CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 1 Money Creation, the Federal Reserve System, and Monetary Policy How Banks Work 17.2Monetary Policy in the Short Run 17.3Monetary Policy in the Long Run

CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 2 Operating a Bank Getting a charter Bank balance sheet Reserve accounts

CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 3 Getting a Charter Charter—the right to operate Net worth—assets minus liabilities, also called owners’ equity Asset—any physical property or financial claim owned by the bank

CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 4 Bank Balance Sheet Liability—an amount owed Balance sheet—a financial statement showing assets, liabilities and net worth at a given time; assets must equal liabilities plus net worth, so the statement is in balance Assets = Liabilities + Net worth

CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 5 Reserve Accounts Required reserve ratio—a Fed regulation that dictates the minimum fraction of deposits each bank must keep in reserve Required reserves—the dollar amount that must be held in reserve; checkable deposits multiplied by the required reserve ratio Excess reserves—bank reserves in excess of required reserves

CONTEMPORARY ECONOMICS© Thomson South-Western Monetary Policy in Action 15.1 The Evolution of Fiscal Policy SLIDE 6

CONTEMPORARY ECONOMICS© Thomson South-Western The Federal Reserve and Open Market Operations Money supply—the supply of money available in the economy at a particular time Money supply—the supply of money available in the economy at a particular time The Fed increases the money supply by buying US government bonds The Fed increases the money supply by buying US government bonds The Fed decreases the money supply by selling US government bonds The Fed decreases the money supply by selling US government bonds 15.1 The Evolution of Fiscal Policy SLIDE 7

CONTEMPORARY ECONOMICS© Thomson South-Western 17.1 How Banks Work SLIDE 8 Money Multiplier Money multiplier—the multiple by which the money supply can increase as a result of an increase in excess reserves in the banking system Money multiplier—the multiple by which the money supply can increase as a result of an increase in excess reserves in the banking system The Fed makes a move (text pg. 513 – buys bond and increases the money supply) The Fed makes a move (text pg. 513 – buys bond and increases the money supply) Round one (MS increased by $10,000) Round one (MS increased by $10,000) Round two and beyond (supports up to $100,000 in checkable deposits) Round two and beyond (supports up to $100,000 in checkable deposits)

CONTEMPORARY ECONOMICS© Thomson South-Western Money Multiplier (cont’d) Formula for the multiple expansion of checkable deposits  Formula for the multiple expansion of checkable deposits  Change in checkable deposits = change in excess reserves x 1/r Change in checkable deposits = change in excess reserves x 1/r Contraction of the money supply works in the same way, but in reverse. Contraction of the money supply works in the same way, but in reverse. It begins with the Fed selling a $10,000 US bond to Home Bank. It begins with the Fed selling a $10,000 US bond to Home Bank The Evolution of Fiscal Policy SLIDE 9

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 10 Demand for Money The money demand curve, Dm, slopes downward. As the interest rate falls, so does the opportunity cost of holding money. The quantity of money demanded increases. Therefore, when interest rates are low, people hold more of their wealth as money. Therefore, when interest rates are low, people hold more of their wealth as money. Figure 17.2

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 11 Ways to Expand the Money Supply Purchasing U.S. government securities Purchasing U.S. government securities Reducing the discount rate Reducing the discount rate Lowering the required reserve ratio Lowering the required reserve ratio

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 12 Effect of an Increase in the Money Supply Figure 17.3

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 13 Effects of the Lower Interest Rate Figure 17.4 A lower interest rate  1)Encourages households to borrow more and save less 2)Encourages businesses to invest more More C + I increases AD AD shifts to the right thereby increasing employment and output (real GDP) and the price level

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 14 Ways to Reduce the Money Supply Selling U.S. government securities Selling U.S. government securities Increasing the discount rate Increasing the discount rate Raising the required reserve ratio Raising the required reserve ratio

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 15 The Federal Funds Rate In order to stimulate the economy the Fed could In order to stimulate the economy the Fed could Cut the federal funds rate Cut the federal funds rate In order to cool down the economy the Fed could In order to cool down the economy the Fed could Increase the federal funds rate Increase the federal funds rate

CONTEMPORARY ECONOMICS© Thomson South-Western 17.2 Monetary Policy in the Short Run SLIDE 16 Ups and Downs in the Federal Funds Rate Since 1996 Figure 17.5

CONTEMPORARY ECONOMICS© Thomson South-Western 15.1 The Evolution of Fiscal Policy SLIDE 17