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J.A.SACCO Module 25- Fractional Reserve Banking and the Money Multiplier.

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Presentation on theme: "J.A.SACCO Module 25- Fractional Reserve Banking and the Money Multiplier."— Presentation transcript:

1 J.A.SACCO Module 25- Fractional Reserve Banking and the Money Multiplier

2 Fractional Reserve Banking Depository institutions are required by the Fed to maintain a specific percentage (reserve requirement) of their customers deposits as reserves Three types of reserves!

3 Fractional Reserve Banking Legal (Total) Reserves- reserves that depository institutions are allowed by law to claims as reserves (deposits held at Federal Reserve District Bank and/or commercial bank vault cash. Required Reserves- the value of reserves that a depository institution must hold in vault cash or with the Federal District Bank. These reserves are required to back its checkable deposits.

4 Fractional Reserve Banking Excess Reserves- the difference between legal reserves and required reserves. These reserves can be used as new loans and/or purchase government bonds & securities. Excess Reserves = Legal Reserves- Required Reserves

5 Fractional Reserve Banking Example: Total (Legal) Reserves is $20 B. and the Reserve Requirement is 10%. What is the required reserves? Excess reserves? RR is $2B in deposits to be held in Fed District Bank or vault cash. ER is $18 B. in new loans or to buy gov’t securities.

6 Reserves and Total Deposits SACCO KEY POINT- New reserves are not created when checks written on one bank are deposited in another bank. The bank writing the check will lose reserves, and the bank receiving the check will gain reserves. Only when the Fed buys/sells securities from banks or the public, or when you put available cash in the bank are reserves increased/decreased and in turn the money supply.

7 7 Money Expansion by the Banking System How much will the money supply increase after you deposit $100,000 cash into a commercial bank. Why is the reserve requirement and excess reserves important?

8 8 How Money is Created? “Multiple Expansion of Checkable Deposits” Assume a 10% Reserve RequirementMaximum New Loans New DepositsNew Requiredplus Investments Bank(new reserves)Reserves(excess reserves) 1$100,000$10,000$90,000 290,0009,00081,000 381,0008,10072,900 472,9007,29065,610 Totals$1,000,000$100,000 $900,000.... All other banks656,10065,610590,490 New money/Inc. in money supply

9 9 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 Initial change in excess reserves x

10 Forces that Reduce the Money Multiplier Leakages Currency Drains- People hold money in wallet. Don’t put money in bank to allow deposit expansion. Excess Reserves- Banks keep more as excess reserves.

11 How the Fed Controls the Money Supply Fed Tools Macro. Effects Reserve Requirement Increase Contractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

12 How the Fed Controls the Money Supply Fed Tools Macro. Effects Discount/Federal Fund Rate Increase Contractionary Money Supply Interest rate Investment Decrease Expansionary Money Supply Interest rate Investment

13 How the Fed Controls the Money Supply Fed Tools Macro. Effects Open Market Operations Sell Securities Contractionary Money Supply Interest rate Investment Buy Securities “Buy Bonds, Big Bucks” Expansionary Money Supply Interest rate Investment “Sell Bonds, Small Bucks” Most used by the Fed to expand the money supply. Why?

14 The Fed and the Money Supply What has a greater affect on the expansion of the money supply: A. $100 deposit of an individual into a commercial bank? B. A Fed purchase of a government bond/security from a commercial bank for a $100? Assume a 20% Reserve Requirement

15 The Fed and the Money Supply A. Money Multiplier? B. Individual- RR= $20, ER= $80--- Expansion of Money Supply is $400. C. Fed- RR= $0, ER=$100--- Expansion of Money Supply is $500. Why the difference?


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