1 Money Creation ©2006 South-Western College Publishing

2 In the Middle Ages, what was used for money? Gold was the money of choice in most European nations

3 Who were the founders of our modern-day banking? Goldsmiths, people who would keep other people’s gold safe for a service charge

4 What was the first currency? People would use the receipts they received from goldsmiths as paper money

5 How did the early goldsmiths act as the first banks? Some goldsmiths made loans and received interest for more gold than the actual gold held in their vaults

6 What is fractional reserve banking? A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed

7 What are required reserves? The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed

8 What is a required reserve ratio? The percentage of deposits that the Fed requires a bank to hold in vault cash or on deposit with the Fed

Money Creation When a bank makes a loan from its reserves, the money supply increases.

10 What are the three steps in the creation of money? Accepting a new deposit Making a loan Clearing the loan check

11 Accepting a new deposit, what conclusion? Transferring currency to a bank and moving deposits from one bank to another do not affect the money supply (M1)

12 Making a loan, what conclusion? When a bank makes a loan, it creates deposits, and the money supply increases by the amount of the loan because the money supply includes checkable deposits

13 Clearing the loan check, what conclusion? Now the money can be used for new purchases

14 What is the money multiplier? The maximum change in the money supply due to an initial change in the excess reserves banks hold

15 What is the money multiplier equal to? 1 / required reserve ratio

The Money Multiplier How much money is eventually created in this economy? Original deposit= $ First National lending= $ [=0.9 x $100.00] Second National lending= $ [=0.9 x $90.00] Third National lending= $ [=0.9 x $81.00]   Total money supply= $1,000

17 Can the multiplier be smaller than indicated? Yes, because of cash leakages and the chance that banks will not use all of their excess reserves to make loans

18 What would the Fed with inflation? Decrease the money supply What would the Fed do with unemployment? Increase the money supply

19 What is monetary policy? The Fed’s use of - open market operations  in discount rate  in required reserve ratio

20 What are open market operations? The buying and selling of government securities by the Federal Reserve System

Open-Market Operations The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: u When the Fed buys government bonds, the money supply increases. u The money supply decreases when the Fed sells government bonds.

22 What is the discount rate? The interest rate the Fed charges on loans of reserves to banks

Changing the Discount Rate The discount rate is the interest rate the Fed charges banks for loans. u Increasing the discount rate decreases the money supply. u Decreasing the discount rate increases the money supply.

24 What would the Fed do if we have inflation? A higher discount rate discourages banks from borrowing reserves and making loans

25 What would the Fed do if we have unemployment? A lower discount rate encourages banks to borrow reserves and make more loans

26 What is the federal funds market? A private market in which banks lend reserves to each other for less than 24 hours

27 What is the federal funds rate? The interest rate banks charge for overnight loans to other banks

28 What would the Fed do if we had inflation? A higher federal funds rate discourages banks from borrowing reserves and making loans

29 What would the Fed do if we had unemployment? A lower federal funds rate encourages banks to borrow reserves and make more loans

30 What is a required reserve requirement? The Fed determines how much a financial institution must keep in reserve as a percentage of its total assets

31 What is the required reserve ratio? That percentage the Fed stipulates that financial institutions must keep in reserve to meet its reserve requirement

Changing the Discount Rate The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. u Increasing the reserve requirement decreases the money supply. u Decreasing the reserve requirement increases the money supply.

33 If the reserve ratio is one tenth, what is the multiplier? 1  1/10 = 10

34 What would the fed do if we had inflation? Increase the reserve ratio What would the fed do if we had unemployment? Decrease the reserve ratio

35 Is changing the reserve ratio a popular monetary tool? No, changing the reserve ratio is considered a heavy- handed approach and is thus infrequently used

36 What are the shortcomings of monetary policy? Money multiplier inaccuracy Nonbanks Which money definition should the Fed control? Lag effects