Monetary aggregates Checkable deposits Balance sheets Money creation Money multiplier Tools of the Fed

These are measures of the money supply. We add together all assets that are liquid enough to be classified as money

The narrow measure of the money supply; includes only the most liquid assets M1 equals Currency and coin in circulation Plus: Checkable deposits Plus: Travelers’ checks

About 60 percent of Federal Reserve notes now circulate abroad

A broader measure of the money supply favored by many economists. M2 equals M1 Plus: Miscellaneous near monies Plus: Small denomination time deposits Plus: Savings deposits Plus: Money market deposit accounts

6 Measures of the money supply (July 2007)

By bringing together both sides of the money market, banks serve as intermediaries or go- betweens. Banks reduce the transactions costs of channeling saving to creditworthy borrowers. Coping with asymmetric information. Reducing risk through diversification.

To start a bank we must obtain a charter from a state government or from the Federal Reserve

9 Home Bank’s balance sheet AssetsLiabilities Building and furniture Stock in district Fed $450,000 50,000 Net worth$500,000 Total$500,000Total$500,000 Note that: Assets = Liabilities + Net Worth

10 Home Bank’s balance sheet after $1,000,000 deposit into checking account AssetsLiabilities Cash Building and furniture Stock in district Fed $1,000, ,000 50,000 Checkable deposits Net worth $1,000, ,000 Total$1,500,000Total$1,500,000 Remember that deposits are an asset for depositors but a liability for the bank.

Banks must maintain a reserve account at the regional Federal Reserve bank Required reserves: The dollar amount of reserves a bank is required to hold as cash in vault or on account at the Fed. Required reserve ratio: The ratio of reserves to deposits that banks by regulation are obligated to hold. Excess reserves: Bank reserves exceeding required reserves

Banks must be ready for customers’ withdrawals, so liquid bank assets are desirable. At the same time, less liquid assets such as commercial and real estate loans are more profitable.

Banks create money when they make loans and credit the accounts of loan recipients. Money creation (lending) is limited by banks’ holdings of excess reserves. Reserve do not earn interest; hence banks seek to minimize reserve holdings

Suppose the Fed pays $1,000 to a securities dealer for a bond. The transaction is handled by the dealer’s bank—Home Bank

15 Changes in Home Bank’s balance sheet after Fed buys a $1,000 bond from Securities dealer AssetsLiabilities Reserves at Fed+$1,000Checkable deposits+$1,000 o The Fed credits home Bank’s reserve account by $1,000. o Home Banks’ liabilities increase by $1,000.

Assume the legal reserve ratio is.10 or 10 percent. The preceding transaction will create a $900 excess reserve for Home Bank. Loans and deposits can be expanded by that amount.

17 Round 2: Changes in Home Bank’s balance sheet after lending $900 to you AssetsLiabilities Loans+$900Checkable deposits+$900 Thus the money supply initially increases by $900 as a result of this loan.

1.Suppose you write a $900 check to your university to pay fees. 2.Your university deposits the check into its account at Merchants Trust bank. 3.When the check clears, the Fed debits Home Banks’ reserve account for $900 and credits Merchant Bank’s reserve account for $ Thus the transaction creates a $810 excess reserve for MerchantsTrust.

Merchants Trust makes a $810 loan to an English major starting an online note-taking service called “Note This.”

20 Round 3: Changes in Merchants Trust’s balance sheet after lending $810 to English Major AssetsLiabilities Loans+$810Checkable deposits+$810 Note that as a result of this loan the money supply has increased by $810.

1.The English major writes an $810 check to the college bookstore. 2.The college bookstore deposits the $810 check into its account at Fidelity Bank 3.When the check clears, the Fed debits Merchant Trust’s reserve account for $810 and credits Fidelity Bank’s reserve account for $ Thus the transaction creates a $729 excess reserve for Fidelity Bank.

Fidelity Bank is now positioned to make loans totaling $729

23 Summary of money creation resulting from Fed’s purchase of $1,000 US Government Bond Bank (1) Increase in Checkable Deposits (2) Increase in Required Reserves (3) Increase in Loans =(1)-(2) 1. Home Bank 2. Merchants Trust 3. Fidelity Bank All remaining rounds $1, ,290 $ $ ,561 Totals$10,000$1,000$9,000

The multiple by which the money supply changes as a result of a fresh change in fresh reserves of the banking system. Change in the money supply = change in fresh reserves x 1/r Where r is the required reserve ratio Simple money multiplier In our case: Change in the money supply = $900 x 1/.10 = (4900)(10)= 9,000

It should be clear now that when Fed buys government securities in large quantities, there are strong effects in terms of bank excess reserves and lending capacity.

26 Federal Reserve Bank balance sheet as of August 22, 2007 (billions) AssetsLiabilities US Treasury securities Foreign currencies Bank buildings Discount loans to depository institutions Other assets $ Federal Reserve notes outstanding Depository institutions reserves US Treasury balance Other liabilities Net Worth $ Total$866.8Total$866.8