Macro Unit 3 Banks and creation of money and tools of central bank policy

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1 Macro Unit 3 Banks and creation of money and tools of central bank policy I. How do banks create money? a. The Fractional Reserve System i. Definition a system where only a portion (or fraction) of checkable deposits are backed up by cash in bank vaults or deposits at a central bank ii. Characteristics 1. Banks can create money through lending 2. Banks must retain reserves of cash to cover normal everyday business and to ensure bank stability/confidence iii. All banks must use a balance sheet to show the bank s assets, liabilities, and net worth 1. Asset = anything of monetary value held or owned by the bank 2. Liability = claims of non-owners against a bank s assets 3. Net worth = claims of the owners of the bank against the bank s assets iv. Balance sheet means: Assets = liabilities + net worth b. Money Creation i. Creating a bank 1. Obtain a charter to operate a commercial bank 2. Raise some financial capital 3. Buy some property and equipment 4. Accept deposits 5. Establish a reserve account at a Federal Reserve Bank 6. Clear checks 7. Buy government securities 8. Make loans ii. Obtaining a charter 1. Must apply to federal or state gov t for a charter iii. Raise some financial capital 1. Sell shares in the bank to firms and individuals a. On the balance sheet you would list the cash from the sale of the shares as assets and the value of the shares (i.e. owner s equity) as net worth iv. Buy some property and equipment 1. Use the cash to purchase equipment a. Equipment/property is listed on the asset side of the balance sheet b. Reduce your cash by the cost of the equipment/property v. Accept deposits 1. Cash received is listed as an asset 2. Value of checkable deposits is listed as a liability 3. NOTE: Deposits are now part of the money supply but the money supply has not increased vi. Establishing a reserve account at a Federal Reserve Bank 1. Federal laws states that every bank or thrift institution my keep required reserves with the Federal Reserve Bank a. Equal to a specified percentage of the bank s own deposit liabilities

2 Reserve Requirements Liability Type Requirement % of liabilities Effective date Net transaction accounts 1 $0 to $10.7 million More than $10.7 million to $58.8 million More than $58.8 million Nonpersonal time deposits Eurocurrency liabilities b. The specified percentage is known as the reserve ratio i. Reserve ratio = Commercial bank s required reserves Commercial bank s checkable deposit liabilities c. Banks also keep vault cash on hand for day-to-day transactions (usually about 2% of their total assets) and this can also be used to calculate amount of required reserves d. While reserves are kept to help with bank stability and confidence, they will not prevent a bank collapse in case of large, unexpected withdrawals by bank depositors (show clip from It s a Wonderful Life) 2. Excess reserves = those assets which are not required reserves a. Excess reserves = actual reserves required reserves b. Excess reserves are used to make loans 3. Purpose of required reserves: a. Fed can control credit markets by easing or tightening reserve requirements b. Fed can control money supply by easing or tightening reserve requirements c. Facilitates the collection or clearing of checks c. Clearing a Check i. When a check is drawn against one bank and deposited in another bank, collection of that check reduces both the reserves and checkable deposits of the bank on which the check is drawn ii. When a check is collected by a bank, its reserves and deposits are increased by the amount of the check. iii. Again the money supply and bank deposits are neither increased or decreased.

3 II. d. Buying gov t securities i. Gov t securities provide banks with income and is a safe asset that is easily converted back into reserves when necessary ii. Gov t securities are assets but they do not count as required reserves e. Making loans i. Loans are granted to individuals and firms based on their creditworthiness and reputation ii. Loans are listed as assets on the banks balance sheet iii. The amount of the loan then becomes a liability because it is now a checkable deposit or is converted to currency iv. The bank has created money the deposit is the original money but then the bank turns that money around and loans it to someone else. In other words, it has monetized a loan v. With loans, the amount of money in the banking system hasn t changed but the amount of loanable funds has increased 1. Individual or firm which received the money from the loan can now deposit it in their own checkable deposit account. 2. The new bank s total reserves amount just increased meaning they have excess reserves which they can loan out to someone else vi. While money has been created with loans, it can also be destroyed as people pay back the loans. The Money Multiplier (also known as the Deposit Expansion Multiplier) a. The banking system then increases the original excess reserves into a larger amount of newly created checkable deposit money b. Monetary multiplier occurs because the spending of one household or firm becomes the income to another household or firm c. The monetary multiplier then magnifies the initial spending into a larger change in Real GDP d. Monetary multiplier = 1 Required reserve ratio Or M = 1 R e. To find the maxim amount of new checkable-deposit money, we need to multiply the amount of excess reserves (loanable funds) by the monetary multiplier Maximum checkable-deposit creation = excess reserves x monetary multiplier D = E x m Or III. Tools of the Central Bank/Monetary Policy the Federal Reserve System has a number of tools to control money supply and money creation a. Open Market operations Most commonly used tool! i. Consists of the buying/selling of gov t bonds from/to commercial banks and the general public ii. Buying Securities - to increase the reserves of commercial banks 1. From Commercial Banks by purchasing gov t bonds from banks, the Fed increases the reserve accounts of these banks which increases their lending ability

4 2. From the Public by purchasing gov t bonds from individuals, the Fed causes an increase in an individual s checkable deposits (which increases the money supply) which then can be loaned out by the commercial banks. iii. Selling Securities to decrease the reserves of commercial banks 1. Fed reduces the reserves of the purchasing bank 2. Reduces the loanable funds/excess reserves of banks to make up for lower reserves 3. Reduces the money supply b. The reserve ration i. Raising the reserve ratio 1. Diminishes the amount of excess reserves thus decreasing the loanable funds amount 2. Reduces the money supply ii. Lowering the Reserve Ratio 1. Increases the amount of excess reserves thus increasing the amount of loanable funds 2. Increases the money supply c. The discount rate i. The Fed is the lender of last resort banks might need a short term loan to maintain its reserve requirement ii. Interest rate charged by the Fed to banks for these short term rates is called the discount rate iii. Loan is deposited in the banks reserve account enabling the bank to increase its excess reserves and thus make more loans iv. An increase in the discount rate discourages banks from borrowing, a decrease encourages banks to borrow v. Raising the discount rate = restrict the money supply vi. Lowering the discount rate = expand the money supply d. The term auction facility i. Functions the same as the discount rate but is based on a limited amount of loanable funds from the Fed ii. Banks bid for these funds based on the interest rate they are willing to pay and the term of the loan iii. Usually a higher interest rate than the discount rate iv. Used to help prop up reserve amounts and allow bank to continue to lend in periods of economic instability (like the mortgage crisis of ). e. Federal Fund Rate i. Definition: the rate of interest that banks charge one another on overnight loans made from temporary excess reserves ii. Day to day, some banks have excess required reserves while some banks find themselves short of require reserves iii. Banks with excess reserves can lend out money to those banks with shortages. Charge each other interest called the Federal Funds Rate iv. Federal Reserve targets the Federal Funds rate by manipulating the supply of reserves that are offered in the Federal funds market 1. By buying or selling government bonds (open market operations), the Fed can increase or decrease reserves in the banking system 2. Federal Open Market Committee meets to choose a desired Federal funds rate then undertakes whatever open-market operations may be necessary to achieve the targeted rate 3. Lower Federal funds rate will encourage banks to borrow from each other

5 4. Higher Federal funds rate will discourage banks to borrow from each other 5. Increase banks reserves (buying gov t securities) will lower the Federal funds rate 6. Decreasing banks reserves (selling gov t securities) will increase the Federal funds rate f. Quick Discussion about Bond Markets i. Interest rates and bond prices are inversely related 1. Meaning when interest rates increase, bond prices fall; when the interest rate falls, bond prices rise ii. Bonds are sold in the bond market and are subject to forces of supply and demand iii. Example suppose that a bond with no expiration date pays a fixed $100 annual interest payment and is selling for its face value of $2000 (it s price). The interest yield on this bond is 5% ($100/$2000) 1. Now suppose the interest rate in the economy rises to 7 ½ % from 5%. 2. Newly issued bonds will pay $150 per $2000 that is lent. 3. Older bonds paying only $100 will not be saleable at their $2000 face value. The price of this bond will have to fall to $1333 a. 100/1333 = 7 1/2 % 4. Similarily if interest rates go down, older bonds at higher yields are more attractive and the price (or face value plus appreciation) goes up.