1. Chapter 16: Money Creation and Deposit Insurance
ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 16: Money Creation and Deposit Insurance
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2. 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.

3. Fractional Reserve Banking
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

4. 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.

5. Depository Institution Reserves (cont'd)
In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions’ vault cash

6. 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

7. 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
The Federal Reserve sets the reserve requirement
Currently it is 10% on most transactions deposits

8. 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

9. Depository Institution Reserves (cont'd)
Excess Reserves
The difference between legal reserves and required reserves
Excess reserves = Legal reserves – Required reserves

10. 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.

11. The Relationship Between Legal Reserves and Total Deposits (cont'd)
We assume
Reserve ratio is 10%
Transactions deposits are the bank’s only liabilities and loans are the bank’s assets
An individual bank can lend as much as legally allowed
Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn)
Zero excess reserves are kept
Banks have zero net worth (the difference between assets and liabilities)

12. The Relationship Between Legal Reserves and Total Deposits (cont'd)
Description of a Balance Sheet
Assets
Liabilities
What is owned
Reserves
Loans
What is owed
Deposits
Net Worth = Assets – Liabilities

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

14. Balance Sheet 16-2 Typical Bank
Assume a depositor deposits in Typical Bank a $100,000 debit-card payment drawn on a transactions account at another depository institution.
Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million.

15. 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?
Required reserves = .10  $1,100,000 = $110,000
Excess reserves = $200,000 – $110,000 = $90,000

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

17. 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

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

19. 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?

20. 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.

21. The Fed’s Direct Effect on the Overall Level of Reserves
The Federal Open Market Committee (FOMC)
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

22. 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.

23. Balance Sheet Bank 1
This shows Bank 1’s original position before the Fed’s purchase of a $100,000 U.S. government security.

24. Balance Sheet Bank 1
Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90,000.

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

26. Balance Sheet 16-9 Bank 2 (Changes Only)
The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out.

27. Balance Sheet 16-10 Bank 2 (Changes Only)
Bank 2 makes a loan for $81,000, the amount of its excess reserves.

28. 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.

29. Balance Sheet 16-11 Bank 3 (Changes Only)
Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank 3.

30. Balance Sheet 16-12 Bank 3 (Changes Only)
We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900).

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

32. 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.

33. Figure The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent

34. 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.

35. The Money Multiplier Money Multiplier
Gives the maximum potential change in the money supply due to a change in reserves
Actual change
in the money
supply =
Actual money
multiplier
Change in
total reserves 
Potential money multiplier = 1
Required reserve ratio

36. 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

37. The Money Multiplier (cont'd)
Forces that reduce the money multiplier
Leakages
Currency drains
Excess reserves
Real-world money multipliers
M1 multiplier = 2.5–3.0
M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s

39. Ways in Which the Federal Reserve Changes the Money Supply
Open market operations
Reserve requirement
Discount rate

40. 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

41. 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

42. Table 16-2 Required Reserve Ratios in Selected Nations

43. 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.

44. Sweep Accounts and the Decreased Relevance of Reserve Requirements (cont'd)
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

45. 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.

46. 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.

47. Source: Federal Deposit Insurance Corporation
Figure Bank Failures
Source: Federal Deposit Insurance Corporation

49. April 16, 2010

50. 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

51. 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.

52. 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.
Asymmetric information > Adverse selection > Moral Hazard
Or… Bad intelligence > Bad decisions > Bad results

53. 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.

54. Chapter 16: Money Creation and Deposit Insurance
ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 16: Money Creation and Deposit Insurance
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 54 54