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Chapter 15: Money, Banking, and Monetary Policy

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Brittany Pollard

on 23 April 2015

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Transcript of Chapter 15: Money, Banking, and Monetary Policy

Chapter 15: Money, Banking, and Monetary Policy
15.1: Money Creation Begins
15.2: How A Single Bank Creates Money
15.4: How Monetary Policy Creates Money
First, a central bank introduces new money to the economy by purchasing financial assets or lending money to smaller banks.
Financial asset
: an intangible asset whose value is derived from a contractual claim, such as bank deposits, bonds, and stocks.
Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates.
-The different types of money are typically classified as "M"s. The "M"s usually range from M0 (narrowest) to M3 (broadest) but which "M"s are actually focused on in policy formulation depends on the country's central bank.
Most money is in the form of bank deposits in the contemporary economic system. The main way in which those bank deposits are created is through loans made by commercial banks. When a bank makes a loan, a deposit is created at the same time in the bank account held by the borrower. In that way, new money is created.
Other monetary policy tools to expand the money supply include decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements.
: currency which derives its value from government regulation or law.
Monetary base
: the portion of the commercial banks' reserves that are maintained in accounts with their central bank plus the total currency circulating in the public (which includes the currency, also known as vault cash, that is physically held in the banks' vault).
Reserve requirements
: a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out)
15.3: Multiplier Expansion of Money by the Banking System
The Money Multiplier:
15.5: Monetary Policy Shortcomings
Jessica Arredondo, Sean Hall, Christopher Mayer, Brittany Pollard, & Dorian Williams
Monetary policy, like fiscal policy, has it's limitations. The Fed's control over the money supply is imperfect for the following reasons.
Money Multiplier Inaccuracy
To mange the money, Fed needs
to know the size of the multiplier

Multiplier is uncertain and subject
to decisions independent of the

It depends on the public's decision
to hold cash and the willingness of
banks to make loans.

These decisions vary with
conditions of prosperity and
Which Money Definition Should the Fed Control?
Lags in Monetary Policy vs. Fiscal Policy
Does not happen instantaneously
Subject to time lags
First, an inside lag
Inside lag is short
Monetary policy lag is shorter than
Fiscal policy lag
Outside lag
Who is the tortoise and who is the hare?

Fractional Reserve Banking
A system in which banks keep only a percentage of their current deposits on reserve as vault cash or deposits to the Fed.
Holding less than 100% on reserve allows banks to make loans which in turn those loans create money in the economy.
• A balance sheet is a statement of assets and liabilities for a bank at any given time.
• Also called T-accounts
• Liabilities are the amounts banks
owes to others
• Assets are the amounts banks own
• Consists of required reserves,excess reserves, and loans
• (Required reserves are the minimum balance the Fed requires a bank to hold)
• The Required Reserve Ratio is the percentage the Fed requires the bank to hold
• The Excess Reserves are potential loan balances of reserves held in vault cash or on deposit with the Fed in excess of required reserves
• Loans are the interest-earning assets of the bank
The relationship between reserves accounts
• Total Reserves = required reserves + excess reserves

Excess Reserves = total reserves – required reserves
How to create money:

• Step One- Accepting a new deposit

•The initial deposit is a liability for the bank because the money can be withdrawn

•Transferring currency to a bank and moving deposits from one bank to another does not affect the money supply(M1).

• Step Two-Making a loan

•The bank wants to make money off of the deposit. In order to do this, the bank will loan out
the initial deposit to accrue interest on it.

•When a bank makes a loan, it creates deposits, and the money supply increases by the amount of the loan because the money supply(M1) includes checkable deposits.

• Step Three-Clearing the loan check

•The person loaned the money will then deposit the money in to whichever bank they use. Who will then send the check to the Federal Reserve district bank for collection. The Fed clears the check by debiting the Reserve account of the first bank and crediting the reserve account of the second bank. The Fed will then return the check to the second bank and will reduce the members checking account.
Money Multiplier =
1 / Required Reserve Ratio
Actual Money Supply Change =
Initial Change in Excess Reserves ∗ Money Multiplier
Otherwise known as the "deposit multiplier", the money multiplier provides one with the maximum change in the money supply as a result of an initial change in the excess reserves held by banks.
The money multiplier is equal to 1
divided by the required reserve ratio.
Required Reserve Ratio:
"Set by the Federal Reserve, this is the fraction of deposits that regulators require a bank to hold in reserves and not loan out."
If the required reserve ratio is 1/10, that means that a bank must hold $0.10 of each dollar it has in deposit in reserves, but can loan out $0.90 of each dollar.
The size of the multiplier will fall when banks do not use all of their excess reserves to make loans.
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