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11 Chapter 16: Money Creation and Deposit Insurance 1 ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which.

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Presentation on theme: "11 Chapter 16: Money Creation and Deposit Insurance 1 ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which."— Presentation transcript:

1 11 Chapter 16: Money Creation and Deposit Insurance 1 ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

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. 16-2

3 Links Between Changes in the Money Supply and Other Economic Variables (cont'd) 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 16-3

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. 16-4

5 Depository Institution Reserves (cont'd) Reserves  In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash 16-5

6 Depository Institution Reserves (cont'd) Legal Reserves  Anything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash 16-6

7 Depository Institution Reserves (cont'd) Required Reserves  The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed  The Federal Reserve sets the reserve requirement Currently it is 10% on most transactions deposits 16-7

8 Depository Institution Reserves (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 16-8 Required reserves = Transactions deposits  Required reserve ratio

9 Depository Institution Reserves (cont'd) Excess Reserves  The difference between legal reserves and required reserves 16-9 Excess reserves = Legal reserves – Required reserves

10 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

11 The Relationship Between Legal Reserves and Total Deposits (cont'd) We assume 1. Reserve ratio is 10% 2. Transactions deposits are the bank’s only liabilities and loans are the bank’s assets 3. An individual bank can lend as much as legally allowed 4. Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn) 5. Zero excess reserves are kept 6. Banks have zero net worth (the difference between assets and liabilities) 16-11

12 The Relationship Between Legal Reserves and Total Deposits (cont'd) Description of a Balance Sheet AssetsLiabilities What is owned Reserves Loans What is owed Deposits Net Worth = Assets – Liabilities

13 Balance Sheet 16-1 Typical Bank Reserve Ratio = 10%

14 Balance Sheet 16-2 Typical Bank Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million. Assume a depositor deposits in Typical Bank a $100,000 debit-card payment drawn on a transactions account at another depository institution.

15 The Relationship Between Legal Reserves and Total Deposits (cont'd) Following the deposit  What are the required reserves of Typical Bank ?  Does Typical Bank have excess reserves? Required reserves =.10  $1,100,000 = $110,000 Excess 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 deposit  What will Typical Bank do with its excess reserves? Loan them out  Could Typical Bank safely loan out more than its excess reserves? By law holds a certain amount of required reserves 16-17

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? Hints  Have the reserves of the banking system changed?  What happened to the loan balance at the bank where the deposit came from? 16-19

20 The Relationship Between Legal Reserves and Total Deposits (cont'd) Effect on the money supply  New 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 Operations  The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System 16-21

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 16-6 Bank This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security.

24 Balance Sheet 16-7 Bank Fed 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 16-8 Bank Figure 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 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) Recall  The 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 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 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 16-31

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 16-2 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent 16-33

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 reserves Actual change in the money supply = Actual money multiplier Change in total reserves  Potential money multiplier = 1 Required reserve ratio

36 The Money Multiplier (cont'd) Example  Fed buys $100,000 of government securities  Reserve ratio = 10% Potential change in the money supply = $100,000 = $1,000,000 x 1.10

37 The Money Multiplier (cont'd) Forces that reduce the money multiplier  Leakages Currency drains Excess reserves Real-world money multipliers  M1 multiplier = 2.5–3.0  M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s 16-37

38 16-38

39 Ways in Which the Federal Reserve Changes the Money Supply 1. Open market operations 2. Reserve requirement 3. Discount rate 16-39

40 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Discount Rate  The interest rate that the Federal Reserve charges for reserves it lends to depository institutions 16-40

41 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Federal Funds Market  A private market in which banks can borrow reserves from other banks that want to lend them Federal Funds Rate  The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market 16-41

42 Table 16-2 Required Reserve Ratios in Selected Nations 16-42

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) Sweep Account  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 16-44

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 Figure 16-4 Bank Failures Source: Federal Deposit Insurance Corporation

48 16-48

49 16-49 April 16, 2010

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 Runs  Attempts 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 16-50

51 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazard  Adverse selection arises when there is asymmetric information. Information possessed by one side of a transaction but not the other The side with more information will be at an advantage

52 Federal Deposit Insurance (cont'd) Deposit insurance, adverse selection, and moral hazard  Moral hazard arises as a result of information asymmetry after a transaction has occurred. Asymmetric information > Adverse selection > Moral Hazard Or… Bad intelligence > Bad decisions > Bad results 16-52

53 Federal Deposit Insurance (cont'd) The results of moral hazard  The S&L crisis of the mid-1980s More than 1,500 savings and loan associations failed. The estimated taxpayer cost was $200 billion

54 54 Chapter 16: Money Creation and Deposit Insurance 54 ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.


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