- open market operations ( OMO )
- changing the discount rate ( DR )
- changing the require reserve ratio ( RR )
PREVIEW OF HOW MONETARY POLICY WORKS
Easy money policy, or expansionary monetary policy, designed to decrease unemployment:
FED
TOOLS ER MS Int. Rates I AD
Tight money policy, or contractionary monetary policy, designed to decrease inflation:
FED
TOOLS ER MS Int. Rates I AD
Goldsmith Banking: the origin of the FRACTIONAL RESERVES system of banking
Money Creation and Reserves In the 16th century gold was used as a medium of exchange (money) Goldsmiths had safes for gold and precious metals. Often consumers and merchants would keep their gold (money) in these safes. The goldsmiths then issued receipts for these deposits. These receipts came to be used as MONEY in place of gold because of their convenience. Goldsmiths became aware that much of the stored gold was never redeemed, people just used the receiptsGoldsmiths realized they could "loan" gold by issuing more receipts to borrowers, who agreed to pay back gold plus interest. HENCE, THE GOLDSMITHS CREATED MONEY. Such loans began "fractional reserve banking," because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold. Significance of fractional reserve banking: banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves).
Bank panics and Regulation
Note that the amount of gold in the goldsmith's safe was less than the value of the receipts circulating as money. Present day banks also lend more than the deposits on hand. This means that not all depositors can get their money back at once. We cannot all go to the back and get all of our money out at the same time. If we tried it is called a "run" on the back. You probably have seen this in the Christmas movie "It's a Wonderful Life.Therefore lending policies must be prudent to prevent bank "panics" or "runs" by depositors worried about their funds. Also, runs on banks are prevented by the U.S. government's deposit insurance system by insuring deposits up to $100,000.
The Money Creation Process
There are two interesting things that we will learn in this chapter. FIRST, banks create money when doing their normal business of accepting deposits and making loans. When banks make loans they create money. remember from chapter 12 that money (M1) is currency (coins and bills) AND checkable deposits. When I got a loan for my boat the bank called me up and said that they deposited the loan in my checking account. This new deposit is NEW MONEY created by the bank. they just turned on their computer, logged into my account, and changed the amount that I had. They created money. The Federal Reserve has tool that it can use to control how much money banks create.
To understand the money creation process we first need to learn about the balance sheet of a bank
Balance Sheet of a Bank A balance sheet states the assets and liabilities of a bank at some point in time. "Assets" are things of value that the bank OWNS and "claims" are what the bank OWES.All balance sheets must balance, that is, the value of assets must equal value of claims.
a. The bank owners claim is called net worth. The bank owes this to its ownersb. Nonowners claims are called liabilities.
Basic equation: Assets = liabilities + net worth. (Assets = Claims)
- cash in the vault
- deposits at the Fed. (All member banks keep deposits at the Fed. Nonmember banks keep deposits at a member bank. These deposits are used by the Fed to help banks "clear" checks.)
- loans made to customers
- government securities (bonds) bought by the banks
- Other (the building, computers, land, etc.)
b. liabilities = what a bank OWES
- Checking deposits of customers (called Demand Deposits or DD)
- Savings Accounts and CDs of customers
- Loans borrowed by the bank from the Fed or other banks
Net worth is what is left over IF a bank goes out of business selling all of its assets and paying off all of its liabilities. Assets - Liabilities = Net Worth
They are also called "owner's equity". It's what the owners of the bank have in the bank, i.e. what is left over after seeing their assets and paying off their liabilities.
c. SUMMARY: the balance sheet or T-account:
- cash in the vault
- deposits at the Fed. (all member banks keep deposits at the Fed. Nonmember banks keep deposits at a member bank. These deposits are used by the Fed to help banks "clear" checks.
- loans made to customers
- government securities (bonds) bought by the banks
- Other (the building, computers, land, etc.)
- NOTE! Students often forget this .
- RR = Legal Reserve Ratio
- Liabilities are the Demand Deposits or DD
- The required reserves are a requirement of all banks.
- Banks must keep a fraction of their reserves that they can not use.
- These are not kept to pay back depositors.
- The required reserves are required by the Fed as a means to control the money supply (see chapter 14).
- See: http://www.federalreserve.gov/monetarypolicy/reservereq.htm
The require reserve ratio is 0% for many small banks.
| The Fed's Reserve Requirements for Banks: | ||
| Type of liability | Current Requirements | Legal limits |
|---|---|---|
| Checkable Deposits | ||
| $0 to $7.8 million | 0 | 3% |
| $7.8 million to $48.3 million | 3 | 3% |
| More than $48.3 million | 10 | 8-14% |
| Noncheckable personal savings and time deposits | 0 | 0-9% |
- pay back depositors (like when I write a check - my bank uses its excess reserves to cover that check)
- to make loans (this is one way that banks earn revenue)
- to buy government securities (another way for banks to earn revenue - it is like loaning funds to the US government)
4. Reserve Formulas Summary:
| Total Reserves = cash in vault + Deposits at Fed. Required Reserves = RR x Liabilities Excess Reserves = Total Reserves - Required Reserves |
How a bank creates money when it grants a loan: A Single Bank and a Cash Deposit
WORKSHEET Print the following to use while going through this worksheet:
moneycreblank.htm
The worksheet should teach you :
- the bank's balance sheet
- M1 (the money supply) - HINT: there is no effect
- Know the balance sheet changes when the loan is granted (see below)
- Know the balance sheet changes when the check is cleared (see below)
- a single bank, and
- the banking system when there is an increase in excess reserves
- NOTE: there is a MULTIPLIER effect here
Banks create money during their normal operations of accepting deposits and making loans. In this example we'll use M1 as our definition of money. (M1 = currency in our pockets and balances in our checking accounts.) When a bank makes a loan it creates money. For example when I got a loan to buy my boat, my credit union called an told me that the loan was approved and that I should come in and get the check. I told them to just deposit it in my checking account. So they did. They turned on their computers, typed in my account number, and added the loan to my checking account balance. I now had more money (M1). The bank created this money when they gave me the loan.
To learn how banks create money during their normal activities of accepting deposits and making loans lets assume that a $10 bill is deposited in the First National Bank (FNB). We will use the balance sheets of banks to see the effects. Our balance sheets will only show the CHANGES made to them. Our study guide has problems where they show actual (but hypothetical) amounts in the bank's T-account.
Major Point: An initial increase in funds available to the banking industry results in a MULTIPLE increase in the money supply.
There is a Three Step Process per Round:
- An increase in demand deposits or other liabilities of a bank increases the banks reserves.
- Bank can make loans equal to its excess reserves. Loans made by increasing demand deposits.
- The loan check is spent, deposited in a different bank, and CLEARS. First bank now has no excess reserves, but second does and can therefore make a loan.
- Liabilities are the Demand Deposits or DD
- RR is the Required Reserve ration set by the Fed
- NOTE: a common error is that students calculate the Required Reserves by: RR x Reserves. DON'T DO THIS!. To calculate the Required Reserves: RR x Liabilities
- CORRECT: Req. Res = RR x Liabilities
- WRONG: Req. Res = RR x Reserves
Excess Reserves = Total Reserves - Required Reserves
- make loans
- pay back depositors when they remove their funds from their accounts (like write a check)
Change in Money Supply = Initial Excess Reserves x Money Multiplier
Money Multiplier = 1 / RR
These two formulas are very important!- Total Reserves = Cash in vault + Deposits at Fed.
- Required Reserves = RR x Liabilities
- Excess Reserves = Total Reserves - Required Reserves
- Change in Money Supply = Initial Excess Reserves x Money Multiplier
- Money Multiplier = 1 / RR
Required Reserve Ratio = 20%
FNB = First National Bank
SNB = Second National Bank
TNB = Third National BankER = excess reserves
DD = Demand Deposits (checking account deposits = liabilities)All banks initially have no excess reserves
Banks make loans equal to their excess reserves (This is not always true - see textbook)
$10 cash is deposited in a checking (DD) account at FNB
The CHANGES in the balance sheets of each bank as a result of this $10 cash deposit and the increased loan making ability of the banks.
I strongly suggest that you print out a blank copy of the table below, if you haven't already done so, (see: moneycreblank.htm) and fill it in as you go through this lecture. You should actually do the calculations.
Step 1: $10 deposited in FNB
The $10 bill becomes cash in the bank's vault so it becomes part of the bank's reserves. the deposit in the customer's checking account is a liability to the bank. Note that the balance sheet still balances.
Now calculate the changes in the bank's excess reserves:
Total Reserves = cash in vault + Deposits at Fed = 10Required Reserves = RR x Liabilities = .20 x 10 = 2
Excess Reserves = Total Reserves - Required Reserves = 10 - 2 = 8
Step 2: FNB makes loan equal to its excess reserves
We will assume that when the bank makes a loan for $8 (the amount of its excess reserves above) it credits the borrower's checking account. THIS IS NEWLY CREATED MONEY !
Note that the balance sheet still balances: the $8 loan is an asset to the bank and the $8 credited to the borrower's checking account (DD) is an additional liability.
Now calculate the changes in the bank's excess reserves:
Total Reserves = cash in vault + Deposits at Fed. = 10
Required Reserves = RR x Liabilities = .20 x 18 = 3.60
Excess Reserves = Total Reserves - Required Reserves = 10 - 3.60 = 6.40
You may notice that the FNB still has excess reserves BUT Excess Reserves are used by banks to:
- make loans
- buy government securities AND
- pay back depositors when they remove their funds from their accounts (like write a check)
and since the FNB just made a loan it can figure that the borrower will probably spend it, so they better keep some excess reserves available to pay back depositor's when they remove their funds from their accounts (like write a check)
KNOW: The most money that a SINGLE bank can safely create is equal to its initial excess reserves .
The Banking System: Multiple Deposit Expansion (all banks combined)
Step 3: Loan is spent, deposited in SNB, and the check clears
Sure enough, the borrower did spend the loan by writing a check which was deposited in the SNB.
When the check clears, the FNB sends the SNB $8 of its reserves. So the reserves of the FNB go down by $8, to $2, and the reserves at the SNB go up by $8. Since all banks either directly or indirectly have deposits at the Fed, checks can clear rapidly simply by having the Fed transfer the funds ($8 from the Fed account of the FNB to the Fed account of the SNB).
Now calculate the changes in the bank's (FNB) excess reserves:
Total Reserves = cash in vault + Deposits at Fed. = 2Required Reserves = RR x Liabilities = .20 x 10 = 2
Excess Reserves = Total Reserves - Required Reserves = 2 - 2 = 0
With no more excess reserves, the FNB cannot make any more loans. (It was a good idea not to make another loan when they had ER of $6.40.)Step 1: Check from round one deposited in SNB
Now the SNB has $8 more reserves (this was transferred from the FNB to cover the check from a depositor of that bank.) and therefore $6.40 in additional excess reserves. It also has $8 in additional liabilities, when an $8 check from a customer of the FNB is spent and then deposited in the SNB.
To calculate the changes in the bank's excess reserves: Total Reserves = cash in vault + Deposits at Fed. = 8Required Reserves = RR x Liabilities = .20 x 8 = 1.60
Excess Reserves = Total Reserves - Required Reserves = 8 - 1.60 = 6.40
Step 2: SNB makes loan equal to its excess reserves
And the process continues . . . . The SNB can now make a loan equal to its new excess reserves ($6.40). This will be NEW MONEY, increasing the Money Supply !
- make loans
- buy government securities AND
- pay back depositors when they remove their funds from their accounts (like write a check)
Step 3: Loan is spent, deposited in TNB, and the check clears
The loan is spent and after covering the check (transferring reserves to the bank where the check was deposited (the TNB), the SNB has no additional excess reserves. It was a good idea not to make another loan.
Step 1: Check from round two deposited in TNB But the TNB now has new excess reserves.
The $ 6.40 loan from the SNB was spent and then deposited in the TNB (DD + $6.40). when the check clears the SNB transfers $ 6.40 from its reserves to the TNB. With these new reserves and new liabilities, the TNB now has $5.12 in new excess reserves.
To calculate the changes in the bank's excess reserves:
Total Reserves = cash in vault + Deposits at Fed. = 6.40Required Reserves = RR x Liabilities = .20 x 6.40 = 1.28
Excess Reserves = Total Reserves - Required Reserves = 6.40 - 1.28 = 5.12
The TNB can now make a loan equal to $5.12. this would be NEW MONEY.
SUMMARY: Money Supply Changes:
1. How much money was created in round one? ____ $ 8 ____
2. How much money was created in round two? ____ $ 6.40 _
3. How much money can be created in round three? ____ $ 5.12 _
If the process continued with each additional bank making loans equal to its excess reserves, the maximum possible change in the money supply will be:
Total Change in Money Supply = initial excess reserves X money multiplier4. What is the money multiplier? _____ 5 ______
money multiplier = 1/RR - 1/.2 = 55. What is the maximum total increase in the money supply that can occur as a result of the initial $10 cash deposit? ____ $ 40 _____
Change in the MS = ER x money multiplier = $8 x 5 = $40
6. What are the limitations on this money creation process?
The formula above gives us the MAXIMUM possible change in the money supply. The chapters discussion of bank credit is in terms of the maximum money-creating potential that would probably not ever be reached due to these modifications introduced at the end of this chapter:
_____ 1) banks may hold ER _______________________
_____ 2) people may hold money _________________________
_____ 3) the required reserve ratio _______________________
To print the completed worksheet: moneycredone.htm
When banks or the Federal Reserve buy government securities from the public
Transaction 7: When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does (see Balance Sheet 7). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer's checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly.
Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does.
OUTLINE - CHAPTER 13 - MONEY CREATION
I. Learning objectives - In this chapter students will learn:
A. Why the U.S. banking system is called a "fractional reserve" system.
B. The distinction between a bank's actual reserves and its required reserves.
C. How a bank can create money through granting loans.
D. About the multiple expansion of loans and money by the entire banking system.
E. What the monetary multiplier is and how to calculate it.
II. Introduction: Although we are fascinated by large sums of currency, people use checkable deposits for most transactions.
A. Most transaction accounts are "created" as a result of loans from banks or thrifts.
B. This chapter demonstrates the money creating abilities of a single bank or thrift and then looks at that of the system as a whole.
C. The term depository institution refers to banks and thrift institutions, but in this chapter the term bank will be often used generically to apply to all depository institutions.
III. The Fractional Reserve System: The Goldsmiths
A. Banks in the U.S. and most other countries are only required to keep a percentage (fraction) of checkable deposits in cash or with the central bank.
B. In the 16th century goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants. They issued receipts for these deposits.
C. Receipts came to be used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed.
D. Goldsmiths realized they could "loan" gold by issuing receipts to borrowers, who agreed to pay back gold plus interest.
E. Such loans began "fractional reserve banking," because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.
F. Significance of fractional reserve banking:
1. Banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves).2. Lending policies must be prudent to prevent bank "panics" or "runs" by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics.
IV. A Single Commercial Bank
A. A balance sheet states the assets and claims of a bank at some point in time.
B. All balance sheets must balance, that is, the value of assets must equal value of claims.
1. The bank owners' claim is called net worth.2. Nonowners' claims are called liabilities.
3. Basic equation: Assets = liabilities + net worth.
C. Formation of a commercial bank: Following is an example of the process.
1. In Wahoo, Nebraska, the Wahoo bank is formed with $250,000 worth of owners' stock shares (see Balance Sheet 1).
2. This bank obtains property and equipment with some of its capital funds (see Balance Sheet 2).
3. The bank begins operations by accepting deposits (see Balance Sheet 3).
4. Bank must keep reserve deposits in its district Federal Reserve Bank (see Table 13.1 for requirements).
a. Banks can keep reserves at Fed or in cash in vaults ("vault cash").b. Banks keep cash on hand to meet depositors' needs.
c. Required reserves are a fraction of deposits, as noted above.
D. Other important points:
1. Terminology: Actual reserves minus required reserves are called excess reserves.
2. Control: Required reserves do not exist to protect against "runs," because banks must keep their required reserves. Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create. In other words, required reserves help the Fed control credit and money creation. Banks cannot loan beyond their excess reserves.
3. Asset and liability: Reserves are an asset to banks but a liability to the Federal Reserve Bank system, since now they are deposit claims by banks at the Fed.
E. Continuation of Wahoo Bank's transactions:
1. Transaction 5: A $50,000 check is drawn against Wahoo Bank by Mr. Bradshaw, who buys farm equipment in Surprise, Nebraska. (Yes, both Wahoo and Surprise exist).
2. The Surprise company deposits the check in Surprise Bank, which gains reserves at the Fed, and Wahoo Bank loses $50,000 reserves at Fed; Mr. Bradshaw's account goes down, and Surprise implement company's account increases in Surprise Bank.
3. The results of this transaction are shown in Balance Sheet 5.
F. Money-creating transactions of a commercial bank are shown in the next two transactions.
1. Transaction 6: Wahoo Bank grants a loan of $50,000 to Gristly in Wahoo (see Balance Sheet 6a). a. Money ($50,000) has been created in the form of new demand deposit worth $50,000.
b. Wahoo Bank has reached its lending limit: It has no more excess reserves as soon as Gristly Meat Packing writes a check for $50,000 to Quickbuck Construction (See Balance Sheet 6b).
c. Legally, a bank can lend only to the extent of its excess reserves.
2. Transaction 7: When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does (see Balance Sheet 7). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer's checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly.
3. Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does.
G. Profits, liquidity, and the federal funds market:
1. Profits: Banks are in business to make a profit like other firms. They earn profits primarily from interest on loans and securities they hold.
2. Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and to meet check clearing transactions.
3. Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other's available reserves on an overnight basis. The rate paid is called the federal funds rate.
V. The Banking System: Multiple Deposit Expansion (all banks combined)
A. The entire banking system can create an amount of money which is a multiple of the system's excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.
B. Three simplifying assumptions:
1. Required reserve ratio assumed to be 20 percent. (The actual reserve ratio averages 10 percent of checkable deposits.)2. Initially banks have no excess reserves; they are "loaned up."
3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender.
C. System's lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system's lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B. See further lending effects on Bank C. The possible further transactions are summarized in Table 13.2.
D. Monetary multiplier is illustrated in Table 13.2.
1. Formula for monetary or checkable deposit multiplier is: Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.
2. Maximum deposit expansion possible is equal to: excess reserves monetary multiplier, or
3. Figure 13.1 illustrates this process.
4. Higher reserve ratios generate lower money multipliers.
a. Changing the money multiplier changes the money creation potential.
b. Changing the reserve ratio changes the money multiplier but be careful! It also changes the amount of excess reserves that are acted on by the multiplier. Cutting the reserve ratio in half will more than double the deposit creation potential of the system.
E. The process is reversible. Loan repayment destroys money, and the money multiplier increases that destruction.
VI. LAST WORD: The Bank Panics of 1930-1933
A. Bank panics in 1930 33 led to a multiple contraction of the money supply, which worsened Depression.
B. Many of failed banks were healthy, but they suffered when worried depositors panicked and withdrew funds all at once. More than 9000 banks failed in three years.
C. As people withdrew funds, this reduced banks' reserves and, in turn, their lending power fell significantly.
D. Contraction of excess reserves leads to multiple contraction in the money supply, or the reverse of situation in Table 13.2. Money supply was reduced by 25 percent in those years.
E. President Roosevelt declared a "bank holiday," closing banks temporarily while Congress started the Federal Deposit Insurance Corporation (FDIC), which ended bank panics on insured accounts.
