copyright © 2010 pearson addison-wesley. all rights reserved. chapter 16 money creation, the demand...
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Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Chapter 16
Money Creation, the Demand for Money, and Monetary Policy
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
16-2
Banks and Money
• As early as 1000 B.C., uncoined gold and silver were being used for money in Mesopotamia.
• Later, goldsmiths started issuing paper notes indicating that the bearers held gold or silver of given weights and on deposit with the goldsmith.
• These notes could be exchanged for goods and were the first paper currency.
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16-3
Banks and Money (cont’d)
• Reserves
– deposits held by Federal Reserve + the bank’s vault cash
• Fractional Reserve Banking– A system in which depository
institutions hold reserves that are less than the amount of deposits
• Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand
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16-4
Banks and Money (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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16-5
Banks and Money (cont’d)
• Excess Reserves
– The difference between actual reserves and required reserves
Excess reserves = Actual reserves – Required reserves
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16-6
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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16-7
Reserve Ratio = 10%
Balance Sheet 16-1 Typical Bank
Now: What if someone makes a deposit of $100,000 in Typical Bank?
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16-8
Typical Bank lends $990,000………
Balance Sheet 16-3 Typical Bank
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16-9
The Relationship Between Total Reserves and Total Deposits (cont'd)
• What do you think?– Did this loan expand the money supply?
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16-10
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 New Deposit90,000 Loan by Bank 181,000 Loan by Bank 272,900 Loan by Bank 3
$343,900 Total
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16-11
Table 16-1 Maximum Money Creation with 10 Percent Required Reserves
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16-12
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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16-13
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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16-14
Monetary Policy
Ways in Which the Federal Reserve Changes the Money Supply
• Open market operations
• Reserve requirement
• Discount rate
• Hint: Monetary policy involves the money supply and interest rates
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16-15
Money Expansion by the Banking System (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
• 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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16-16
The Money Multiplier (cont'd)
– Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.
• Discount Rate
– The interest rate that the Federal Reserve charges for reserves it lends to depository institutions
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16-17
The Money Multiplier (cont’d)
• Changes in the reserve requirements
– An increase (decrease) in the required reserve ratio
• Makes it more (less) expensive for banks to meet reserve requirements
• Reduces (expands) bank lending
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16-18
Reserve Ratios
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16-19
Why is the money supply important?
• There are links between changes in the money supply and changes in GDP (short run) and the rate of inflation (long run).
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16-20
Myth #16: As for money, the more the better
• The more money we have, other things being equal, the more you will spend only in dollar terms (not more in quantity) -- inflation