Presentation on theme: "Module 25- Fractional Reserve Banking and the Money Multiplier"— Presentation transcript:
1 Module 25- Fractional Reserve Banking and the Money Multiplier J.A.SACCO
2 Fractional Reserve Banking Depository institutions are required by the Fed to maintain a specific percentage (reserve requirement) of their customers deposits as reservesThree 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 Money Expansion by the Banking System Why is the reserve requirement and excess reserves important?How much will the money supply increase after you deposit $100,000 cash into a commercial bank.
8 How Money is Created? “Multiple Expansion of Checkable Deposits” Assume a 10% Reserve Requirement MaximumNew LoansNew Deposits New Required plus InvestmentsBank (new reserves) Reserves (excess reserves)1 $100,000 $10,000 $90,0002 90,000 9,000 81,0003 81,000 8,100 72,9004 72,900 7,290 65,610All other banks 656,100 65, ,490Totals $1,000,000 $100,000 $900,000New money/Inc. in money supply
9 The Money Multiplier = x Money Multiplier Gives the maximum potential change in the money supply due to a change in reservesActual changein the moneysupply=Actual moneymultiplierInitial change inexcess reservesx
10 Forces that Reduce the Money Multiplier LeakagesCurrency 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. EffectsReserve RequirementIncrease ContractionaryMoney SupplyInterest rateInvestmentDecreaseExpansionaryMoney SupplyInterest rateInvestment
12 How the Fed Controls the Money Supply Fed Tools Macro. EffectsDiscount/Federal Fund RateIncrease ContractionaryMoney SupplyInterest rateInvestmentDecreaseExpansionaryMoney SupplyInterest rateInvestment
13 How the Fed Controls the Money Supply Fed Tools Macro. EffectsOpen Market OperationsSell Securities ContractionaryMoney Supply“Sell Bonds, Small Bucks”Interest rateInvestmentBuy Securities“Buy Bonds, Big Bucks”ExpansionaryMoney SupplyInterest rateInvestmentMost used by the Fed toexpand the money supply. Why?
14 The Fed and the Money Supply What has a greater affect on the expansion of the money supply:$100 deposit of an individual into a commercial bank?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 Money Multiplier?Individual- RR= $20, ER= $80--- Expansion of Money Supply is $400.Fed- RR= $0, ER=$ Expansion of Money Supply is $500.Why the difference?