Monetary Policy - Total

Monetary policy is the Federal Reserve System´s use of the money supply, interest rates, and the loans generated by the banking system to influence the level of overall spending in the economy.

Objectives

After studying this chapter, you should be able to:
· define monetary policy.
· define fiscal policy.
· explain how expansionary monetary policy influences the economy.
· explain how contractionary monetary policy influences the economy.
· define money.
· explain the three functions of money and provide examples of money used in each of these functions.
· define barter, double coincidence of wants, and the relationship between the two concepts.
· explain the difference between currency, paper bills, and coins.
· explain the difference between fiat money and commodity money.
· recite, translate, and explain the Jacksonville University motto.
· explain the difference between the M1, M2, and M3 definitions of the money supply.
· define a central bank.
· explain when and why the Federal Reserve System was created.
· list and explain the functions of the Federal Reserve System.
· explain the structure of the Federal Reserve System and describe the duties performed by each part.
· list the cities in which the 12 regional Federal Reserve Bank are headquartered.
· list and explain the three instruments of monetary policy.
· define and explain fractional-reserve banking.
· define reserves and explain the difference between required reserves and excess reserves.
· explain the difference between the reserve ratio (R) and the required reserve ratio (rr).
· define and explain the money multiplier.
· define and explain the monetary base.
· explain the relationship between assets, liabilities, and net worth.
· define U.S. government securities.
· define liquidity.
· use T-accounts to illustrate how required reserves help make the banking system solvent.
· explain the difference between the discount rate and the federal funds rate.
· define open market operations
· explain how the Federal Reserve System uses the required reserve ratio to influence the economy.
· explain how the Federal Reserve System uses the discount and federal funds rates to influence the economy.
· explain how the Federal Reserve System uses open market operations to influence the economy.
· define a commercial bank.









Macroeconomic Policy Tools

Monetary and fiscal policies are two tools that are used to manage the economy in attempts to achieve macroeconomic policy goals. Monetary policy is used more frequently to manage the economy because it has a smaller political bias than fiscal policy.

Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

Fiscal policy is taxing and spending by the government.


How Monetary Policy Affects the Economy

Monetary policy is conducted in the United States by the Federal Reserve System (the Fed), which is the U.S. central bank. A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy. The Fed influences the economy by changing the money supply and interest rates to either increase or decrease aggregate demand (AD), which is overall spending on newly produced goods and services. When the Federal Reserve conducts monetary policy, it may increase or decrease the money supply depending on the condition of the economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans. Thus, expansionary monetary policy increases the money supply. If the economy needs stimulation (e.g., to fight unemployment), then the Fed usually conducts expansionary monetary policy to increase the money supply, reduce interest rates, and encourage more consumption and investment spending. Low interest rates encourage households and businesses to borrow money. If they use this borrowed money to increase spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand increases. Aggregate demand is composed of consumption spending (C), investment spending (I), government purchases (G), and net exports (X-M).


AD = C + I + G + X - M


Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans. Thus, contractionary monetary policy decreases the money supply. If the economy needs dampening (e.g., to fight inflation), then the Fed usually conducts contractionary monetary policy to decrease the money supply, increase interest rates, and discourage consumption and investment spending. High interest rates discourage households and businesses from borrowing money. If higher interest costs reduce spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand decreases.


Money and its Functions

Money is anything that is generally accepted to serve as a medium of exchange, store of value, and unit of account.

Functions of Money

· Money is a medium of exchange when it is used to facilitate trade. In the absence of money, trade is done by barter. Barter is the exchange of a good or service for another good or service. Barter is often difficult because it requires a double coincidence of wants, which is the need for a trader to find a partner who has a product he wants and who wants what he is offering to trade. Buying food from the grocery store with a twenty-dollar bill is an example of using money as a medium of exchange.

· Money is a store of value when it is used to hold purchasing power for use at a later time. Putting coins in a piggy bank is an example of using money as a store of value.

· Money is a unit of account when it is used to measure the prices of things. In the United States, items are priced in dollars and cents.

Many things have been used as money throughout history. In Colonial Virginia, bundles of tobacco were used as money. In World War II, soldiers used cigarettes as money. On the Pacific island of Yap, giant circular stones with holes in the center are used as money.

Types of Money

Currency is paper bills and coins. Paper bills are paper or cloth notes with markings that indicate their monetary denominations. Paper bills are an example of fiat money. Coins are hard materials, typically metals, with markings that indicate their monetary denominations. Coins are an example of commodity money.

Fiat money is money that does not have intrinsic value. It generally cannot be used except as money. “Fiat” is Latin for “let it be done.” In English, a fiat is an arbitrary order or degree. Thus, fiat money is money because the government has declared it to be so. The Jacksonville University motto is “fiat lux,” which translates as “let there be light” or “let the light shine.” The goal of the university is to enlighten its students.

Commodity money is money that has intrinsic value. It can be used as something other than money. Gold and silver coins are commodity money because they can be melted down and used to make jewelry or other goods.


Definitions of the U.S. Money Supply

In the United States, the money supply has several definitions.

M1 = currency[1] + travelers checks[2] + demand deposits[3] and other checkable deposits[4],[5]

A traveler’s check is a draft, available in various denominations, that must be signed at the time of purchase and which can be redeemed only when countersigned with a matching signature at the time of redemption.

A demand deposit is the balance in a checking account at a commercial bank. Depositors may withdraw these funds on demand using a check or debit card.

M2 = everything in M1 + savings accounts + money market accounts + money market mutual funds + small denomination certificates of deposit

M3 = everything in M2 + large denomination certificates of deposit



U.S. Money Stock Measures


Table 1. Money Stock Measures.

Totals for the week ending
March 14, 2005
(in billions of dollars)
Currency[1]
703.2
Travelers checks[2]
7.5
Demand deposits[3]
320.8
Other checkable deposits at commercial banks[4]
182.2
Other checkable deposits at thrift institutions[5]
137.4
M1
1,351.1
M2
6,407.5
M3
9,477.4
Source: Federal Reserve System (http://www.federalreserve.gov/releases/H6/Current/)





Overview of the Federal Reserve System

Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

The Federal Reserve System (the Fed), the central bank of the United States, conducts U.S. monetary policy. The Fed is a quasi-government agency that was created in 1913, after a series of bank failures, to ensure the health of the banking system of the United States.

The Federal Reserve System is composed of a Board of Governors (BOG), the Federal Open Market Committee (FOMC), and twelve regional Federal Reserve Banks. These three parts work together to accomplish the Fed’s three main responsibilities:

(1) conducting monetary policy to promote economic growth, low unemployment, and low inflation;
(2) supervising and regulating banks to maintain the stability of the financial system; and
(3) providing financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve System does not print currency. U.S. currency is printed by the Bureau of Engraving and Printing, which is part of the U.S. Department of the Treasury.


Functions of the Federal Reserve System

Function #1: Conducting Monetary Policy

The primary function of the Fed is the conduct of monetary policy. Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

If the Fed thinks the economy needs a stimulus (e.g., to fight unemployment), it will increase the money supply by inducing commercial banks to create more money through loans. Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans. Commercial banks are usually referred to simply as banks. Depositors are paid little or no interest on their deposited funds. Borrowers are charged moderate to high interest rates on their loans from commercial banks, however. Most commercial banks attempt to earn profits for their stockholders (i.e., the owners of the bank). Credit unions are not-for-profit organizations that provide banking services to members. Credit unions usually offer more favorable interest rates than other financial institutions. Many credits unions pay slightly higher rates of return on deposits and charge slightly lower rates of interest on loans than traditional banks.

If the Fed thinks the economy needs to slow down (e.g., to fight inflation), it will decrease the money supply by inducing commercial banks to create less money through loans.

Open market operations are the purchases and sales of government securities by the Fed to or from the general public. Monetary policy is conducted primarily through open market operations by the Federal Open Market Committee (FOMC). The FOMC meets approximately every six weeks to discuss the condition of the economy and consider changing the nation’s money supply. The 12 regional Federal Reserve Banks play an important role in monetary policy by providing economic data and research to the FOMC for its consideration. After each meeting, the FOMC directs the Open Market Desk at the Federal Reserve Bank of New York to increase, decrease or maintain the growth rate of the nation’s money supply. To increase the money supply, the Open Market Desk buys Treasury securities each day from the general public (i.e., in the open market). These transactions are open market purchases. To decrease the money supply, the Open Market Desk sells Treasury securities each day to the general public (i.e., in the open market). These transactions are open market sales.

If the Board of Governors thinks the economy needs more influence than is provided by the open market operations, it can change the discount and federal funds rates, which are the interest rates charged on loans to commercial banks. Low interest rates provide an incentive for commercial banks to create more money in the form of loans to the general public. The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks. Loans from regional Federal Reserve Banks to commercial banks are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate. Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves. Reserves are explained later in this chapter.

If the Board of Governors wants to make a major adjustment to the economy, it might change the required reserve ratio. Decreasing the required reserve ratio allows commercial banks to create more money in the form of loans to the general public. Increasing the required reserve ratio causes commercial banks to create less money in the form of loans to the general public.


Function #2: Supervising and Regulating Banks

The Federal Reserve System maintains the stability of the financial system and protects the credit rights of consumers. Prior to the creation of the Federal Reserve System in 1913, the United States endured many banking panics. So to stabilize the banking system, Congress gave the Fed the responsibility to supervise and regulate banks. The Board of Governors develops the written rules that define acceptable behavior for financial institutions. The 12 regional Federal Reserve Banks supervise the enforcement of these rules by overseeing state-chartered member banks, the companies that own banks (bank holding companies) and international organizations that do banking business in the United States. The Federal Reserve System also ensures the stability of the banking system by acting as a lender of last resort. This means that if a commercial bank is in danger of going bankrupt, the Fed will provide the bank with enough funds to keep it solvent. A bank is solvent if it is able to meet its financial obligations, such as providing money to all depositors who wish to wish to withdraw their funds.






Function #3: Providing Financial Services[6]

The Federal Reserve System provides financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve Banks and their branches provide a safe and efficient method of transferring funds throughout the banking system by offering banking services to all financial institutions in the United States.

Each Federal Reserve Bank provides banking services to all financial institutions in its geographic region. These services include the provision of currency as needed by the area’s financial institutions and the processing of commercial checks and other electronic payments.

The electronic payment services provided by the Fed are funds transfers and the automated clearinghouse (ACH). Funds transfers occur between financial institutions or government agencies. ACH transactions include payroll deposits, electronic bill payments, insurance payments, and Social Security distributions.

Because the Federal Reserve System provides banking services to financial institutions, such as commercial banks, the Fed is sometimes called the bankers’ bank. The Federal Reserve also provides banking services to the U.S. government. These services include the maintenance of U.S. Treasury accounts, the processing of government checks, the sale, service, and redemption of U.S. Treasury securities, savings bonds and postal money orders, and the collection of federal tax deposits.


Structure of the Federal Reserve System


The Federal Reserve System is composed of three parts: (1) the Board of Governors (BOG), (2) the Federal Open Market Committee (FOMC), and (3) twelve regional Federal Reserve Banks

The Board of Governors sets policy for the Federal Reserve System. Its seven members are appointed by the President of the United States and confirmed by the Senate. The Federal Reserve governors are given 14-year terms to insulate them from political pressure. The terms are staggered so one term expires every two years. The chairman of the Board of Governors is the most important member of the Fed. The chairman oversees the Fed staff, presides over board meetings, reports regularly to congressional committees, and influences the direction of monetary policy. The President of the United States appoints the Fed chairman to a four-year term. It is not uncommon for a Fed chairman to serve many consecutive terms. For example, Alan Greenspan was originally appointed in 1987 by President Ronald Reagan, and later reappointed by Presidents George H.W. Bush, Bill Clinton, and George W. Bush.

The Federal Open Market Committee (FOMC) conducts open market operations to alter the money supply and influence the economy. Open market operations are the purchases and sales of U.S. government securities by the Federal Reserve System. The FOMC is composed of the seven members of the Board of Governors and five of the 12 regional bank presidents. The president of the New York Fed is always on the FOMC because the purchases and sales of government bonds are conducted at the New York Fed’s trading desk. The other four positions on the FOMC are rotated among the remaining 11 regional bank presidents. Open market operations are the Fed’s primary tool for conducting monetary policy and influencing the economy. The FOMC typically meets every six weeks in Washington, D.C. to discuss the condition of the economy and to consider changes in monetary policy.

The United States is divided into 12 Federal Reserve districts with one regional Federal Reserve Bank headquartered in each district. The 12 regional Federal Reserve Banks oversee the health of the banking system. They are headquartered in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco. The presidents of the regional banks are chosen from each bank’s board of directors, who are typically leaders of the region’s banking and business community.

The 12 regional Federal Reserve banks perform the following functions:
1. clear checks
2. issue new currency
3. withdraw damaged currency from circulation
4. evaluate some merger applications
5. administer and make discount loans to banks in their districts
6. act as liaisons between the business community and the Federal Reserve System
7. examine state member banks
8. collect data on local business conditions
9. use their large staffs of professional economists to research topics related to the conduct of monetary policy[7]






Figure 2. A map of the twelve Federal Reserve districts, their regional headquarters, and branch offices. Source: The Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/)


Instruments of Monetary Policy


The Federal Reserve System uses three instruments of monetary policy: (1) the required reserve ratio, (2) the discount and federal funds rates, and (3) open market operations. All three instruments affect the economy by influencing the amount of money commercial banks create through loans.

In order to understand how the Fed uses these monetary policy instruments to influence the economy, it is necessary to understand the fractional reserve banking system.


Fractional Reserve Banking

Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves. Reserves are a commercial bank’s deposits in accounts at a Federal Reserve Bank plus its vault cash. Vault cash is the currency held in the commercial bank’s vault. When banks hold only part of their deposits as reserves, they are able to create money by making loans. If banks held all deposits as reserves, banks would not influence the money supply because they would not be able to issue loans. The money supply increases when banks create new loans. The money supply decreases when banks reduce the amount of money loaned to the public.

Banks are businesses that make profits by accepting deposits of funds and lending a portion of them to businesses and households. Banks pay depositors little or no interest, but charge moderate to high interest rates to borrowers. The difference in the interest rates charged to borrowers and paid to depositors allows banks to cover their costs of operation and make a profit.

When a customer deposits currency in a bank, the bank does not write the customer’s name on it and place it in the vault until the customer returns to withdraw it. Only a small fraction of all the money deposited in banks is kept in the bank's vault or on account with the Fed. The majority of the money deposited in banks is loaned to businesses or households or otherwise invested by the bank.

To illustrate how fractional reserve banking works, it helps to examine a simplified bank balance sheet.



Table 2. A simplified balance sheet for a commercial bank.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,000)
(excess = $ 400,000)
$1,400,000
Deposits
$10,000,000
Loans
$7,500,000


Government Securities
$ 900,000


Property & other assets
$600,000
Net Worth
$ 400,000




Total Assets
$10,400,000
Total Liabilities
& Net Worth
$10,400,000


The left side of the balance sheet lists the assets of the bank. An asset is a financial claim or piece of property that is a store of value. Assets are what the bank owns or is owed. The right side of the balance sheet lists the bank’s liabilities and net worth. Liabilities are debts. Liabilities represent what the bank owes someone else. Net worth is the difference between a firm’s assets and its liabilities. In the sample balance sheet above, the bank’s assets include reserves, loans, government securities, and property & other assets. Reserves are the bank’s deposits in accounts with the Fed plus currency that is held in the bank’s vault. Required reserves are the vault cash and deposits at the Fed that commercial banks hold to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves. Excess reserves are the vault cash and deposits at the Fed that commercial banks hold is addition to those held to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves. Thus, excess reserves are the reserves that banks hold in excess of the required reserves. U.S. government securities are long-term debt instruments (such as bonds) issued by the U.S. Treasury to finance the budget deficits of the federal government. They are the most widely traded bonds in the United States and are thus the most liquid security. Liquidity is the relative ease and speed with which an asset can be converted into cash. Loans are assets for banks because they represent money that the borrowers owe to the bank. Deposits are liabilities for banks because they represent money that the bank is obligated to pay back to the depositors. By definition, net worth is assets minus liabilities.




How Required Reserves Keep the Banking System Solvent


Reserves are deposits that banks have received but not loaned out. Instead they are kept as currency in the vault of the bank (vault cash) or deposited in the bank’s accounts at the Federal Reserve System.

Banks do not earn a rate of return on reserves. Reserves can be divided into two categories: reserves that the Fed requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves).

The Federal Reserve System established and controls the required reserve ratio. The required reserve ratio (rr) is the fraction or percentage of deposits that commercial banks are required to hold in the form of reserves. This money can be kept in the vault of the commercial banks (as vault cash) or deposited with the regional Federal Reserve Banks that serve the commercial banks. In the absence of a required reserve ratio, commercial banks might not hold enough reserves. This might cause consumers to lose confidence in the banking system.

To illustrate how the required reserve ratio helps maintain the solvency of the banking system, consider the following example. Suppose a new bank, the Dolphin Bank, is created. Suppose the first depositor, Tracy, deposits 100 dollar bills in the Dolphin Bank and these are placed in the bank’s vault. At the end of this transaction, Tracy has a $100 deposit at the Dolphin Bank (which is a liability for the bank) and the Dolphin Bank has $100 of reserves (cash in the vault, which is an asset for the bank).
Table 3.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)

The Dolphin Bank will not earn any profit if it leaves the $100 in its vault. Banks earn profits by creating loans. Suppose the Dolphin Bank lends the $100 to Brenda. It takes all 100 dollar bills from the vault and gives them to Brenda as a loan. The Dolphin Bank now has no cash in the vault, but its loan to Brenda is an asset for the bank.

Table 4.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves 0
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 100
(owed to the bank by Brenda)


This is not a good situation, however. Suppose Tracy decides to withdraw $10 from her account. Since the bank has no reserves, it does not have any currency in the vault to give Tracy. The bank is now insolvent. A bank is insolvent if it does not have enough cash to provide to the depositors who wish to withdraw their funds. To avoid this situation, the Federal Reserve System requires banks to keep a fraction of their deposits as reserves (vault cash and deposits at the Fed). If the required reserve ratio is .10 (i.e., 10 percent), then the maximum loan the Dolphin Bank could create from a $100 deposit would be $90. Ten dollars would be required to be kept as reserves. The balance sheet of the Dolphin Bank is now illustrated in Table 5.

Table 5.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 10
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)


If Tracy goes to withdraw $10 from her account, the bank will have the currency in the vault. If Tracy withdraws $10, the balance sheet of the Dolphin Bank is:

Table 6.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves 0
(cash in the bank’s vault)
Deposits $ 90
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)



In this scenario, the bank is able to give Tracy the $10 she requests, but the bank no longer has 10% of deposits as reserves. Thus it is normal for banks to hold excess reserves.

Consider again the example of Tracy making an initial $100 deposit at the Dolphin Bank. Suppose the bank keeps $30 of this deposit as reserves and creates loans of $70. Of the $30 in reserves, $10 are required reserves (because 10 percent of $100 is $10) and the remaining $20 are excess reserves. In this case, the balance sheet of the Dolphin Bank is:

Table 7.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 30
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 70
(owed to the bank by Brenda)


Suppose Tracy now withdraws $10 from her account. The bank takes $10 of currency out of the vault and gives it to Tracy and reduces the balance in Tracy’s account to $90. The balance sheet of the Dolphin Bank is now:

Table 8.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 20
(cash in the bank’s vault)
Deposits $ 90
(owed to Tracy by the bank)
Loans $ 70
(owed to the bank by Brenda)


The bank now has $90 of deposits and $20 of reserves. Of the $20, $9 are required reserves (because 10 percent of $90 is $9) and the remaining $11 are excess reserves.

By holding excess reserves, the Dolphin Bank avoided falling short of reserves when Tracy withdrew part of her deposit.


The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply


The total amount of money in an economy depends on two things: the monetary base and the reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Reserves are the currency commercial banks hold in their vaults plus deposits in their accounts at the Fed.

The reserve ratio (R) is the fraction of deposits that banks hold as reserves. The reserve ratio (R) equals the required reserve ratio (rr) only if banks hold no excess reserves. The reserve ratio (R) is larger than the required reserve ratio (rr) when banks hold excess reserves.

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is the reciprocal of the reserve ratio.


money multiplier = 1/R where R = reserve ratio


The money supply can be calculated as the monetary base multiplied by the money multiplier. If the reserve ratio is .10, for example, then the money multiplier is (1/.10) = 10. If the monetary base is $1 billion, then the money supply is $10 billion.


Using T-accounts to Illustrate How Banks Create Money


Suppose the only currency in our simple economy is the 100 dollar-bills that Tracy deposited in the Dolphin Bank. If the required reserve ratio is .10 and all banks choose to hold no excess reserves, how large can the money supply become? If banks hold no excess reserves, then the reserve ratio is the same as the required reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Thus, this simple economy has a monetary base of $100. The money multiplier is 10 because it is the inverse of the reserve ratio (.10). Since the money supply is the monetary base multiplied by the money multiplier, the money supply in this economy is $1000.

To illustrate how a bank creates money, return to the previous example. Suppose a new bank, the Dolphin Bank, is created. Suppose the first depositor, Tracy, deposits 100 dollar bills in the Dolphin Bank and these are placed in the bank’s vault. At the end of this transaction, Tracy has a $100 deposit at the Dolphin Bank (which are liabilities for the bank) and the Dolphin Bank has $100 of reserves (cash in the vault, which are assets for the bank).

Table 9.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)


The Dolphin Bank will not earn any profit if it leaves the $100 in its vault. Banks earn profits by creating loans. Suppose the Dolphin Bank keeps $10 as required reserves and lends $90 to Brenda. It takes 90 dollar bills from the vault and gives them to Brenda as a loan. The Dolphin Bank now has $10 cash in the vault and its $90 loan to Brenda as assets.


Table 10.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 10
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)



When people borrow money, they usually spend it. Suppose Brenda uses the $90 loan to buy a guitar from Carlos. Suppose Carlos deposits the $90 in an account at the Dolphin Bank. The bank now has $190 in deposits, $100 in vault cash, and $90 in loans.


Table 11.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 90
(owed to the bank by Brenda)



The Dolphin Bank now has excess reserves that can be used to create more loans. Since the bank is only required to keep $19 as reserves (10% of $190 is $19), it can create an $81 loan. Suppose the Dolphin Bank lends $81 to Jasmine.

Table 12.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 19
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Suppose Jasmine uses the $81 to buy a painting from Vincent. Suppose Vincent deposits the $81 in an account at the Dolphin Bank. The bank now has $271 is deposits, $100 in vault cash, and $171 in loans.


Table 13.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Once again, the Dolphin Bank has excess reserves that can be used to create additional loans. Since the bank is only required to keep $27.10 as reserves (10% of $271 is $27.10), it can create a $72.90 loan. Suppose the Dolphin Bank lends $72.90 to August.


Table 14.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 27.10
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)




Suppose August uses the $72.90 to buy a book from Maya. Suppose Maya deposits the $72.90 in an account at the Dolphin Bank. The bank now has $343.90 in deposits, $100 in vault cash, and $243.90 in loans.


Table 15.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 343.90
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
($72.90 owed to Maya by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)



This process can continue until the entire $100 currency becomes required reserves. In this case, $1000 of deposits will have been created by issuing $900 in loans.

Table 16 provides an example of how $100 currency could create $1000 of money in the form of deposits in bank accounts if banks hold 10% of all deposits as reserves and create loans that equal 90% of the value of each deposit.

Table 16.
Loan number
Loan amount
(dollars)
Total value of the loans
(dollars)
Total value of deposits
(dollars)
Loan number
Loan amount
(dollars)
Total value of the loans
(dollars)
Total value of deposits
(dollars)
0
0
0
100
49
0.57
894.83
994.83
1
90
90
190
50
0.52
895.35
995.35
2
81
171
271
51
0.46
895.81
995.81
3
72.9
243.90
343.90
52
0.42
896.23
996.23
4
65.61
309.51
409.51
53
0.38
896.61
996.61
5
59.05
368.56
468.56
54
0.34
896.95
996.95
6
53.14
421.70
521.70
55
0.30
897.25
997.25
7
47.83
469.53
569.53
56
0.27
897.52
997.52
8
43.05
512.58
612.58
57
0.25
897.77
997.77
9
38.74
551.32
651.32
58
0.22
897.99
997.99
10
34.87
586.19
686.19
59
0.20
898.19
998.19
11
31.38
617.57
717.57
60
0.18
898.37
998.37
12
28.24
645.81
745.81
61
0.16
898.53
998.53
13
25.42
671.23
771.23
62
0.15
898.68
998.68
14
22.88
694.11
794.11
63
0.13
898.81
998.81
15
20.59
714.70
814.70
64
0.12
898.93
998.93
16
18.53
733.23
833.23
65
0.11
899.04
999.04
17
16.68
749.91
849.91
66
0.10
899.14
999.14
18
15.01
764.92
864.92
67
0.09
899.23
999.23
19
13.51
778.43
878.43
68
0.08
899.31
999.31
20
12.16
790.59
890.59
69
0.07
899.38
999.38
21
10.94
801.53
901.53
70
0.06
899.44
999.44
22
9.85
811.38
911.38
71
0.06
899.50
999.50
23
8.86
820.24
920.24
72
0.05
899.55
999.55
24
7.98
828.22
928.22
73
0.05
899.60
999.60
25
7.18
835.40
935.40
74
0.04
899.64
999.64
26
6.46
841.86
941.86
75
0.04
899.68
999.68
27
5.81
847.67
947.67
76
0.03
899.71
999.71
28
5.23
852.90
952.90
77
0.03
899.74
999.74
29
4.71
857.61
957.61
78
0.03
899.77
999.77
30
4.24
861.85
961.85
79
0.02
899.79
999.79
31
3.82
865.67
965.67
80
0.02
899.81
999.81
32
3.43
869.10
969.10
81
0.02
899.83
999.83
33
3.09
872.19
972.19
82
0.02
899.85
999.85
34
2.78
874.97
974.97
83
0.02
899.87
999.87
35
2.50
877.47
977.47
84
0.01
899.88
999.88
36
2.25
879.72
979.72
85
0.01
899.89
999.89
37
2.03
881.75
981.75
86
0.01
899.90
999.90
38
1.82
883.57
983.57
87
0.01
899.91
999.91
39
1.64
885.21
985.21
88
0.01
899.92
999.92
40
1.47
886.68
986.68
89
0.01
899.93
999.93
41
1.33
888.01
988.01
90
0.01
899.94
999.94
42
1.20
889.21
989.21
91
0.01
899.95
999.95
43
1.08
890.29
990.29
92
0.01
899.96
999.96
44
0.97
891.26
991.26
93
0.01
899.97
999.97
45
0.87
892.13
992.13
94
0.01
899.98
999.98
46
0.79
892.92
992.92
95
0.01
899.99
999.99
47
0.70
893.62
993.62
. . .
0.01
900
1000
48
0.64
894.26
994.26








How the Instruments of Monetary Policy Affect the Economy


All three of the Fed’s monetary policy tools affect the number of reserves banks hold and thus affect the amount of money banks create through loans.


Monetary Policy Instrument #1: the Required Reserve Ratio

The most powerful, but least used, instrument of monetary policy is the required reserve ratio.

Lowering the required reserve ratio increases the money supply (expansionary monetary policy).
· If the Fed decreases the required reserve ratio, banks will be required to keep a smaller percentage of their deposits in the form of required reserves.
· Consequently, banks will be allowed to loan out more when the required reserve ratio is smaller.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)
Raising the required reserve ratio reduces the money supply (contractionary monetary policy).
· If the Fed increases the required reserve ratio, banks will be required to keep a larger percentage of their deposits in the form of required reserves.
· Consequently, banks will not be allowed to loan out as much when the required reserve ratio is higher.
· Fewer loans mean the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)


Monetary Policy Instrument #2: the discount rate and the federal funds rate

The discount rate is the interest rate charged by the Fed on loans to commercial banks. These loans are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate.

Lowering the discount and federal funds rates increases the money supply (expansionary monetary policy).
· If the Fed decreases the discount and federal funds rates, banks will be more willing to risk putting themselves in a position where they would need to borrow from the Fed to meet the required reserve ratio.
· Consequently, banks will keep fewer excess reserves and loan out more money than they would if the discount rate were higher.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)
Raising the discount and federal funds rates reduces the money supply (contractionary monetary policy).
· If the Fed increases the discount and federal funds rates, banks will be reluctant to risk putting themselves in a position where they would need to borrow from the Fed to meet the required reserve ratio.
· Consequently, banks will keep more excess reserves and not loan out as much as they would if the discount rate were lower.
· Fewer loans mean the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)



Monetary Policy Instrument #3: open market operations

The most frequently used instrument of monetary policy is open market operations. Open market operations are the purchases and sales of government securities by the Federal Open Market Committee (FOMC).

Open market purchases of government securities increases the money supply (expansionary monetary policy).
· If the Fed buys government securities, then the monetary base increases and banks end up with more excess reserves.
· Banks typically will use these excess reserves to make more loans.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)

Open market sales of government securities decreases the money supply (contractionary monetary policy).
· If the Fed sells government securities, the monetary base decreases and banks end up with fewer excess reserves.
· Fewer excess reserves imply that banks typically will reduce the quantity of money they lend.
· Less money loaned means the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)[8]




Example of How the Fed Uses an Open Market Purchase to Increase the Money Supply in a Fractional Reserve Banking System with 10% Required Reserves

Suppose the Fed conducts an open market purchase of a $1000 Treasury bill from a securities dealer, Adam Aardvark, with a checking account at the First National Bank. What would be the total effect on the money supply?

To examine changes in the balance sheets of banks, economists use T-accounts. A T-account is a simplified balance sheet with lines in the form of a T that lists only the changes that occur in the balance sheet items from some initial balance sheet position.

For simplicity, assume all banks have the same initial balance sheet as illustrated in the sample above for the First National Bank.

Assume the required reserve ratio is 10% (rr = .10) and banks do not hold any additional excess reserves. If banks hold more reserves than required, the reserve ratio, R, is larger than the required reserve ratio, rr. If banks do not hold excess reserves, however, the reserve ratio is equal to the required reserve ratio (R = rr). This implies banks will make loans for the maximum amount of any new deposits. When the Fed purchases the $1000 government security from Adam Aardvark (who has an account at the First National Bank), the bank’s balance sheet changes as follows:


Table 17.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $1000
Deposits
(Adam’s account)
+ $1000



Table 18.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,100)
(excess = $ 400,900)
$1,401,000
Deposits
$10,001,000
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,000
Total Liabilities
& Net Worth
$10,401,000

When the Fed conducts the open market purchase of the $1000 government security, the Fed has credited $1000 to the First National Bank’s account at the Fed. This increases the First National Bank’s reserves. Its reserves are the sum of the currency in the First National Bank’s vault plus the balance in the First National Bank’s account at the Federal Reserve. The First National Bank, in turn, credits $1000 to the securities dealer’s account at the First National Bank. The open market operation has increased the assets of the First National Bank by $1000 (the increase in its reserves) and has increased the liabilities of the First National Bank by $1000 (the additional $1000 deposited in Adam Aardvark’s account).

Since it is assumed banks do not want to hold any additional excess reserves, the First National Bank will keep only the required amount of reserves and will loan out the additional reserves in order to earn additional interest income. Since the required reserve ratio is .10, the First National Bank will be required to keep 10 percent of this additional deposit as reserves. Since the new deposit in the securities dealer’s account is $1000, the First National Bank is required to keep $100 of it as reserves and can create $900 in loans.


Table 19.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $900
Deposits
+ $900


Table 20.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,190)
(excess = $ 400,810)
$1,401,000
Deposits
$10,001,900
Loans
$7,500,900


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,900
Total Liabilities
& Net Worth
$10,401,900


Suppose the First National Bank loans the $900 to Bernice Bear. It does this by increasing the balance in Bernice’s checking account at First National Bank. The money supply has just increased by another $900. (Remember the M1 definition of the money supply is currency in circulation plus the balances in checking accounts plus travelers’ checks outstanding.) The total effect on the money supply to this point is $1900. The securities dealer, Adam Aardvark, still has the $1000 increase in his account (deposits) and Bernice Bear has the $900 increase in her account.

When people borrow money, they usually spend it right away. Suppose Bernice buys a $900 painting from Charlie Cheetah. Suppose Charlie deposits this in his bank, Second National Bank. Bernice’s account balance at First National Bank decreases by $900 and Charlie’s account balance at Second National Bank increases by $900. One of the Fed’s functions is to clear checks in the banking system. In this case, the check is cleared when the Fed deducts $900 from the First National Bank’s account at the Fed and adds $900 to the Second National Bank’s account at the Fed. Notice that the First National Bank’s reserves decrease by $900 and the Second National Bank’s reserves increase by $900. The total amount of reserves in the banking system remains unchanged, however.


Table 21.
Changes in the Balance Sheet of the FIRST NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
- $900
Deposits
- $900


Table 22.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,100)
(excess = $ 400,000)
$1,400,100
Deposits
$10,001,000
Loans
$7,500,900


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,000
Total Liabilities
& Net Worth
$10,401,000

Table 23.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $900
Deposits
+ $900

Table 24.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,900
Deposits
$10,000,900
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,400,900
Total Liabilities
& Net Worth
$10,400,900

The total change in the money supply to this point is still $1900. Adam still has the additional $1000 in his account at First National Bank and Charlie now has an additional $900 in his account at Second National Bank.

With Charlie’s $900 deposit, the Second National Bank also has a $900 increase in its reserves. The bank is only required to keep 10% of deposits as reserves and it is assumed banks do not hold any additional excess reserves. Thus, the Second National Bank will keep $90 of the new deposit as reserves and will create $810 in new loans.

Table 25.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $810
Deposits
+ $810


Table 26.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,171)
(excess = $ 400,729)
$1,400,900
Deposits
$10,001,710
Loans
$7,500,810


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,710
Total Liabilities
& Net Worth
$10,401,710


Suppose Second National Bank loans $810 to Dino Dolphin and increases his account balance by $810. The creation of this loan will increase the money supply by an additional $810. The total effect on the money supply so far is $2710. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Dino now has a $810 increase in his account at the Second National Bank. ($1000 + $900 + $810 = $2710.)

Suppose Dino uses the $810 to buy a decorative ceramic bowl from Esmeralda Elephant. Suppose Esmeralda deposits the $810 in her account at the Third National Bank. Dino’s account balance at the Second National Bank decreases by $810 and Esmeralda’s account balance at the Third National Bank increases by $810.

When the Fed clears this check, it deducts $810 from the Second National Bank’s account at the Fed and adds $810 to the Third National Bank’s account at the Fed. Notice that the Second National Bank’s reserves decrease by $810 and the Third National Bank’s reserves increase by $810. The total amount of reserves in the banking system remains unchanged.


Table 27.
Changes in the Balance Sheet of the SECOND NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
- $810
Deposits
- $810


Table 28.
Balance Sheet of the Second National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,000)
$1,400,090
Deposits
$10,000,900
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,401,710
Total Liabilities
& Net Worth
$10,400,900

Table 29.
Changes in the Balance Sheet of the THIRD NATIONAL BANK
Assets
Liabilities & Net Worth
Reserves
+ $810
Deposits
+ $810

Table 30.
Balance Sheet of the Third National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,810
Deposits
$10,000,810
Loans
$7,500,000


Government Securities
$900,000


Property & other assets
$600,000
Net Worth
$400,000




Total Assets
$10,400,810
Total Liabilities
& Net Worth
$10,400,810

The total change in the money supply is still $2710. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Esmeralda now has a $810 increase in her account at the Third National Bank. ($1000 + $900 + $810 = $2710.)

The Third National Bank is required to keep 10% of this new deposit as reserves and can loan out the rest. This means the Third National Bank will keep $81 of reserves and will create $729 of new loans.

Table 31.
Changes in the Balance Sheet of the THIRD NATIONAL BANK
Assets
Liabilities & Net Worth
Loans
+ $729
Deposits
+ $729





Table 32.
Balance Sheet of the Third National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,090)
(excess = $ 400,810)
$1,400,810
Deposits
$10,001,539
Loans
$7,500,729


Government Securities
$ 900,000


Property & other assets
$600,000
Net Worth
$ 400,000




Total Assets
$10,401,539
Total Liabilities
& Net Worth
$10,401,539


Suppose the Third National Bank loans $729 to Francesca Ferret. Francesca’s account balance at the Third National Bank increases by $729. The total increase in the money supply at this point is now $3439. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, Esmeralda still has the $810 increase in her account at the Third National Bank, and Francesca now has a $729 increase in her account balance at the Third National Bank. ($1000 + $900 + $810 + $729 = $3439.)

Suppose Francesca uses the $729 to buy a tapestry from Gary Gorilla. Suppose Gary deposits the $729 in his bank, the Fourth National Bank. Francesca’s account balance at the Third National Bank decreases by $729 and Gary’s account balance at the Fourth National Bank increases by $729.

The total change in the money supply is still $3439. Adam still has the $1000 increase in his account at the First National Bank, Charlie still has the $900 increase in his account at the Second National Bank, and Esmeralda still has the $810 increase in her account at the Third National Bank and Gary now has a $729 increase in his account at the Fourth National Bank. ($1000 + $900 + $810 + $729 = $3439.)

The Fourth National Bank is required to keep 10% of this new deposit as reserves and can loan out the rest. This means the Fourth National Bank will keep $72.90 of reserves and will create $656.10 of new loans.

Table 33.
FOURTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $81
Deposits + $810
Excess Reserves

Loans + $729
Net Worth
Government Securities

Property & other assets


Suppose Fourth National Bank loans $656.10 to Gary Gorilla. Gary uses the money to buy a sculpture from Helen Hyena. Suppose Helen deposits the $656.10 in her bank, Fifth National Bank.

This bank will be required to keep 10% of this deposit as reserves and will loan out the rest. This means the Fifth National Bank will increase its required reserves by $72.90 and will increase its loans by $656.10.

Table 34.
FIFTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $72.90
Deposits + $729
Excess Reserves

Loans + $656.10
Net Worth
Government Securities

Property & other assets


Suppose Fifth National Bank loans $656.10 to Ian Impala. Ian uses the money to buy a hand-made rug from Julius Jaguar. Julius now has $656.10 that he did not have before. Suppose Julius deposits the $656.10 in his bank, Sixth National Bank. This bank will be required to keep 10% of this deposit as reserves and will loan out the rest. This means the Sixth National Bank will increase its required reserves by $65.61 and will increase its loans by $590.49.

Table 35.
SIXTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $65.61
Deposits + $656.10
Excess Reserves

Loans + $590.49
Net Worth
Government Securities

Property & other assets


The open market purchase of a $1000 government security from the First National Bank has caused an increase in the money supply that is much larger than $1000. So far, the money supply has increased by $4095.10.

Bernice Bear still has the additional $1000 in her account at the Second National Bank, Diego Dolphin still has the additional $900 in his account at Third National Bank, Francesca Ferret still has the additional $810 in her account at the Fourth National Bank, Helen Hyena still has the additional $729 in her account at the Fifth National Bank, and Julius Jaguar still has the additional $656.10 in his account at the Sixth National Bank. The additions to people’s checking accounts are $1000 + $900 + $810 + $729 + $656.10 = $4095.10. This process could continue, however. Eventually the total increase in the money supply would be $10,000. The amount of money the banking system generates with each dollar of reserves is the money multiplier. The money multiplier is the inverse of the reserve ratio. In this example, the reserve ratio is .10. Thus the money multiplier is 1/.10 = 10. Thus, each dollar of reserves generates $10 of money. Since the open market operation increased reserves by $1000, the total effect on the money supply is 10 times $1000 = $10,000.

If we continued this example, new loans would be created and deposited, creating new loans to be deposited, creating new loans, etc.
So what is the total effect on the money supply?

The increase in the money supply from a $1000 increase in the reserves when the reserve ratio is 10% and banks loan out all additional excess reserves is:

Change in money supply = 1000 + $900 + $810 + $729 + $656.10 + . . . + . . . + . . . = $10,000.

The formula for making this calculation is:

Increase in reserves / reserve ratio = total increase in the money supply

or

$1000 / .10 = $10,000






Example of Fractional Reserve Banking with 20% Required Reserves

Suppose the Fed conducts an open market purchase of a $1000 Treasury bill from the First National Bank. What would be the total effect on the money supply from this $1000 increase in the reserves if the required reserve ratio is 20%?

If banks do not hold any additional excess reserves, banks will make loans for the maximum amount of any new deposits. When the Fed purchases the $1000 government security from the First National Bank, the bank’s balance sheet changes as follows:

Table 36.
FIRST NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves
Deposits
Excess Reserves + $1000

Loans
Net Worth
Government Securities - $1000

Property & other assets

Since the bank has not acquired any additional deposits, its required reserves do not change. The sale of the Treasury bill has reduced the bank’s holdings of government securities by $1000. In exchange for the government bond, the Fed has credited $1000 to the First National Bank’s account at the Fed.

Since it is assumed banks do not want to hold any additional excess reserves, the First National Bank will loan out the $1000 to earn additional interest income. Suppose the First National Bank loans the $1000 to Adam Aardvark. It does this by increasing the balance in Adam’s checking account at First National Bank. The money supply has just increased by $1000. (Remember the M1 definition of the money supply is currency in circulation plus the balances in checking accounts plus travelers’ checks outstanding.)

Table 37.
FIRST NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves
Deposits
Excess Reserves - $1000

Loans + $1000
Net Worth
Government Securities

Property & other assets


Notice that the net affect of the open market operation is that the First National Bank has decreased its holdings of government securities by $1000 and increased its loans by $1000.

When people borrow money, they usually spend it right away. Suppose Adam buys a $1000 painting from Bernice Bear. Bernice now has $1000 she did not have before. Suppose she deposits this in her bank, Second National Bank. This bank will be required to keep 20% of this deposit as reserves, and will loan out $800.

Table 38.
SECOND NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $200
Deposits + $1000
Excess Reserves

Loans + $800
Net Worth
Government Securities

Property & other assets


Suppose Second National Bank loans $800 to Charlie Cheetah. Charlie uses the money to buy a stereo from Diego Dolphin. Diego now has $800 that he did not have before this transaction. Suppose Diego deposits the $800 in his bank, Third National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Third National Bank will increase its required reserves by $160 and will increase its loans by $640.

Table 39.
THIRD NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $160
Deposits + $800
Excess Reserves

Loans + $640
Net Worth
Government Securities

Property & other assets




Suppose Third National Bank loans $640 to Esmeralda Elephant. Esmeralda uses the money to buy a wide screen television from Francesca Ferret. Francesca now has $640 that she did not have before. Suppose Francesca deposits the $640 in her bank, Fourth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Fourth National Bank will increase its required reserves by $128 and will increase its loans by $512.

Table 40.
FOURTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $128
Deposits + $640
Excess Reserves

Loans + $512
Net Worth
Government Securities

Property & other assets


Suppose Fourth National Bank loans $512 to Gary Gorilla. Gary uses the money to buy a sculpture from Helen Hyena. Helen now has $512 that she did not have before. Suppose Helen deposits the $512 in her bank, Fifth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Fifth National Bank will increase its required reserves by $102.40 and will increase its loans by $409.60.

Table 41.
FIFTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $81.92
Deposits + $409.60
Excess Reserves

Loans + $327.68
Net Worth
Government Securities

Property & other assets


Suppose Fifth National Bank loans $327.68 to Ian Impala. Ian uses the money to buy a hand-made rug from Julius Jaguar. Julius now has $327.68 that he did not have before. Suppose Julius deposits the $327.68 in his bank, Sixth National Bank. This bank will be required to keep 20% of this deposit as reserves and will loan out the rest. This means the Sixth National Bank will increase its required reserves by $65.54 and will increase its loans by $262.14.


Table 42.
SIXTH NATIONAL BANK
ASSETS
LIABILITIES & NET WORTH
Required Reserves + $65.54
Deposits + $327.68
Excess Reserves

Loans + $262.14
Net Worth
Government Securities

Property & other assets


The open market purchase of a $1000 government security from the First National Bank has caused an increase in the money supply that is much larger than $1000. So for, the money supply has increased by $4095.10. Bernice Bear still has the additional $1000 in her account at the Second National Bank, Diego Dolphin still has the additional $900 in his account at Third National Bank, Francesca Ferret still has the additional $810 in her account at the Fourth National Bank, Helen Hyena still has the additional $729 in her account at the Fifth National Bank, and Julius Jaguar still has the additional $656.10 in his account at the Sixth National Bank. The additions to people’s checking accounts are $1000 + $800 + $640 + $512 + $409.60 + $327.68 = $3,689.28. This process could continue, however. Eventually the total increase in the money supply would be $5,000. The amount of money the banking system generates with each dollar of reserves is the money multiplier. The money multiplier is the inverse of the reserve ratio. In this example, the reserve ratio is .20. Thus the money multiplier is 1/.20 = 5. Thus, each dollar of reserves generates $5 of money. Since the open market operation increased reserves by $1000, the total effect on the money supply is 5 times $1000 = $5,000.

Notice that with a higher required reserve ratio, the increase in the money supply is smaller.
· A $1000 increase in banking system reserves caused a $10,000 increase in the money supply when the required reserve ratio was 10%.
· A $1000 increase in banking system reserves caused a $5,000 increase in the money supply when the required reserve ratio was 20%.







IMPORTANT DEFINITIONS FROM CHAPTER 9


· Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

· Fiscal policy is taxing and spending by the government.

A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy.

The Federal Reserve System (the Fed) is the U.S. central bank, which oversees the banking system and regulates the quantity of money in an economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans and thus increases the money supply.

Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans and thus decreases the money supply.

Money is anything that is generally accepted to serve as a medium of exchange, store of value, and unit of account.

· A medium of exchange is something, such as money, that facilitates trade.

· Barter is the exchange of a good or service for another good or service.

· A double coincidence of wants is the need for a trader to find a partner who has a product he wants and who wants what he is offering to trade.

· A store of value is something, such as money, that is used to hold purchasing power for use at a later time.

· A unit of account is something, such as money, that is commonly used to measure the prices of things.

· Currency is paper bills and coins.

· Paper bills are paper or cloth notes with markings that indicate their monetary denominations.

· Coins are hard materials, typically metals, with markings that indicate their monetary denominations.

· Fiat money is money that does not have intrinsic value.

· Fiat lux is the motto of Jacksonville University. It is Latin for “let there be light” or “let the light shine.”

· Commodity money is money that has intrinsic value.

· M1 is the narrowest definition of the U.S. money supply. It includes currency, travelers’ checks, demand deposits and other checkable deposits.

· A traveler’s check is a draft, available in various denominations, that must be signed at the time of purchase and which can be redeemed only when countersigned with a matching signature at the time of redemption.

· A demand deposit is the balance in a checking account at a commercial bank.

· M2 is a definition of the U.S. money supply that includes currency, travelers’ checks, demand deposits and other checkable deposits, savings accounts, money market accounts, money market mutual funds, and small denomination certificates of deposit

· M3 is a definition of the U.S. money supply that includes currency, travelers’ checks, demand deposits and other checkable deposits, savings accounts, money market accounts, money market mutual funds, small denomination certificates of deposit, and large denomination certificates of deposit

· Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans.

· Credit unions are not-for-profit organizations that provide banking services to members.

· Open market operations are the purchases and sales of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) to or from the general public.

· Open market purchases are the purchases of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) from the general public.


· Open market sales are the sales of government securities by the Federal Reserve System’s Federal Open Market Committee (FOMC) to the general public.

· The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks.

· Discount loans are loans from regional Federal Reserve Banks to commercial banks

· The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. It is one half of a percentage point less than the discount rate.

· Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves.

· The Board of Governors is the seven-member committee that sets policy for the Federal Reserve System.

· The Federal Open Market Committee (FOMC) is the twelve-member Federal Reserve System committee that conducts open market operations to alter the money supply and influence the economy.

· Regional Federal Reserve Banks are the Federal Reserve System institutions that oversee the health of the U.S. banking system. The 12 regional Federal Reserve banks also clear checks, issue new currency, withdraw damaged currency from circulation, evaluate some merger applications, administer and make discount loans to banks in their districts, act as liaisons between the business community and the Federal Reserve System, examine state member banks, collect data on local business conditions, and research topics related to the conduct of monetary policy.

· Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves.

· Reserves are the cash in the vault of a commercial bank plus its deposits in accounts at a Federal Reserve Bank.

· Vault cash is the currency held in a commercial bank’s vault.

· An asset is a financial claim or piece of property that is a store of value.

· Liabilities are debts.

· Net worth is the difference between a firm’s assets and its liabilities.

· Reserves are a commercial bank’s deposits in accounts at the Fed plus currency that is held in the bank’s vault.

· Required reserves are the vault cash and deposits at the Fed that commercial banks hold to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves.

· Excess reserves are the vault cash and deposits at the Fed that commercial banks hold is addition to those held to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves.

· U.S. government securities are long-term debt instruments (such as bonds) issued by the U.S. Treasury to finance the budget deficits of the federal government.

· Liquidity is the relative ease and speed with which an asset can be converted into cash. Loans are assets for banks

· The required reserve ratio (rr) is the fraction or percentage of deposits that commercial banks are required to hold in the form of reserves.

· The monetary base is the amount of currency in circulation or held as reserves.

· The reserve ratio (R) is the fraction of deposits that banks hold as reserves.

· The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is the reciprocal of the reserve ratio.

· A T-account is a simplified balance sheet with lines in the form of a T that lists only the changes that occur in the balance sheet items from some initial balance sheet position.





QUESTIONS FOR FURTHER STUDY

1. The island of Yap is known for an unusual form of money. Where is Yap? What is its unique money? Would you classify it as commodity money or fiat money?

2. Do the components of the M1 money supply serve all three functions of money? How about M2 and M3? What is the relationship between the different definitions of the money supply and their abilities to fulfill the functions of money?

3. Is the Federal Reserve System financed by general tax revenues or does it receive income from other sources? How much of the federal government annual budget is devoted to the support of the Federal Reserve System?




ENDNOTES






[1] The currency component of the U.S. money supply is the currency outside the U.S. Treasury, the Federal Reserve Banks and the vaults of depository institutions.

[2] The travelers checks component of the U.S. money supply is the outstanding amount of U.S. dollar-denominated travelers checks of non-bank issuers. Travelers checks issued by depository institutions are included in demand deposits.

[3] The demand deposits component of the U.S. money supply includes the demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and the Federal Reserve float.

[4] Other checkable deposits at commercial banks consist of NOW and ATS balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.

[5] Other checkable deposits at thrift institutions consist of NOW and ATS balances at thrifts, credit union share draft balances, and demand deposits at thrifts.

[6] This is based on the detailed explanation of the Federal Reserve System available from the Board of Governors’ web site. It is accessible at http://www.federalreserve.gov/.

[7] This is based on the detailed explanation of the Federal Reserve System available from the Board of Governors’ web site. It is accessible at http://www.federalreserve.gov/.

[8] This is based on the detailed explanation of the Federal Reserve System available from the Board of Governors’ web site. It is accessible at http://www.federalreserve.gov/.