Download Tools of Monetary Policy

What is Money?
• Money is any commodity or token that is
generally acceptable as the means of
payment.
• A means of payment is a method of settling
a debt.
Copyright © 1998 Addison Wesley Longman, Inc.
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What Money Does?
• functions of Money
1) Medium of exchange
2) Unit of account
3) Store of value
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Measures of Money?
• Official Measures of Money
1) M1 consists of currency and traveler’s
checks plus checking deposits.
• Includes accounts held by individuals and
businesses, but does not include currency held by
banks, or currency and checking deposits owned by
the U.S. government
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Measures of Money?
• Official Measures of Money
2) M2 consists of M1 plus saving deposits
and time deposits
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Measures of Money?
• Official Measures of Money
3) M3 consists of M2 plus large-scale time
deposits and term deposits
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Two Measures of Money
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Financial Intermediaries
• Financial intermediaries are firms that take
deposits from households and firms and
makes loans to other households and firms.
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Financial Intermediaries
• Four Types of Financial Intermediaries
1) Commercial banks
2) Savings and loan associations
3) Savings banks and credit unions
4) Money market mutual funds
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Financial Intermediaries
• Commercial Banks
• A commercial bank is a firm, licensed by the
Comptroller of the Currency or by a state
agency to receive deposits and make loans.
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Financial Intermediaries
• Commercial Banks
• Their balance sheet is described by the
following formula:
Liabilities + Net Worth = Assets
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Financial Intermediaries
• Reserves and Loans
• Banks divide their funds into two parts:
• Reserves are cash in a bank’s vault plus its deposits
at Federal Reserve banks
• Loans
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Financial Intermediaries
• Three Types of Assets Held by Banks
1) Liquid assets are U.S. government Treasury
bills and commercial bills
2) Investment securities are longer-term
U.S. government bonds and other bonds
3) Loans are commitments of fixed amounts of
money for agreed- upon periods of time
Copyright © 1998 Addison Wesley Longman, Inc.
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Financial Intermediaries (FI)
• The Economic Functions of FI
1) Creating Liquidity
2) Minimizing the cost of borrowing
3) Minimizing the cost of monitoring
borrowers
4) Pooling Risk
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How Banks Create Money
• Reserves: Actual and Required
• The reserve ratio is the fraction of a bank’s total
deposits that are held in reserves.
• The required reserve ratio is the ratio of
reserves to deposits that banks are required, by
regulation, to hold.
• Excess reserves are actual reserves minus
required reserves.
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How Banks Create Money
• Creating Deposits by Making loans in a
One-Bank Economy
Let’s see an example of how
banks create money.
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Creating Money at the
One-and-Only Bank
Balance sheet on January 1
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$100
Loans
$300
Total
$400
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Deposits
$400
Total
$400
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Creating Money at the
One-and-Only Bank
Balance sheet on January 2
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$101
Loans
$300
Total
$401
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Deposits
$401
Total
$401
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Creating Money at the
One-and-Only Bank
Balance sheet on January 3
Assets
(millions of dollars)
Liabilities
(millions of dollars)
Reserves
$101
Loans
$303
Total
$404
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Deposits
$404
Total
$404
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How Banks Create Money
• The Deposit Multiplier
Change in deposits
Deposit multiplier 
Change in reserves
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How Banks Create Money
• Creating Deposits by Making Loans with
Many Banks
Let’s see how the
banking system creates money
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
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Loans
Deposits
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$100,000
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
$75,000
$25,000
Deposit
$100,000
Reserve
$25,000
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Loan
$75,000
$25,000
$75,000
$100,000
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
$75,000
$25,000
Deposit
$100,000
Reserve
$25,000
Loan
$75,000
$25,000
$75,000
$100,000
Deposit
$75,000
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
$75,000
$25,000
Deposit
$100,000
Reserve
$25,000
Loan
$75,000
$25,000
$75,000
$100,000
$43,750
$131,250
$175,000
Deposit
$75,000
Reserve
$18,750
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Loan
$56,250
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Loans
Deposits
Deposit
$56,250
Copyright © 1998 Addison Wesley Longman, Inc.
TM 13-‹#›
The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Deposit
$56,250
Reserve
$14,063
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Loan
$42,187
$43,750
$57,813
Loans
$131,250
$173,437
Deposits
$175,000
$231,250
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Deposit
$56,250
Reserve
$14,063
Loan
$42,187
$43,750
$57,813
Loans
$131,250
$173,437
Deposits
$175,000
$231,250
Deposit
$42,187
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Reserve
$10,547
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Loan
$31,640
$68,360
Loans
$205,077
Deposits
$273,437
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The Multiple Creation
of Bank Deposits
The sequence
The running tally
Reserves
Reserve
$10,547
Loan
$31,640
Loans
Deposits
$68,360
$205,077
$273,437
$100,000
$300,000
$400,000
and
so on...
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The Fed controls the money supply by
adjusting the reserves of the banking
system.
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The Fed controls the money supply by
adjusting the reserves of the banking
system. These reserves are controlled by
three tools available to the Fed.
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1) Required reserve ratios
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1) Required reserve ratios
2) Discount rate
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1) Required reserve ratios
2) Discount rate
3) Open market operations
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• Required Reserve Ratios
• The Fed determines a required reserve ratio for
each type of deposit.
• In 1997, banks were required to keep 3 percent of
checking deposits up to $49 million and 10 percent
of deposits in excess of $49 million.
• Other deposits had no reserve requirement.
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• Discount Rate
• The discount rate is the interest rate at which
the Fed stands ready to lend reserves to
commercial banks.
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• Open Market Operations
• Open market operations are the purchase or sale
of government securities by the Federal
Reserve System on the open market.
Copyright © 1998 Addison Wesley Longman, Inc.
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