Chapter 16 Money Creation and Deposit Insurance

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction Smart cards permit people to use digital cash, which consists of funds contained in software programs called digital algorithms. By the time you finish this chapter, you will understand how the use of digital cash may affect the quantity of money in circulation.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions Understand why the money supply is unaffected when someone deposits in a depository institution funds transferred from a transactions account at a another depository institution Explain why the money supply changes when someone deposits in a depository institution funds transferred from the Federal Reserve System

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives (cont'd) Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities Discuss the ways in which the Federal Reserve conducts monetary policy Explain the essential features of federal deposit insurance

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline Links Between Changes in the Money Supply and Other Economic Variables Links Between Changes in the Money Supply and Other Economic Variables Depository Institution Reserves The Relationship Between Reserves and Total Deposits The Relationship Between Reserves and Total Deposits

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline (cont'd) The Fed’s Direct Effect on the Overall Level of Reserves The Fed’s Direct Effect on the Overall Level of Reserves Money Expansion by the Banking System Money Expansion by the Banking System The Money Multiplier Federal Deposit Insurance

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That… Through actions initiated by a central bank such as the Federal Reserve, depository institutions together create money? In this chapter, we shall examine the money multiplier process, which explains how an injection of new money into the banking system leads to an eventual multiple expansion in the total money supply.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 16-1 Money Supply Growth versus the Inflation Rate

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Depository Institution Reserves What do you think?  Can banks pay off all of their depositors?  How is it possible that they can pay them off eventually but not pay them off simultaneously?

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Depository Institution Reserves (cont'd) Question  Do banks set their own reserve rate? Answer  No, the Federal Reserve sets the reserve requirement  Currently it is 10% on most transactions deposits

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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 Required reserves = Transactions deposits  Required reserve ratio

Copyright © 2008 Pearson Addison Wesley. All rights reserved Depository Institution Reserves (cont'd) Excess Reserves  The difference between legal reserves and required reserves Excess reserves = Legal reserves – Required reserves

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Legal Reserves and Total Deposits (cont'd) Net Worth  The difference between assets and liabilities

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Reserve Ratio = 10% Balance Sheet 16-1 Typical Bank

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Legal Reserves and Total Deposits (cont'd) AssetsLiabilities Balance Sheet: Typical Bank Assume a depositor deposits in Typical Bank a $100,000 debit-card payment drawn on a transactions account at another depository institution.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million. Balance Sheet 16-2 Typical Bank

Copyright © 2008 Pearson Addison Wesley. All rights reserved Required reserves =.10  $1,100,000 = $110,000 Excess reserves = $200,000 – $110,000 = $90,000 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?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Balance Sheet 16-2 Typical Bank (cont'd) Typical Bank has required reserves of $110,000 and excess reserves of $90,000.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Typical Bank lends $90,000, but the borrowers do not leave this amount on deposit at Typical Bank. Balance Sheet 16-3 Typical Bank

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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?

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Fed’s Direct Effect on the Overall Level of Reserves The Federal Open Market Committee (FOMC)  Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Fed’s Direct Effect on the Overall Level of Reserves (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Fed buys $100,000 of U.S. government securities. Balance Sheet 16-4

Copyright © 2008 Pearson Addison Wesley. All rights reserved The reserves and the money supply increase by $100,000. Balance Sheet 16-4

Copyright © 2008 Pearson Addison Wesley. All rights reserved Now the Fed sells $100,000 of U.S. government securities. Balance Sheet 16-5

Copyright © 2008 Pearson Addison Wesley. All rights reserved The bank’s reserves and money supply both fall by $100,000. The Fed’s Direct Effect on the Overall Level of Reserves (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security. Balance Sheet 16-6 Bank 1

Copyright © 2008 Pearson Addison Wesley. All rights reserved Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000. Balance Sheet 16-7 Bank 1

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 16-8 shows Bank 1 expands its loans by $90,000. Balance Sheet 16-8 Bank 1

Copyright © 2008 Pearson Addison Wesley. All rights reserved The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out. Balance Sheet 16-9 Bank 2 (Changes Only)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Bank 2 makes a loan for $81,000, the amount of its excess reserves. Balance Sheet Bank 2 (Changes Only)

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3. Balance Sheet Bank 3 (Changes Only)

Copyright © 2008 Pearson Addison Wesley. All rights reserved We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900). Balance Sheet Bank 3 (Changes Only)

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Money Expansion by the Banking System (cont'd) Question  Looking over our balance sheets, how much do you think the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Money Expansion by the Banking System (cont'd) What do you think? Could Banks 4, 5, 6, etc. create even more money? How much can be created? $100,000Purchase by the Fed 90,000Loan by Bank 1 81,000Loan by Bank 2 72,900Loan by Bank 3 $343,900Total

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 16-1 Maximum Money Creation with 10 Percent Required Reserves

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Money Multiplier Money Multiplier  Gives the maximum potential change in the money supply due to a change in reserves

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Money Multiplier (cont'd) Actual change in the money supply = Actual money multiplier Change in total reserves  Potential money multiplier = 1 Required reserve ratio

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Money Multiplier (cont'd) Forces that reduce the money multiplier  Leakages  Currency drains  Excess reserves

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Money Multiplier (cont'd) Real-world money multipliers  M1 multiplier = 2.5–3.0  M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s

Copyright © 2008 Pearson Addison Wesley. All rights reserved Ways in Which the Federal Reserve Changes the Money Supply 1.Open market operations 2.Reserve requirement 3.Discount rate

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Today’s discount rate policy is to set discount rate above the federal funds rate. Question  Why would the Fed do this?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Ways in Which the Federal Reserve Changes the Money Supply (cont'd) Question  What if the Fed changes reserve requirements it imposes?  What if reserve requirements go from 10 to 20%? Answer  Then the money multiplier changes from 10 to 5.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 16-2 Required Reserve Ratios in Selected Nations

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 16-3 Sweep Accounts and Reserves of U.S. Depository Institutions at Federal Reserve Banks

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Source: Federal Deposit Insurance Corporation Figure 16-4 Bank Failures

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Federal Deposit Insurance (cont'd) How deposit insurance causes increased risk taking by bank managers  Lack of correlation between risk taking and insurance premiums.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Smart Cards, Digital Cash, and the Money Supply The microchips embedded in smart cards give them a technical edge over debit cards. At present, about 300 million smart cards are used around the globe. In a world in which people widely use digital cash the money multiplier would be larger.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 16-5 The Distribution of the World’s Smart Cards

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives How the Federal Reserve assesses reserve requirements  Establishes a required reserve ratio, currently 10% Why the money supply does not change when someone deposits in a depository institution funds transferred from another depository institution  Because total deposits remain unchanged for the banking system as a whole

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why the money supply does change when someone deposits in a depository institution funds transferred from the Federal Reserve System  There is an immediate increase in total deposits in the banking system as a whole The maximum potential change in the money supply following a Federal Reserve purchase or sale of U.S. government securities  The multiplier

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The Fed influences the money supply through  Open market operations, the discount rate, and the reserve requirement The FDIC was established in 1933 to prevent bank runs.  Difficulties include adverse selection and moral hazard

End of Chapter 16 Money Creation and Deposit Insurance