Macroeconomics ECON 2301 May 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 16

Chapter 16: Money Creation & Deposit Insurance

16-3 Learning Objectives - By the time you finish this chapter, you should be able to: 1. Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions 2. 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 3. Explain why the money supply changes when someone deposits in a depository institution funds transferred from the Fed 4. Determine the maximum potential extent to which the money supply will change following a Fed purchase or sale of government securities 5. Discuss the ways in which the Federal Reserve conducts monetary policy 6. Explain the essential features of federal deposit insurance

16-4 Did You Know That… 4 Through actions initiated by a central bank such as the Federal Reserve, depository institutions together create money? 4 In this chapter, we’ll 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.

16-5 Links Between Changes in the Money Supply and Other Economic Variables 4 There are links between changes in the money supply and changes in GDP. 4 There are links between changes in the money supply and the rate of inflation.

16-6 Figure 16-1 Money Supply Growth versus the Inflation Rate

16-7 Links Between Changes in the Money Supply and Other Economic Variables (cont'd) 4 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 4 In a fractional reserve banking system, banks do not keep sufficient reserves on hand to cover 100% of their depositors' accounts.

16-8 Depository Institution Reserves (cont'd) 4 There are three distinguishable types of reserves: legal, required and excess. 4 Reserves : In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash

16-9 Depository Institution Reserves (cont'd) 1. Legal Reserves: Anything that the law permits banks to claim as reserves—for example, deposits held at Federal Reserve district banks and vault cash 2. Required Reserves: The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed 3. Excess Reserves: The value of reserves that a depository institution holds in the form of vault cash or deposits with the Fed – beyond the amount of reserves that the bank is required to hold. Excess Reserves = Legal Reserves - Required Reserves

16-10 Depository Institution Reserves (cont'd) 4 Question ÜDo banks set their own reserve rate? 4 Answer ÜNo, the Federal Reserve sets the reserve requirement Currently it is 10% on most transactions deposits.

16-11 Depository Institution Reserves (cont'd) 4 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 4 Excess Reserves: The difference between legal reserves and required reserves Required reserves = Transactions deposits  Required reserve ratio Excess reserves = Legal reserves – Required reserves

16-12 The Relationship Between Legal Reserves and Total Deposits 4 Balance Sheet: Statements of assets (what is owned) and liabilities (what is owed) 4 How a single bank reacts to an increase in reserves ÜWe will examine the balance sheet of a single bank. 4 Net Worth: The difference between assets and liabilities

16-13 The Relationship Between Legal Reserves and Total Deposits – application: 4 For this application, 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

16-14 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 ÜNet Worth = Assets – Liabilities

16-15 Reserve Ratio = 10% Balance Sheet 16-1 Typical Bank

16-16 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.

16-17 Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million. Balance Sheet 16-2 Typical Bank

16-18 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) 4 Following the deposit ÜWhat are the required reserves of Typical Bank? ÜDoes Typical Bank have excess reserves?

The Relationship Between Total Reserves and Total Deposits (cont'd) 4 Following a deposit ÜWhat will a “Typical Bank” do with its excess reserves? Loan them out ÜCould a “Typical Bank” safely loan out more than its excess reserves? By law each bank is required to hold a certain amount of required reserves

16-20 Balance Sheet 16-2 Typical Bank (cont'd) Typical Bank has: required reserves of $110,000 and excess reserves of $90,000.

16-21 The Relationship Between Legal Reserves and Total Deposits (cont'd) 4 Following the deposit ÜWhat will Typical Bank do with its excess reserves? Loan them out ÜCould Typical Bank safely loan out more than its excess reserves? By law holds a certain amount of required reserves

16-22 Typical Bank lends $90,000, but the borrowers do not leave this amount on deposit at Typical Bank. Balance Sheet 16-3 Typical Bank

16-23 The Relationship Between Legal Reserves and Total Deposits (cont'd) 4 What do you think: Did this loan expand the money supply? 4 Hints ÜHave the reserves of the banking system changed? ÜWhat happened to the loan balance at the bank where the deposit came from?

16-24 The Relationship Between Legal Reserves and Total Deposits (cont'd) 4 Effect on the money supply ÜNew 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. ÜThe Federal Reserve System can however, create new reserves—the subject of our next section.

16-25 The Fed’s Direct Effect on the Overall Level of Reserves 4 The Federal Open Market Committee (FOMC) can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds 4 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

16-26 The Fed buys $100,000 of U.S. government securities. Balance Sheet 16-4

16-27 The reserves and the money supply increase by $100,000. Balance Sheet 16-4

16-28 Now the Fed sells $100,000 of U.S. government securities. Balance Sheet 16-5

16-29 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)

16-30 Money Expansion by the Banking System 4 Consider the entire banking system; for practical purposes, we can look at all depository institutions taken as a whole. 4 To understand how money is created, we must understand how depository institutions respond to Fed actions that increase reserves in the entire system.

16-31 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

16-32 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

16-33 Figure 16-8 shows Bank 1 expands its loans by $90,000. Balance Sheet 16-8 Bank 1

16-34 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)

16-35 Bank 2 makes a loan for $81,000, the amount of its excess reserves. Balance Sheet Bank 2 (Changes Only)

16-36 Money Expansion by the Banking System (cont'd) 4 Recall ÜThe Fed bought a bond and deposited it at Bank 1, immediately increasing the money supply by $100,000. ÜThe deposit creation process (in addition to the $100,000) occurs because of the fractional reserve banking system. ÜBanks will lend out any excess reserves as they can earn interest income on new loans.

16-37 Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3. Balance Sheet Bank 3 (Changes Only)

16-38 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)

16-39 E-Commerce Example: Remote Capture Speeds the Check Clearing Process 4 Traditional check-clearing typically takes one to three days to complete. 4 Internet based institutions pioneered a concept called remote capture. 4 Remote capture cuts the time to just an hour.

16-40 Money Expansion by the Banking System (cont'd) 4 Question ÜLooking 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?

16-41 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

E-Commerce Example: What Goes On Inside Envelope-Free Automated teller Machines 4 The latest in bank automated teller machines (ATMs) is the envelope-free machine. These ATMs allow customers to insert a check for deposit directly into a slot in the machine 4 The new ATMs are equipped with digital cameras that record a digital image of the deposited check, which the bank can transmit immediately to an electronic check- clearing network. 4 What does a bank gain from speeding its access to funds that its customers deposit at ATMs?

16-43 Table 16-1 Maximum Money Creation with 10 Percent Required Reserves

16-44 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

16-45 Money Expansion by the Banking System (cont'd) 4 The money supply increases only when additional new reserves and deposits come into the banking system created by (1) the Federal Reserve System or (2) money from outside the country. 4 The reverse process occurs when there is a decrease in reserves because the Fed sells government securities, or money is sent out of the country.

16-46 The Money Multiplier 4 Money Multiplier: the maximum potential change in the money supply due to a change in reserves Actual  in money supply = Actual money multiplier  in total reserves  Potential money multiplier = 1 Required reserve ratio

16-47 The Money Multiplier (cont'd) 4 Example ÜFed buys $100,000 of government securities ÜReserve ratio = 10% Potential change in the money supply = $100,000 = $1,000,000 x 1.10

16-48 The Money Multiplier (cont'd) 4 Forces that reduce the money multiplier ÜLeakages Currency drains Excess reserves 4 Real-world money multipliers ÜM1 multiplier = 2.5–3.0 ÜM2 multiplier = 6.5 in the 1960s to over 12 in the 2000s

16-49 Ways in Which the Federal Reserve Changes the Money Supply 1. Open market operations (as seen above) 2. Reserve requirement 3. Discount rate

How the Fed Influences Interest Rates (cont'd) 4 Open market operations ÜFed purchases and sells government bonds issued by the U.S. Treasury At first, there is some equilibrium level of interest rate (and bond prices). ÜAn open market operation must cause a change in the price of bonds.

How the Fed Influences Interest Rates (cont'd) 4 Relationship between the price of existing bonds and the rate of interest ÜThe market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy Question ÜSo what happens to the yield on a bond when the price of a bond increases (decreases)?

How the Fed Influences Interest Rates (cont'd) 4 Example ÜYou pay $1,000 for a bond that pays $50/year in interest. 4 Bond Yield = $50 = 5% $1,000 ÜNow suppose someone later pays $500 for the same bond. Bond Yield = $50 = 10% $500

How the Fed Influences Interest Rates (cont'd) 4 The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy.

16-54 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) 4 Discount Rate: The interest rate that the Federal Reserve charges for reserves it lends to depository institutions 4 Federal Funds Market: A private market in which banks can borrow reserves from other banks that want to lend them 4 Federal Funds Rate: The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market

The Money Multiplier (cont'd) 4 Today’s discount rate policy ÜThe discount rate is kept at 1 percentage point above the market-determined federal funds rate. 4 Question ÜWhy would the Fed do this? 4 Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves.

The Money Multiplier (cont’d) 4 Changes in the reserve requirements ÜAn increase (decrease) in the required reserve ratio Makes it more (less) expensive for banks to meet reserve requirements Reduces (expands) bank lending

16-57 Ways in Which the Federal Reserve Changes the Money Supply (cont'd) 4 Question ÜWhat if the Fed changes reserve requirements it imposes? ÜWhat if reserve requirements go from 10% to 20%? 4 Answer ÜThen the money multiplier changes from 10 to 5.

16-58 Table 16-2 Required Reserve Ratios in Selected Nations

16-59 Sweep Accounts and the Decreased Relevance of Reserve Requirements 4 Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed. 4 This feature allows banks to hold fewer reserves as savings deposits are exempt from reserve requirements. 4 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

16-60 Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd) 4 Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments. 4 Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.

16-61 Federal Deposit Insurance 4 Deposit insurance, adverse selection, and moral hazard ÜAdverse 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.

16-62 Federal Deposit Insurance (cont'd) 4 Deposit insurance, adverse selection, and moral hazard ÜMoral hazard arises as a result of information asymmetry after a transaction has occurred. 4 The results of moral hazard ÜThe S&L crisis of the mid-1980s More than 1,500 savings and loan associations failed. The estimated taxpayer cost was $200 billion.

16-63 Summary of Learning Objectives 1. How the Federal Reserve assesses reserve requirements ÜEstablishes a required reserve ratio, currently 10% 2. Why the money supply does not change when someone deposits in a depository institution funds transferred from another depository institution ÜBecause total deposits remain unchanged for the banking system as a whole

16-64 Summary of Learning Objectives (cont'd) 3. Why the money supply does change when someone deposits in a depository institution funds transferred from the Federal Reserve System ÜThere is an immediate increase in total deposits in the banking system as a whole 4. The maximum potential change in the money supply following a Federal Reserve purchase or sale of U.S. government securities ÜThe multiplier

16-65 Summary of Learning Objectives (cont'd) 5. The Fed influences the money supply through ÜOpen market operations, Üthe discount rate Üthe reserve requirement 6. The FDIC was established in 1933 to prevent bank runs. ÜDifficulties include adverse selection and moral hazard

Final Exam: May points possible Miller’s Chapters 15, 16 & all previous chapters  25 multiple choice questions, worth 4 points each (100 points total) + 3 extra credit questions  You may select among resources you’ll use, as with previous exams.  I’ll provide the Scantron sheets.

Test Resources Used Please check any applicable box concerning "fees" for test resources you plan to use DURING the exam:  3x5 card with notes, 5 test points  textbook and notebook, 15 test points  information from others,100 test points  Will NOT use additional resources* * Two (2) points will be added to your score if you choose to NOT use any of these test resources. Name (please print):____________________ ID #:______________________ Signature: ___________________________

 Four major functions of money  For something to act as money, the properties it must have  Commodity money v. fiduciary money  Importance and major role of financial intermediaries  Federal Reserve System (Fed)  Major components  Major responsibilities  Reserves: legal, required & excess reserves  Federal Deposit Insurance Corporation  Moral hazard in the context of financial intermediaries Chapter 15 Exam Question Topics:

 Fractional reserve banking  The effect of a new deposit (or withdrawal) on a single bank’s ability to make loans  The effect of a new deposit from outside the banking system on the amount of money in the banking system  Formula for the maximum money (deposit expansion) multiplier – and how to use that formula  Three tools of monetary policy & how/why the Fed conducts expansionary (or contractionary) monetary policy  Federal Funds Market/Federal Funds Rate  Fed as “lender of last resort”  Relationship between bond price & bond yield (% interest Chapter 16 Exam Question Topics: