1. ©2005 South-Western College Publishing
Money Creation
Key Concepts
Summary
©2005 South-Western College Publishing

2. What will I learn in this chapter?
You will discover that the Federal Reserve (the Fed) and the banks work together to determine the money supply.

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

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

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

6. 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

7. 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

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

9. 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

10. What are excess reserves?
Potential loan balances held in vault cash or on deposit with the Fed in excess of required reserves

11. Typical Bank - Balance Sheet 1
Assets
Liabilities
Required Reserves
$5 million
Checkable Deposits
$50 million
Excess Reserves
Loans
$45 million
Total
$50 million
Total
$50 million
Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

12. What are total reserves?
Total Reserves = required reserves + excess reserves

13. Required Reserve Ratio of the Fed Required Reserve Ratio
Type of Deposit
Checkable deposits 3%
0 - $46.5 million
10%
Over $46.5 million

14. Best National Bank - Balance Sheet 2
Assets
Liabilities
 in M1
Required Reserves
Brad Rich Account
$10,000
$100,000
Excess Reserves
+$90,000
$100,000
Total
$100,000
Total
Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

15. Best National Bank - Balance Sheet 3
Assets
Liabilities
 in M1
Required Reserves
Brad Rich Account
$19,000
$100,000
Excess Reserves
Connie Jones Account
$81,000
+$90,000
$90,000
Loans
+$90,000
Total
$190,000
Total
$190,000
Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

16. Best National Bank - Balance Sheet 4
Assets
Liabilities
 in M1
Required Reserves
Brad Rich Account
$10,000
$100,000
Excess Reserves
Connie Jones Account
Loans
$90,000
Total
$100,000
$100,000
Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

17. Yazoo Bank - Balance Sheet 5
Assets
Liabilities
Required Reserves
+$9,000
Better Health Span Account
+$90,000
Excess Reserves
+$81,000
Total
$90,000
Total
$90,000
Note: The Fed requires the bank to keep 10% of its checkable deposits in reserve.

18. Expansion of the Money Supply #
Increase in Required Reserves
Increase in Excess Reserves
Increase in Deposits #
Bank 1
$10,000
$90,000
Best Nat’l Bank
$100,000
9,000
81,000 2
90,000
Yazoo Nat’l Bank
8,100
72,900 3
Bank A
81,000
Bank B
7,290
65,610 4
72,900 5
Bank C
65,610
6,561
59,049 6
Bank D
59,049
5,905
53,144 7
Bank E
53,144
5,314
47,830
478,297
47,830
430,467
Total all other banks
Total increase
$1,000,000
$100,000
$900,000

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

20. 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)

21. 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

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

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

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

25. Initial change in excess reserves
Actual money supply change
 M1 = ER x m
Initial change in excess reserves
Money multiplier

26. 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

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

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

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

30. Federal Reserve System - Balance Sheet 6 Government securities
Assets
Liabilities
Government securities
Fed notes
$472
$492
Loans to banks
Deposits 34 1
Other liabilities and net worth 22
Other assets 75
Total
$548
Total
$548

31. Federal Reserve Bank - Balance Sheet 7 Assets Liabilities
Initial  in M1
Assets
Liabilities
Government securities
Reserves of Best Nat’l bank
+$100,000
+$100,000
+$100,000
Note: The Fed conducted open market operations in order to increase the money supply by purchasing $100,000 in government securities.

32. Federal Reserve Bank - Balance Sheet 8 Assets Liabilities
Initial  in M1
Assets
Liabilities
Government securities
Reserves of Best Nat’l bank
-$100,000
-$100,000
-$100,000
Note: The Fed conducted open market operations in order to decrease the money supply by selling $100,000 in government securities.

33. Fed
Fed buys government securities and banks gain reserves
Fed sells government securities and banks loose reserves $ $
Banks $ $
Public

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

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

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

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

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

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

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

41. 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

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

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

44. If the reserve ratio is one twentieth, what is the multiplier?
1  1/20 = 20

45. 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

46. 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

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

48. Key Concepts

49. Who were the founders of our modern-day banking?
What is fractional reserve banking?
What are required reserves?
What is a required reserve ratio?
What are excess reserves?
What are total reserves?
What is the money multiplier?
What is the money multiplier equal to?

50. What is monetary policy?
What are open market operations?
What is the discount rate?
What is the federal funds rate?
What is a required reserve requirement?
What is the required reserve ratio?
What are the shortcomings of monetary policy?

51. Summary

52. Fractional reserve banking, the basis of banking today, originated with the goldsmiths in the Middle Ages.

53. Because depository institutions (banks) are not required to keep all their deposits in vault cash or with the Federal Reserve, banks create money by making loans.

54. Required reserves are the minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. The percentage of deposits that must be held as required reserves is called the required reserve ratio.

55. Excess reserves exist when a bank has more reserves than required
Excess reserves exist when a bank has more reserves than required. Excess reserves allow a bank to create money by exchanging loans for deposits. Money is reduced when excess reserves are reduced and loans are repaid.

56. The money multiplier is used to calculate the maximum change (positive or negative) in checkable deposits (money supply) due to a change in excess reserves. As a formula:
$ multiplier = 1/required reserve ratio.

57. Monetary policy is action taken by the Fed to change the money supply
Monetary policy is action taken by the Fed to change the money supply. The Fed uses three basic tools: (1) open market operations (2) changes in the discount rate and (3) changes in the required reserve ratio.

58. Open-market operations are the buying and selling of government securities by the Fed through its trading desk at the New York Federal Reserve Bank.

59. Buying government securities creates extra bank reserves and loans, thereby expanding the money supply. Selling government securities reduces bank reserves and loans, thereby contracting the money supply.

60. Fed
Fed buys government securities and banks gain reserves
Fed sells government securities and banks loose reserves $ $
Banks $ $
Public

61. Changes in the discount rate occur when the Fed changes the rate of interest it charges on loans of reserves to banks.

62. Dropping the discount rate makes it easier for banks to borrow reserves from the Fed and expands the money supply.

63. Raising the discount rate discourages banks from borrowing reserves from the Fed and contracts the money supply.

64. Changes in the required reserve ratio and the size of the money multiplier are inversely related. Thus, if the Fed decreases the required reserve ratio the money multiplier and money supply increase. If the Fed increases the required reserve ratio the money multiplier and money supply decrease.

65. Monetary policy limitations include the following: (1) The money multiplier can vary (2) Nonbanks, such as insurance companies, finance companies, and Sears, can offer loans and other financial services not directly under the Fed’s control (3) The Fed might control M1 while the public can shift funds to M2, M3, or another money supply definition (4) Time lags occur.

66. END