ECO Ch 15 notes - Summary Macroeconomics PDF

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Professor James D'Angelo...

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ECO 200 Ch 15 – Money Creation 15.1 – The Fractional Reserve System - Fractional Reserve Banking System – a system in which commercial banks & thrift institutions hold less than 100% of their checkable-deposit liabilities as reserves of currency held in bank vaults or as deposits at the central bank 15.2 – A Single Commercial Bank - Actual Reserve – the funds that a bank has on deposit at the Federal Reserve Bank of its district (plus its vault cash) - Balance Sheet – a statement of the assets, liabilities, & net worth of a firm or individual at some given time - Excess Reserves – the amount by which a commercial bank’s or thrift institution’s actual reserves exceed its required reserves; actual reserves minus required reserves o Excess reserves = actual reserves – required reserves - Reserve Ratio – the fraction of checkable deposits that each commercial bank or thrift institution must hold as reserves at its local Federal Reserve Bank or in its own bank vault; also called the reserve requirement o Reserve ratio = commercial bank’s required reserves / commercial bank’s checkable-deposit liabilities - Required Reserves – the funds that each commercial bank & thrift institution must deposit with its local Federal Reserve Bank (or hold as vault cash) to meet the legal reserve requirement; a fixed percentage of each bank’s or thrift’s checkable deposits - Vault Cash – a currency a bank has on hand in its vault & cash drawers - Assets = liabilities + net worth - Bank transactions involving balance sheets to establish how individual banks can create money: o Transaction 1: Creating a Bank o Transaction 2: Acquiring Property & Equipment o Transaction 3: Accepting Deposits o Transaction 4: Depositing Reserve in a Federal Reserve Bank o Transaction 5: Clearing a Check Drawn against the Bank 15.1 -15.2 Review - The US has a fractional reserve banking system, in which the collective reserves of the banks usually are considerably less than 100% of their checkable deposit liabilities - When a bank accepts deposits of cash, the composition of the money supply is changed, but the total supply of money is not directly altered - Commercial banks & thrifts are obliged to keep required reserves equal to a specified percentage of their own checkable-deposit liabilities as cash or on deposit with the Federal Reserve Bank of their district - The amount by which a bank’s actual reserves exceed its required reserves is called excess reserves - A bank that has a check drawn & collected against it will lose to the recipient bank both reserves & deposits equal to the value of the check 15.3 – Money-Creating Transactions of a Commercial Bank - Federal Funds Rate – the interest rate that US banks & other depository institutions charge one another an overnight loan made out of their excess reserves - Bank transactions involving balance sheets to establish how individual banks can create money: o Transaction 6: Grating a Loan o Transaction 7: Buying Government Securities - The asset items on a commercial bank’s balance sheet reflect the banker’s pursuit of 2 conflicting goals: o Profit o Liquidity 15.3 Review

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Banks create money when they make loans; money vanishes when bank loans are repaid New money is created when banks buy government bonds from the public; money disappears when banks sell government bonds to the public Banks balance profitability & safety in determining their mix of earning assets & highly liquid assets Although the Fed pays interest on excess reserves, banks may be able to obtain higher interest rates by temporarily lending the reserves to other banks in the federal funds market; the interest rate on such loans is the federal funds rate

15.4 – The Banking System: Multiple-Deposit Expansion - 3 assumptions to how paradoxical results come about: o The reserve ratio for all commercial banks is 20% o Initially all banks are meeting this 20% reserve requirement exactly. No excess reserves exist; or in the parlance of banking, they are “loaned up” (or “loaned out”) fully in terms of the reserve requirement o If any bank can increase its loans as a result of acquiring excess reserves, an amount equal to those excess reserves will be lent to one borrower, who will write a check for the entire amount of the loan & give it to someone else, who will deposit the check in another bank. This means the worst thing possible happens to every lending bank – a check for the entire amount of the loan is drawn & cleared against it in favor of another bank 15.5 – The Monetary Multiplier - Monetary Multiplier – the multiple of its excess reserves by which the banking system can expand checkable deposits & thus the money supply by making new loans (or buying securities); equal to 1 divided by the reserve requirement 15.4 -15.5 Review - A single bank in a multibank system can safely lend (create money) by an amount equal to its excess reserves; the banking system can lend (create money) by a multiple of its excess reserves - The monetary multiplier is the reciprocal of the required reserve ratio; it is the multiple by which the banking system can expand the money supply for each dollar of excess reserves - The monetary multiplier works in both directions; it applies to money destruction from the payback of loans as well as the money creation from the making of loans...