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Chapter 16 Section 3 By: Layne Cumby Lee Johnson and Dakota Hisle 5-24-10 Vocabulary • Money multiplier formula-amount of new money that will be created with each demand deposit calculated as 1 divide RRR. • Excess reserves-reserves greater than the required amounts. Vocabulary • Money creation-the process by which money enters into circulation. • Money creation is carried out by the Fed and by banks all around the country. Vocabulary • Required reserve ratio-(RRR) ratio of reserves to deposits required of banks by the Federal Reserve. • The RRR is the fraction of deposits that banks are required to keep on reserve. Vocabulary • Open market operations are the buying and selling of government securities to alter the supply of money • Omo’s involve the circulation of bonds and the money supply Prime Rate • Prime rate is the rate of interest banks charge on short term loans to their best customers • These loans are usually made to large companies with good credit ratings Monetary Policy Tools •As you read, one of the Feds roles is to help stabilize the macro economy. •Monetary policy refers to the actions the Fed takes to control the money supply, influencing the level of real GDP and the rate of inflation in the economy. Money Creation • The Department of the Treasury is responsible for manufacturing money. • Federal Reserve is responsible for putting dollars into circulation.. Money Creation Contd. • Recall from Chapter 15 the multiplier effect of government spending. • The multiplier effect of government in fiscal policy holds that every one dollar in fiscal policy creates a change greater than one dollar in the economy. How Banks Create Money • Money creation does not mean the printing of money. • Banks create money not by printing it, but by simply going about their business. How Banks Create Money • For example, suppose you take out a loan of 1,000. • You decide to deposit the money in a checking account. • Once you have deposited the money, you now you have a balance. How Banks Create Money • Suppose in our example that the RRR is 0.1, or 10 percent. • This means that your 1,000 dollar demand deposit balance, the bank is allowed to lend 900 dollars. • Let’s say the bank lends that 900 dollars to Elaine, and she deposits it in her checking account. The Money Multiplier • This process will continue until the loan amount, and hence the amount of new money that can be created, becomes very small. • The amount of new money that will be created, in the end, is given by the money multiplier formula, which is calculated as 1divide RRR. The Money Multiplier • In our example the RRR 0.1, so the money multiplier is 1 divided by 0.1 = 10. • This means that the initial deposit 1,000 dollars will ultimately lead to a 10,000 dollar increase in the money supply. U.S. banks • As of 1999 in the United States, banks were required to hold three percent reserves against demand deposit assets up to 49 million dollars and ten percent on all demand deposit assets exceeding 49 million dollars. Real world • In the real world however people hold some cash outside of the banking system meaning that some funds leak out of the money multiplier process. Also banks sometimes hold excess reserves which are reserves greater than the required amounts. Federal reserve • The federal reserve has three tools for adjusting the amount of money in the economy. These tools are reserve requirements, the discount rate, and open market operations. Reserve requirements • the simplest way for the fed to adjust the amount of reserves in the banking system is to change the required reserve ratio. It is not, however the tool most used by the fed. • A reduction of the RRR would free up reserves for banks, allowing them to make more loans. Increasing reserve requirements • The process also works in reverse. Even a slight increase in the RRR would force banks to hold more money in reserves. This would cause the money supply to contract or shrink. Although changing reserve requirements can be an effective way of changing the money supply. Cont. from last. • The fed does not use this tool often because it is disruptive to the banking system. Even a small increase in the RRR would force banks to call in significant numbers of loans that is to require the borrower. For this reason the fed rarely changes reserve requirements. Discount rate • The discount rate is the interest rate that the federal reserve charges on loans to financial institutions. Banks borrow from the fed to maintain reserves at the required level. Changes in the discount rate affect the cost of borrowing from the fed. Cont. • In turn changes in the discount rate can affect the prime rate. Which is the interest rate of banks charge on short term loans to their best customers usually large companies with good credit rating could be those customers. Changes in the discount rate are reflected in the prime rate. Reducing discount rate • If the fed wants to encourage banks to lend more of their reserves it may reduce the discount rate. With a lower discount rate banks can reduce their excess reserves by lending them out. They wont have to worry about their reserves falling too low. They can add to their reserves by borrowing from the fed at a low rate. Open Market Operations • The most important monetary policy tool is open market operations • Open market operations are by far the most-used monetary policy tool Bond Purchase • When the Federal Open Market Committee chooses to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to purchase a certain amount of government securities on the open market • The Federal Reserve bank buys these securities with a check drawn on federal reserve funds Bond Purchases (cont.) • The bond seller then deposits the money from the bond sales in its bank • In this way, funds enter the banking system, setting in motion the money creation process described earlier Bond Sales • If the FOMC chooses to decrease the money supply, it must make an open market bond sale. • In this case, the Fed sells government securities back to bond dealers, receiving from them checks drawn on their own banks Bond Sales (cont.) • After the Fed processes these checks, the money is out of circulation. • This operation reduces reserves in the banking system • Banks will reduce their outstanding loans in order to keep reserves at the required levels Using Monetary Policy Tools • Open market operations are the most used of the Federal Reserve’s monetary policy tools. • They can be conducted smoothly and on an ongoing basis to meet the Fed’s goals • The Fed changes the discount rate less frequently Using Monetary Policy Tools (cont.) • It usually follows a policy of keeping the discount rate in line with other interest rates in the economy in order to prevent excess borrowing by member banks from the Fed. • Today the Fed doesn’t change reserve requirements to conduct monetary policy. Using Monetary Policy Tools (cont.) • Changing reserves requirements would force banks to make drastic changes in their plans • Open market operations or changes in the discount rate do not disrupt financial institutions however. Question 1 What is money creation? Question 2 What is required reserve ratio (RRR)? Question 3 State the money multiplier formula. Question 4 If the discount rate rose, would you expect the prime rate to rise or fall? Question 5 What are Open Market Operations? Question 6 What are excess reserves? Question 7 What is the Prime Rate? Question 8 When Bonds circulating are up, the Money supplies are ________? Question 9 If you deposit $1,000 in your checking account, then your $1,000 deposit minus the $100 in reserves is loaned to Elaine, who gives it to Joshua. Joshua’s $900 deposit minus $90 in reserves is loaned to another customer. By this point the money supply has increased to ________? Question 10 If reserve requirements go up, then the total money supply reacts how?