Unit 4: Money

Balance Sheet: summarizes the financial position of the bank at a certain time

Assets = Liabilities

How do banks create money? Banks create money by lending out deposits

Fractional Reserve Banking System: the bank holds a fraction of the total money supply in reserves as currency                      

Where do the loans come from? Loans come from people who make deposits.         



Money Market: the market where the fed and the users of money interact thus determining the nominal interest rate.

• Money demand comes from households, firms, the government, and foreign sector. 
• Money supply is determined only by the federal reserve because the fed has a monopoly over the supply of money, and for this reason the MS curve is vertical 
• MS is also vertical because it is independent of the interest rate 

OMO: the Fed can buy or sell bonds to the bank or the public

• if the Fed sells bonds, the Fed gets the cash and thus removes it from the money supply
• if the Fed buys bonds, the nation gets the cash, which increases money supply  

Increase MS:

• Buy bonds
• DR decreases
• RR increases

Decrease MS: 

• Sell bonds
• DR increases
• RR increase

Required Reserve: 

• Banks must hold a percentage of all private deposits in the vault, this cannot be used for loans. 
• Raising the RR forces banks to reduce loans. 
• Lowering the RR allows banks to create more loans. 

Discount Rate: 

• FDIC member banks and other eligible institutions may borrow short-term loans directly from the Fed 
• it is considered to be the bank of the last resort 

Federal Fund Rate: 

• FDIC member banks loan each other overnight funds 
• the Fed cannot set this rate, they can only give them a target (i.e suggesting between 0 - 4%)

Prime Rate: 

• the interest rate that banks charge their most creditworthy customers
• has nothing to do with the other rates

Money Creation Process (Assume 10% Reserve Requirement)

Option 1: Option 2:

$1000 in cash deposited into a checking account	$1000 FED purchase of bonds from the public (Deposited into checking account)
No immediate change in MS	Immediate increase of MS of $1000

↘                           ↙

Assets	Liabilities
Reserves $1000	Demand Deposits $1000

Repaired Reserves = $100 (.10 x $1000 deposit)

Single Bank: Amount of money single bank can create (loans out) = ER

Actual Reserves - Required Reserves = Excess, reserves

$1000 - $100 = $900 in ER

Banking System: Can create money by a multiple of its initial excess reserves

Monetary Multiplier = 1/RR = 1/.10 = 10

System New $ = Deposit Multiplier x Initial Excess Reserves

10 x 900 = $9000

Total change in the money supply as a result of the deposit

Initial Deposit (if new) + Banking System Created Money = Total Change in MS

$1000 + $900

If initial deposit is not new money, the total change in MS is only the new money created by the banking systems  

Expansionary Monetary Policy “Easy” Money (Recession) Buy bonds (Big Bucks) RR decreases Dr decreases FFR decreases i decreases Ig increases AD increases MS increases Money depreciates

Contractionary Monetary Policy “Tight” Money (Inflation) Sell bonds RR increases DR increases FFR increases i increases Ig decreases AD decreases MS decreases Money appreciates

Money Demand: 

• Transaction Demand: the demand for money as a medium of exchange 
• Asset Demand: demand for money as a store of value 
• Money demand is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks and bonds

Expansionary Monetary Policy MS shifts to the right Interest rate decreases Reserve ratio decreases Discount rate decreases Open Market Operation buys bonds (more money) = MS increases

Contractionary Monetary Policy MS shifts to the left Interest rate decreases Reserve ratio increases Discount rate increases OMO sells bonds (less money) = money supply decreases