1. Chapter 20 The Instruments of Central Banking

2. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-2 KEY WORDS AND CONCEPTS BANK RESERVES RESERVE REQUIREMENT DEMAND DEPOSIT EXPANSION MULTIPLIER DISCOUNT RATE OPEN MARKET OPERATIONS – Buying and selling of government securities by the FED

3. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-3 Introduction Bank lending and money supply are related to the level of bank reserves FED has control over bank lending and money supply by changing the level of reserves in the system and the demand deposit expansion multiplier. The Fed helps with deposit creation for banks. Fed does this by changing the reserve requirements and by changing the actual amount of reserves held by banks. Reserve requirements apply to all commercial banks.

4. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-4 Reserve Requirements With limits set by Congress, the FED determines the reserve amount banks must hold against deposits. Reserves can be in form of vault cash or deposits in regional bank—do not earn interest

5. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-5 Reserve Requirements

6. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 18-6 Deposit Expansion: The Banking System (From CH 19 p. 362) The demand deposit expansion multiplier is always the reciprocal of the reserve requirement ratio Where: is the simple multiplier

7. THE MONEY MULTIPLIER – US EXAMPLE 1.Member banks set up an account in the Federal Reserve Bank equaling the total of their savings and checking accounts $100,000 2.Fed requires a certain percent (10%) to be kept on reserveX.10 3.Reserve required$10,000 4.Balance basis for loans$90,000 5.Total amount is “multiplied” 10 time because the bank can create through loans, demand deposits equaling $10 for Each $1 it adds to its reserve.X 10 6. Total amount available to loan$900,000 The $90,000 is deposited into another bank ad the process starts over again

8. THE MONEY MULTIPLIER – US EXAMPLE 1.Money deposited into another bank$90,000 2.Fed requires a certain percent (10%) to be kept on reserveX.10 3.Reserve required$9,000 4.Balance basis for loans$81,000 5.Total amount is “multiplied” 10 time because the bank can create through loans, demand deposits equaling $10 for Each $1 it adds to its reserve.X 10 6. Total amount available to loan$810,000 The $81,000 is deposited into another bank ad the process starts over again

9. THE MONEY MULTIPLIER – US EXAMPLE 1.Money deposited into another bank$81,000 2.Fed requires a certain percent (10%) to be kept on reserveX.10 3.Reserve required$8,100 4.Balance basis for loans $72,900 5.Total amount is “multiplied” 10 time because the bank can create through loans, demand deposits equaling $10 for Each $1 it adds to its reserve.X 10 6. Total amount available to loan$72,900 The $72,900 is deposited into another bank ad the process starts over again

10. THE MONEY MULTIPLIER – CHINA EXAMPLE 1.Member banks set up an account in the People’s Bank of China equaling the total of their savings and checking accounts 100,000 rmb 2.Requires a certain percent (20%) to be kept on reserveX.20 3.Reserve required 20,000 rmb 4.Balance basis for loans 80,000 rmb 5.Total amount is “multiplied” 5 times because the bank can create through loans, demand deposits equaling 10 rmb for Each 2 rmb it adds to its reserve.X 5 6. Total amount available to loan400,000 rmb The 80,000 rmb is deposited into another bank ad the process starts over again

11. THE MONEY MULTIPLIER – CHINA EXAMPLE 1.Money deposited into another bank80,000 rmb 2.Fed requires a certain percent (10%) to be kept on reserveX.20 3.Reserve required 16,000 4.Balance basis for loans64,000 rmb 5.Total amount is “multiplied” 10 time because the bank can create through loans, demand deposits equaling 10 rmb for Each 2 rmb it adds to its reserve.X 5 6. Total amount available to loan 320,000 rmb The 64,000 is deposited into another bank ad the process starts over again

12. THE MONEY MULTIPLIER – CHINA EXAMPLE 1.Money deposited into another bank64,000 rmb 2.Fed requires a certain percent (10%) to be kept on reserveX.20 3.Reserve required 12,800 rmb 4.Balance basis for loans51,200 rmb 5.Total amount is “multiplied” 10 time because the bank can create through loans, demand deposits equaling 10 rmb for Each 2 rmb it adds to its reserve.X 5 6. Total amount available to loan256,000 rmb The 51,200 is deposited into another bank ad the process starts over again

13. HOW A BANK CREATES MONEY Money Creation and Reserve Requirements The graph shows the total amount of money that can be created with the addition of $100 in reserves, using different reserve requirements as examples.

14. CREATION OF DEPOSITS – MONEY MULTIPLIER

15. RESULT OF THE DEMAND DEPOSIT MONEY MULTIPLIER INCREASE IN THE MONEY SUPPLY AS BANKS HAVE MORE IN EXCESS RESERVES TO MAKE LOANS. THIS IS A DIRECT RESULT OF THE FED LOWERING THE RESERVE REQUIREMENT OF BANKS THIS IS DONE BY THE FED FOR WHAT REASON?

16. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-16 Reserve Requirements (Cont.) Effect of raising the reserve requirement –Decreases lending and deposit creation –Decreases the money supply

17. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-17 Reserve Requirements (Cont.) Even without legal reserve requirements, banks would still need to hold cash reserves as vault cash or on deposit with Federal Reserve –Cash to meet customer withdrawals –Balances at Fed to clear checks

18. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-18 Discounting and the Discount Rate DISCOUNT RATE—amount the Federal Reserve charges banks for a temporary loan of reserves to cover a deficit. Ability to borrow means that a bank does not need to call in loans or sell securities (reduce money supply) to deal with a deficit All depository institutions have access to borrowing from the FED, even if not a member of the FED.

19. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-19 Discounting and the Discount Rate Federal Reserve influences banks’ desire to borrow reserves by changing discount rate –Lower the rate—more borrowing, increase money supply –Raising the rate—less borrowing, decrease money supply Actual borrowing (changes in money supply) depends on banks’ willingness to use this service of the FED

20. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-20 Discounting and the Discount Rate Quantity of discount lending (Cont.) –Discounting is a privilege, not a right. Should only be used in emergencies. –Banks are supposed to use discount facility because of need, not to make profit

21. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-21 Discounting and the Discount Rate Relationship between discount rate and other market interest rates –Discount rate is set by FED –Figure 20.1 Change in the discount rate comes after a change in the Treasury bill rate or federal funds rate

22. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-22 Figure 20.1 Movements in the discount rate tend to come after Treasury bill rates

23. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-23 Open Market Operations p. 382 Fed’s most important tool to alter reserves About $4,000 billion worth of marketable government securities outstanding –Held by individuals, corporations, and financial institutions –Used by the US Treasury to borrow to finance budget deficits

24. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-24 Open Market Operations (Cont.) Open market operations— Buying and selling government securities to influence bank reserves –Purchase securities—expand reserves (money supply) –Sell securities—decrease reserves (money supply) –Fed sells or buys government securities to/from a bank, other financial institution, or individual

25. Open Market Purchase (Buy) of Securities from a Bank Government securities +1,000Deposit of Bank +1000 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-25 Federal Reserve Commercial Bank Deposits in Fed +1,000 Government Securities -1,000 The Fed buys 1000 in securities from a bank. The bank sends the 1000 to its regional FED bank and increases its excess reserves by 1000, so it can make more loans. If the FED wants to take away the reserve just the opposite takes place. The + signs become – and now the bank has 1000 less in reserve.

26. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-26 Conducting Open Market Operations The Federal Open Market Committee (FOMC) decides the goals of monetary policy and sets monetary targets (bank reserves, money supply, and interest rates)

27. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-27 DISCUSSION QUESTIONS 1.WHAT ARE BANK RESERVES? 2.WHAT ARE REQUIRED RESERVES? 3.WHO DETERMINES THE RESERVE RATIO? 4.WHAT DOES THE MULTIPLIER EFFECT DO? 5.WHAT IS THE FORMULA? 6.WHAT DOES RAISING THE RESERVE RATIO DO TO THE MONEY SUPPLY? 7.WHAT ABOUT LOWERING THE RESERVE RATIO?

28. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-28 DISCUSSION QUESTIONS 8. WHO SETS THE DISCOUNT RATE? 9. WHAT DOES LOWERING THE DISCOUNT RATE DO TO THE MONEY SUPPLY 10. WHAT IS OPEN MARKET OPERATIONS? 11. WHEN THE FED PURCHASES SECURITIES FROM THE BANK WHAT DOES THAT DO TO THE MONEY SUPPLY? 12. WHAT ABOUT SELLING SECURITIES TO THE BANK? 13. WHO CONDUCTS OPEN MARKET OPERATIONS?

29. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-29 CHAPTER 20 SUMMARY 1.All depository institutions are legally required to hold reserves in vault cash or deposits with the FED. 2.Reserve requirements apply to all commercial banks. 3.By changing the required reserves, the FED, alters bank excess reserves,which changes the money multiplier for banks. Lower required reserves means an increase in the money supply.

30. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-30 CHAPTER 20 SUMMARY 4. Higher reserves takes money out of the system to slow down the economy (decrease the money supply). 5. All banks can borrow from the FED through the discount window at the discount rate. By Lowering the rate = increase in the money supply. Increasing the rate=decrease in the money supply.

31. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 19-31 CHAPTER 20 SUMMARY 6. Open Market Operations – The FED buys or sells government securities to supply or take reserves from the banks. Buying securities = increase in money supply Selling securities = decrease in money supply 7. By changing bank reserves and the money supply, the FED alters liquidity of people’s money and their spending on goods and services, which grows the economy, increases the GDP, the level of unemployment, and the rate of inflation.