Download Fractional Reserve Banking

Fractional Reserve Banking
a. The Fractional Reserve System
-banks are required to keep only a fraction of their deposits in
reserves
-the % (10% today) is known as the reserve requirement
b. How Banks Operate
-Balance Sheet
-Assets are the properties, possessions and claims on others
-Banks major asset is their loans to customers
-Liabilities are its debts and obligations to others
-Bank’s major liability is their customers’ deposits
-Assets minus Liabilities = net worth (value of the bank)
c. Fractional Reserves and Monetary Expansion
-the system allows the money supply to grow to several times the
size of the reserves the banking system keeps
How does a bank create money?
-Example
-$100,000 deposit with a 20% reserve requirement
-$20,000 must go into required reserves
-$80,000 goes into Excess Reserves and can be lent out
-$80,000 loan is made to Jim
-$80,000 deposit made by Jim with the loan proceeds
-$16,000 must go into required reserves (20% of $80,000)
-$64,000 goes into Excess Reserves and can be lent out
-$64,000 loan is made to Jill
-$64,000 deposit made by Jill with the loan proceeds
-$12,800 must go into required reserves (20% of $64,000)
-$51,200 goes into Excess Reserves and can be lent out
-$51,200 loan to John
-$51,200 deposit made by John
-$10,240 must go into required reserves (20% of $51,200)
-$40,960 goes into Excess Reserves and can be lent out
From the initial $100,000 deposit, the banks have created a total of $295,200 in
deposits
This process will continue until the total new required reserves is equal to the
original deposit made (in this case $100,000)
-How much in new deposits will the original $100,000 deposit create?
-Oversimplified deposit creation formula
Original Deposit X 1 / Reserve Requirement = New Deposits Created
$100,000 X 1/.20 = $500,000
From this we can figure out how much new money supply is created
Since a total of $100,000 in new required reserves were created (equal to the
amount of the new deposit) we have to subtract that number from the new
deposits created – because required reserves are not part of the money supply in
circulation.
Total New Deposits Created =
-Total New Reserves Created =
Total new money supply created =
$500,000
$100,000
$400,000
The Process will also work the same in reverse when a withdrawal is made
Why is the Deposit Creation Formula Oversimplified?
1. Every recipient of cash must redeposit the cash into another bank
rather than hold it
-If they don’t keep it in the bank, that is less excess reserves that the bank
can lend out, therefore less expansion of deposits and the money supply
2. Every bank must hold reserves no larger than the legal minimum
-Banks will for the most part always have money in excess reserves and
therefore have money to lend out
Fractional Reserve Banking
d. The Fractional Reserve System
- Banks are required to keep only a
fraction of their deposits in reserves
- The % (10% today) is known as the
reserve requirement
Making the Money Supply Grow
-In order to make the money supply grow,
bank’s excess reserves must grow in order for
them to make more loans
-How does that happen?
1) When you and I make deposits in the bank
2) When the Fed uses their tools of monetary
policy to influence the levels of excess
reserves
- REMEMBER: Main role of FED is to
control the money supply (excess
reserves)
Feds Tools of Monetary Policy
- The Fed has 3 major tools it uses to conduct
monetary policy
- Each affects the amount of excess reserves in
the system, which in turn affects the monetary
expansion process explained above
- The outcome of monetary policy is to influence
the cost and availability of credit
-Cost of Credit = interest rates
-Availability of Credit = Money Supply
Loose (easy) monetary policy
- The Fed allows the money supply to grow
and interest rates to fall which will normally
stimulate the economy
- Low interest rates encourage borrowing by
consumers and businesses
- Use this to fight unemployment but can lead
to inflation
Tight monetary policy
- The Fed restricts the growth of the money
supply which drives up interest rates
- This slows growth in the economy by getting
consumers and businesses to borrow less
- This is used to fight inflation but can cause
unemployment
The Tools of the Fed
1). Reserve Requirement
- gives the Fed control over the money
supply by requiring member banks to
hold a certain percentage of deposits
in reserves
IF Increase the Reserve Requirement
- more of every deposit must go into
required reserves means less money
in excess reserves and less money to
lend out
- tight/contractionary monetary policy
IF Decrease the Reserve Requirement
- less of every deposit must go into
required reserves means more money
in excess reserves and more money
to lend out
- loose/expansionary monetary policies
- can be a very powerful tool if used – seldom
is used
2. Open Market Operations
- most popular tool of the monetary
policy
- the buying and selling of government
securities in financial markets
- To increase the money supply
o The Fed will buy Gov’t
securities/bonds from banks
o Banks give the Fed bonds in
return for $$ which increases
excess reserves
o This means more money to lend
out and an increasing money
supply
- To decrease the money supply
o FED sells Gov’t securities to
banks
o Banks give the Fed $$ in return
for bonds which decreases excess
reserves
o This means less money to lend
out and a decreasing money
supply
3. Discount Rate
- Rate of interest paid by member
banks who take loans from the Fed
- By decreasing the discount rate
o Banks will be more likely to take
loans from the Fed
o The more in loans they take, the
greater their excess reserves
o The greater their excess reserves,
the more they have to lend
o The more they have to lend, the
more the money supply can grow
- By increasing the discount rate
o Banks will want to pay back their
loans from the Fed and will use
their excess reserves
o This means less to lend – this
means shrinking money supply
Impact of Monetary Policy
a. Short-Run Impact
- Increases and decreases in the
money supply affect interest rates
- This in turn affects the cost and
availability of credit
b. Long-Run Impact
- Changes in the supply of money affect
the general levels of prices
- Too much money in circulation for too
long leads to inflation
- Loose policies lead to inflation and
intended to fight unemployment
(recession)
- Tight policies can lead to
unemployment and intended to fight
inflation (expansion)
Money
- M1 – represents the transactional
components of the money supply
o The components that most closely
match money’s roles as a medium
of exchange
o Traveler’s checks, coins,
currency, demand deposits and
other checkable deposits (money
you can spend NOW)
- M2 – the components of the money
supply that most closely conform to
money’s roles as a store of value
o M1 and small denomination time
deposits, savings deposits and
money market funds
- M1 is more liquid than M2
- liquidity - the measure of how fast a
financial asset can be converted into
cash
The Cost of Economic Instability
a. Economic Costs
- Stagflation- a period of stagnant
growth and inflation at the same time
o Recession usually brings inflation
under control, but this does not
always happen – Example 1970s
- GDP Gap
o the difference between the actual
GDP and the Potential GDP
o Pot. GDP – what could be
produced if all resources were
fully employed
o measure of unemployment in
terms of output not produced
- Misery Index
o sum of the monthly inflation and
unemployment rates
o measure of consumer suffering
during periods of high inflation and
unemployment
- Uncertainty
o worrying about your job in times of
declining GDP
o put off purchases
o if a lot of people do this, less
production, more lay offs
b. Social Costs
- Wasted resources
o labor wasted because people can
not find jobs
o people have a feeling of
uselessness and non-productive
- Political instability
o dissatisfied voters will vote out
politicians they blame for the
problems
o voters may vote for radical change
leading to instability
- Crime
o crime rates often increase
o less people making money, less
taxes paid, less money to pay for
police and other services
- Family problems
- less income, more debt, inability to
pay debt, bankruptcy
Macroeconomic Equilibrium
a. Aggregate Supply – COST OF
PRODUCTION
-AS curve shows the real levels of GDP that
would be produced at various price levels
-Figure 163 (p. 443)
- a - b (horizontal range)
o Can increase production by
employing more resources at a
relatively low cost, no need to
increase price
- b –c (middle range)
o to increase production, employing
more resources costs more, so
price has to increase with
additional production
- c – d (vertical range)
o cost to increase production high
because producers competing for
increasingly scarce resources
o price will increase relatively more
for not much increase in output
Shifts in the AS curve
- Costs of inputs – down, shift to the
right – up, shift to the left
- discovering of less expensive natural
resources, increases in labor
production, new technologies, lower
interest rates, lower taxes,
deregulation
- all would shift it to the right (and vice
versa)
b. Aggregate Demand- SPENDING
- (Figure 16.4 – p. 444)
- Summary of demand for all economic
units in the economy
- AD curve – shows the quantity of real
GDP that would be purchased at each
possible price level in the economy
- A change in the price level will move
you along the curve
o higher price level, less GDP
demanded (and vice versa)
Shifts in the AD curve
- How much people spend instead of
save
o Spend more, AD shifts out to the
right
o expectations about the future
 expectations are high, may
spend more, AD shifts to the
right
o increase in transfer payments
(government spending) or
reductions in taxes
 both will increase the amount
people have to spend
 shifts AD out to the right
c. Equilibrium (Figure 16.5 – p. 445)
- Where the AD curve and the AS
intersect
- Macroeconomic equilibrium
o The level of real GDP is
consistent with a given price level
o where producers are satisfied to
produce at a given price level and
purchasers are satisfied to
purchase at a given price level
Stabilization Policies
- economic growth, full employment and
price stability are three of the major
economic goals of the American
people
- in order to reach these goals sound
economic policy must be implemented
- many ways to achieve stability
1. Demand Side Policies
a. Federal policies designed to either
increase or decrease aggregate
demand by shifting the AD curve
b. Fiscal policy – the use of government
spending and taxing to influence
economic activity
c. Derived from Keynesian economics
A. Keynesian Economics
a. Basic framework
b. C + I + G + F = GDP
c. Of the sectors, (I) was the most
unstable and most to blame for
economic instability
d. Government’s role was to step in and
offset the changes in investment sector
spending
e. could lower taxes and enact other
measures to stimulate spending by
consumers and investors
f. major drawback was the deficits that
would be incurred by the government,
but it was believed that the deficits
could be recovered in better economic
times
B. Automatic Stabilizers (Government
Spending)
a. Another key component in fiscal policy
b. Programs that automatically trigger
benefits if changes in the economy
threaten people’s incomes
c. Created to provide for Americans but
also to ensure that aggregate demand
is propped up during times of low
demand in the economy
i. Unemployment insurance
1. Paid for through payroll
deductions
2. Get paid 1/3 to ½ your weekly
pay – up to 26 weeks
ii. Federal entitlement programs
1. social welfare programs
designed to provide minimum
health
2. Ensures demand does not fall
below a certain level for a
selected group of people
C. Fiscal Policy and Aggregate Demand
a. Can shift AD with fiscal policy
b. Tax cuts or increased government
spending can increase AD and shift to
the right
c. Increase AD will increase GDP but will
also increase price levels
D. Limitations of Fiscal Policy
a. Increasing government spending is not
difficult, but decreasing government
sending is
b. Planning fiscal policy to offset
decreases in investment spending is
almost impossible
c. It takes a long time from planning to
implementation of fiscal policy
a. It could take so long that the
spending isn’t needed any more
2. Supply-Side Policies
a. Economic policies designed to
stimulate output and lower
unemployment by increasing
production
b. Include a smaller role of the
government (than demand-side)
c. Deregulation of industries – less
government involvement
d. Less regulations to comply with can
low costs, increase supply
A. Federal tax structure
a. higher income taxes make people not
want to work as much as they could
b. lower taxes would give people
incentive to work harder and in the long
run have more money to spend (more
tax receipts)
B. Supply Side Policies and the AS Curve
a. Policies to increase AS would shift the
AS curve out to the right
a. Deregulation
b. Lower Taxes
b. The result would be an increase in
GDP and a decrease in price level
a. THIS IS A PERFECT WORLD!
BUT….
C. Limitations
a. Lack of experience with them to know
how they affect the economy
b. The foundation that tax receipts would
eventually be recovered even after
reducing tax rates was found to be
weak
c. Policy made more to restore economic
growth rather than remedy instability
IN THE SHORT RUN
a. money expansion (fiscal or monetary)
can be used to lower interest rates
b. Lower the cost of borrowing, shift the
AS curve to the right
c. This can increase GDP
BUT…
In The Long Run
a. This can lead to inflation
b. how fast should the money supply be
allowed to grow?
Growth of The Money Supply
a. Monetarists believe in slow but steady
growth
b. Allow the money supply to grow at a
rate that is equal to the anticipated rate
of GDP increase plus the rate of
productivity (how much more can be
produced this year from last year with
same amount of resources)
c. If GDP up 3% and productivity up 1%
then money supply growth should be
4%
d. Just enough extra money each year to
buy the additional goods and services
the economy produces
e. With less money in circulation, inflation
would slowly be reduced
Monetary Policy and Unemployment
a. Monetarists argue that attempts to cut
unemployment by expanding the
money supply provide only temporary
relief
b. Excessive rate of monetary growth
drive up prices and interest rates
c. Higher interest rates raise the cost of
borrowing for business
d. This will shift the AS curve in to the left
e. It will also shift the AD curve in to the
left
f. Result will be minimal if any gains in
GDP but higher price levels
g. Overly expansionary monetary policy
will cause inflation in the long term
h. Monetary policy is not a long term
solution for unemployment