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M1: The Narrowest Definition of the Money Supply: Means of Payment How Is Money Measured in the United States Today? Measuring the Money Supply, May 2007.

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Presentation on theme: "M1: The Narrowest Definition of the Money Supply: Means of Payment How Is Money Measured in the United States Today? Measuring the Money Supply, May 2007."— Presentation transcript:

1 M1: The Narrowest Definition of the Money Supply: Means of Payment How Is Money Measured in the United States Today? Measuring the Money Supply, May 2007 M2: A Broader Definition of Money What about Credit Cards and Debit Cards?

2 How Banks Create Money Balance Sheet for Wachovia Bank, December 31, 2006

3 Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve = R Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits = RR. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves RR = r D.

4 How Banks Create Money in a Fractional Reserve Banking System: Using T-Accounts

5 How Banks Create Money Now PNC has excess reserves and can make a loan

6 How Banks Create Money: The multiple creation of money and credit BANKINCREASE IN CHECKING ACCOUNT DEPOSITS Wachovia$1,000 PNC+ 900(= 0.9 x $1,000) Third Bank+ 810(= 0.9 x $900) Fourth Bank+ 729(= 0.9 x $810) Total Change in Checking Account Deposits =$10,000 Deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. The Simple Deposit Multiplier versus the Real-World Deposit Multiplier: People hold currency and banks hold excess reserves, slowing multiple creation of deposits and credit Simple deposit multiplier = 1/r

7 Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve = R = RR + ER = rD + eD Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits = RR. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves RR = r D. Excess reserves Reserves that banks hold over and above the legal requirement. ER = e D

8 The Money Supply Model Money = Currency plus checkable deposits: M1 M = C + D The monetary base (MB)the assets of the central bank backs the money supply The CBs assets = MB =The CBs liabilities = C + R The Fed controls the monetary base (MB) better than it controls reserves … but it doesnt perfectly control MB MB = MB n + BR The money supply (M) is a multiple m of the monetary base M = m x MB = m x (MB n + BR)

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10 Factors that Affect The Money Multiplier Changes in the required reserve ratio r –The money multiplier and the money supply are negatively related to r Changes in the currency ratio c –The money multiplier and the money supply are negatively related to c Changes in the excess reserves ratio e –The money multiplier and the money supply are negatively related to the excess reserves ratio e –The excess reserves ratio e is negatively related to the market interest rate –The excess reserves ratio e is positively related to expected deposit outflows

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16 Money and the Great Depression The Great Contraction in monetarist analysis Banking Crises –Currency holdings –Excess reserve holdings –Monetary contraction

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