required reserve ratio,
currently 10%
• Why the money supply does not change when someone deposits in a depository institution funds transferred from another depository institution Because total deposits remain unchanged for the
banking system as a whole
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Summary Discussion of Learning Objectives (cont'd)
• Why the money supply does change when someone deposits in a depository institution funds transferred from the Federal Reserve System There is an immediate increase in total deposits in
the banking system as a whole
• The maximum potential change in the money supply following a Federal Reserve purchase or sale of U.S. government securities The multiplier
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Summary Discussion of Learning Objectives (cont'd)
• The Fed influences the money supply through Open market operations, the discount rate,
and the reserve requirement
• The FDIC was established in 1933 to prevent bank runs. Difficulties include adverse selection and
moral hazard
End of Chapter 16
Money Creation and Deposit Insurance