CHAPTER 32 Creation of Money Two Definitions of the Money Supply, January 2005 M1 = $1361 billion...
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Transcript of CHAPTER 32 Creation of Money Two Definitions of the Money Supply, January 2005 M1 = $1361 billion...
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CHAPTER 32
Creation of Money
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Two Definitions of the Money Supply, January 2005
M1 = $1361 billion
CurrencyOutside banks$710 billion
Othercheckabledeposits$321 billions
Checking depositsIn commercialBanks $330 billion
M2 = $6443 billion
Money marketmutual funds$704 billion
M1$1361 billion
Savingsdeposits
$4378 billion
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The Banking System
Bank Regulation Deposit insurance (FDIC)
Moral hazard Problem
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The Banking System
Bank Regulation Bank Supervision
Reserve Requirements
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The Origins of the Money Supply
How Bankers Keep Books Banks keep balance sheets
Assets = liabilities + net worth
Assets include:
Liabilities include:
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The Money Multiplier
Banking system is not just a guard of the money supply
This multiplying effect is the work of the infamous money multiplier.
Each time a bank receives a deposit from a customer, it is required by the reserve requirement ratio set by the Fed (a.k.a. required by law) to keep in its reserves a fraction of the deposit
The rest of the deposit can be lent out to potential borrowers.
Called “fractional reserve system”
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Fractional Reserve Banking
The Goldsmiths Principle Stored goldReceipts used as moneyMade loans
CharacteristicsBanks create money
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Fractional Reserve System
Balance sheetAssets = Liabilities + Net Worth
Both sides balanceNecessary transactions
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Reserve Requirements
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Assets Liabilities and Net Worth
Lets create a bank… in the town of Vossdonium
Transaction #1Vault cash: cash held by the bankSold stocks to acquire operating funds
Balance Sheet 1: Vossome Bank
Cash Stock Shares
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Assets Liabilities and Net Worth
Transaction 2
Acquiring property and equipment
Balance Sheet : Vossome Bank
CashStock Shares
Property
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Assets Liabilities and Net Worth
Transaction 3Commercial bank functions
Accepting depositsMaking loans
Balance Sheet 3: Vossome Bank
Cash Checkable DepositsProperty
Stock Shares
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Transaction 4
Depositing reserves in a Federal Reserve bank Required reserves Reserve ratio
Reserveratio =
Fed establishes and varies rr within limits set by Congress
rr helps Fed control lending abilities of commercial banks
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Assets Liabilities and Net Worth
Transaction 4
Assume the bank deposits all cash on reserve at the Fed
Balance Sheet 4: Vossome Bank
Cash Checkable Deposits
Property Stock Shares
Reserves
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Reserve Requirements
Excess reserves
Required reserves
Example:
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Assets Liabilities and Net Worth
Transaction 5a
Granting a loan
Balance Sheet 6: Vossome Bank
Checkable Deposits
PropertyStock Shares
Reserves
Loans
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Assets Liabilities and Net Worth
Transaction 6aUsing the loan
$50,000 loan cashed
Balance Sheet 6b: Vossome Bank
Checkable Deposits
PropertyStock Shares
Required Reserves
Excess Reserves
Banks can lend money in their vault that is above the minimum required reserve ratio.
Loans
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Assets Liabilities and Net Worth
Transaction 6b
Bank buys government securities from dealer Deposits payment into checking
Balance Sheet 7: Vossome Bank
Checkable Deposits
PropertyStock Shares
Reserves
Securities
New money is created
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The Banking System
Multiple-deposit expansionAssumptions:
A $100 bill is found and deposited
Multiple deposits can be created
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Bank
(1)AcquiredReserves
and Deposits
(2)RequiredReserves
(3)Excess
Reserves(1)-(2)
(4)Amount Bank CanLend; New Money
Created = (3)
Bank A $100 $20 $80 $80Bank B $80 $16 $64 $64
Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96
The process will continue…
The Banking System
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The Banking System
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The Monetary Multiplier
Monetarymultiplier =
1
required reserve ratio
New Reserves$100
$20RequiredReserves
$80Excess
Reserves
$100Initial
Deposit
$400Bank System Lending
Money Created
GraphicExample
=1
R
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The Monetary Multiplier
Maximum amount of new money created by single dollar of excess reserves
Higher R, lower mReversibility
Making loans creates moneyLoan repayment destroys money
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Another Illustration of Money Creation
Assume 20% legal reserve requirement
Suppose Nina deposits $1,000 in her checking account at Citibank.
T-account of Citibank:
______Assets________________Liabilities____________
Reserves Demand deposits
Loans
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Kevin borrows $800 from Citibank, and buys a computer at BestBuy
BestBuy deposits Kevin’s check at Fleet Bank.
Fleet Bank’s T-account:
_____Assets________________Liabilities_____________ Required Reserves Demand Deposits
Loans (Excess)
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Vivian borrows $640 from Fleet Bank and buys a new outfit from Macy’s.
Macy’s deposits Vivian’s check at Bank of New York.
T-account of Bank of New York: ______Assets____________________Liabilities_______ Required Reserves Demand deposits
Loans (Excess)
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Total Demand Deposits After Lending and Re-lending by banks
Banks Demand Deposits
Citibank $1,000Fleet 800Bank of New York 640 + other banks + additional deposits ___________ = $ 5,000 Total
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Banks and Money Creation
The Process in Reverse: Multiple Contractions of the Money Supply
Banks reduce their loan commitments Contraction in the money supply utilizes
the same formula as for money expansion.
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The Need for Monetary Policy
Left uncontrolled, banks would:
Changes in the money supply would exacerbate the business cycle
One reason for monetary policy: Prevent this behavior on the part of banks.