Banking & The Federal Reserve

Modules 26-27

Banks1) Banks

2) How Banks Create Money

3) The Money Multiplier

• Banks have several important functions

1. Store money• Keep it safe

2. Save money• We can earn interest on our deposits

3. Loan money• Lending is how banks make money

Banks1) Banks

2) How Banks Create Money

3) The Money Multiplier

• When people deposit money in a bank, the bank does not keep the full value of that deposit

• Instead, it keeps only a fraction and uses the rest for loans

• The portion of deposits that banks keep on hand makes up its reserves

Banks1) Banks

2) How Banks Create Money

3) The Money Multiplier

• The Federal Reserve sets the reserve ratio– the percentage of deposits banks must

keep readily available– Currently this is 10%

• As banks make loans, those funds are re-deposited, and a portion of them can be loaned out again…and again

Banks1) Banks

2) How Banks Create Money

3) The Money Multiplier

• This cycle of depositing – loaning – depositing, etc increases the money supply– Remember, M1 includes checking accounts

as well as currency!

• The value of the money multiplier is:M = 1/rr

rr= reserve ratio

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The nation’s decentralized central bank with two goals assigned by US Congress:

1. Maximize Employment– Stimulate economic growth

2. Influence the growth of the money supply

– Control inflation

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The Federal Reserve is tasked with:

1. Providing financial services to the US government

2. Regulating financial institutions3. Maintaining the payments system4. Enforcing consumer protection laws5. Monetary Policy

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The Fed is a blend of private sector and government:

1. Government and private banks both appoint board members

2. Regional structure

3. Funded by interest on holdings

Figure 26.1 The Federal Reserve SystemRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 27.1 The Federal Reserve’s Assets and LiabilitiesRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 25.4 The Monetary Base and the Money SupplyRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Monetary Policy1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

• The Federal Reserve uses monetary policy to affect the amount of the money supply, and thus influence economic growth and inflation

• Setting the Reserve Rate– If the Fed increases the reserve rate, the

money supply will go down– If the Fed decreases the reserve rate, the

money supply will go up

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The Discount Rate is the interest rate that the Fed charges bank to borrow funds

– Normally set 1% above the federal funds rate, which is the rate at which member banks borrow from each other

– By lowering the discount rate, the Fed can encourage more borrowing and thus increase the money supply

The Federal Reserve1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The primary way the Fed influences the money supply, is through open market transactions:

• The Fed buys or sells US Treasury Bonds

• If the Fed buys bonds, the money supply increases

• If the Fed sells bonds, the money supply decreases

Figure 27.2 Open-Market Operations by the Federal ReserveRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Problems1) The Federal Reserve - Purpose - Structure

2) Monetary Policy - Reserve Rate - Discount Rate - Open Market Transactions

3) Problems

The Federal Reserve purchases $25 million in treasury bonds from the public.

1. If the reserve rate is 5%, theoretically, how much would the money supply increase?

2. What if the reserve rate were 20%?