Presentation on theme: "Chapter 16: Money Creation and Deposit Insurance"— Presentation transcript:
1 Chapter 16: Money Creation and Deposit Insurance ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 16: Money Creation and Deposit InsuranceMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.11
2 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.
3 Fractional Reserve Banking Links Between Changes in the Money Supply and Other Economic Variables (cont'd)Fractional Reserve BankingA 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
4 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.
5 Depository Institution Reserves (cont'd) In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash
6 Depository Institution Reserves (cont'd) Legal ReservesAnything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash
7 Depository Institution Reserves (cont'd) Required ReservesThe value of reserves that a depository institution must hold in the form of vault cash or deposits with the FedThe Federal Reserve sets the reserve requirementCurrently it is 10% on most transactions deposits
8 Depository Institution Reserves (cont'd) Required Reserve RatioThe percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the FedRequired reserves = Transactions deposits Required reserve ratio
10 The Relationship Between Legal Reserves and Total Deposits Balance SheetStatements of assets (what is owned) and liabilities (what is owed)How a single bank reacts to an increase in reservesWe will examine the balance sheet of a single bank.
11 The Relationship Between Legal Reserves and Total Deposits (cont'd) We assumeReserve ratio is 10%Transactions deposits are the bank’s only liabilities and loans are the bank’s assetsAn individual bank can lend as much as legally allowedEvery time a loan is made, the proceeds are put into a deposit account (nothing withdrawn)Zero excess reserves are keptBanks have zero net worth (the difference between assets and liabilities)
12 The Relationship Between Legal Reserves and Total Deposits (cont'd) Description of a Balance SheetAssetsLiabilitiesWhat is ownedReservesLoansWhat is owedDepositsNet Worth = Assets – Liabilities
13 Balance Sheet 16-1 Typical Bank Reserve Ratio = 10%
14 Balance Sheet 16-2 Typical Bank Assume a depositor deposits in Typical Bank a $100,000 debit-card payment drawn on a transactions account at another depository institution.Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million.
15 The Relationship Between Legal Reserves and Total Deposits (cont'd) Following the depositWhat are the required reserves of Typical Bank?Does Typical Bank have excess reserves?Required reserves = .10 $1,100,000 = $110,000Excess reserves = $200,000 – $110,000 = $90,000
16 Balance Sheet 16-2 Typical Bank (cont'd) Typical Bank has required reserves of $110,000 and excess reserves of $90,000.
17 The Relationship Between Legal Reserves and Total Deposits (cont'd) Following the depositWhat will Typical Bank do with its excess reserves?Loan them outCould Typical Bank safely loan out more than its excess reserves?By law holds a certain amount of required reserves
18 Balance Sheet 16-3 Typical Bank Typical Bank lends $90,000, but the borrowers do not leave this amount on deposit at Typical Bank.
19 The Relationship Between Legal Reserves and Total Deposits (cont'd) What do you think?Did this loan expand the money supply?HintsHave the reserves of the banking system changed?What happened to the loan balance at the bank where the deposit came from?
20 The Relationship Between Legal Reserves and Total Deposits (cont'd) Effect on the money supplyNew 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.
21 The Fed’s Direct Effect on the Overall Level of Reserves The Federal Open Market Committee (FOMC)Open Market OperationsThe purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System
22 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.
23 Balance Sheet Bank 1This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security.
24 Balance Sheet Bank 1Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000.
25 Balance Sheet Bank 1Figure 16-8 shows Bank 1 expands its loans by $90,000.
26 Balance Sheet 16-9 Bank 2 (Changes Only) The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out.
27 Balance Sheet 16-10 Bank 2 (Changes Only) Bank 2 makes a loan for $81,000, the amount of its excess reserves.
28 Money Expansion by the Banking System (cont'd) RecallThe 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.
29 Balance Sheet 16-11 Bank 3 (Changes Only) Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3.
30 Balance Sheet 16-12 Bank 3 (Changes Only) We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900).
31 Table 16-1 Maximum Money Creation with 10 Percent Required Reserves
32 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.
33 Figure The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent
34 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.
35 The Money Multiplier Money Multiplier Gives the maximum potential change in the money supply due to a change in reservesActual changein the moneysupply=Actual moneymultiplierChange intotal reservesPotential money multiplier =1Required reserve ratio
36 The Money Multiplier (cont'd) ExampleFed buys $100,000 of government securitiesReserve ratio = 10%Potential changein the moneysupply=$100,000= $1,000,000x1.10
37 The Money Multiplier (cont'd) Forces that reduce the money multiplierLeakagesCurrency drainsExcess reservesReal-world money multipliersM1 multiplier = 2.5–3.0M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s
39 Ways in Which the Federal Reserve Changes the Money Supply Open market operationsReserve requirementDiscount rate
40 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Discount RateThe interest rate that the Federal Reserve charges for reserves it lends to depository institutions
41 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Federal Funds MarketA private market in which banks can borrow reserves from other banks that want to lend themFederal Funds RateThe interest rate that depository institutions pay to borrow reserves in the interbank federal funds market
42 Table 16-2 Required Reserve Ratios in Selected Nations
43 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.
44 Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd) 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
45 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.
46 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.
47 Source: Federal Deposit Insurance Corporation Figure Bank FailuresSource: Federal Deposit Insurance Corporation
50 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 RunsAttempts 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
51 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazardAdverse selection arises when there is asymmetric information.Information possessed by one side of a transaction but not the otherThe side with more information will be at an advantage.
52 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazardMoral hazard arises as a result of information asymmetry after a transaction has occurred.Asymmetric information > Adverse selection > Moral HazardOr… Bad intelligence > Bad decisions > Bad results
53 Federal Deposit Insurance (cont'd) The results of moral hazardThe S&L crisis of the mid-1980sMore than 1,500 savings and loan associations failed.The estimated taxpayer cost was $200 billion.
54 Chapter 16: Money Creation and Deposit Insurance ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 16: Money Creation and Deposit InsuranceMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.5454