EQ: What is Monetary Policy? EQ: What is the Money Supply? EQ: What is a Required Reserve? EQ: What is a Required Reserve?

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1 EQ: What is Monetary Policy? Monetary Policy is the branch of economic policy which: Attempts to achieve economic goals: Economic growth Full employment Price level stability Through manipulation of the money supply. That is, economic leaders (usually the Central Bank) increase or decrease the supply of money to manage the economy. EQ: What is the Money Supply? The money supply is the amount of money available in an economy for use by households, businesses, and governments to save or make purchases for consumption. There are many forms money can take in the economy: Physical money (currency) Money deposited in banks: Savings, checking, certificate of deposit (CD) There are many ways to measure how much money is in the economy. When people deposit money in a bank, the bank lends that money out to borrowers and collects interest on the loan. Financial Intermediation (see Lesson 1-6) The U.S. banking system is a fractional reserve banking system, in which banks maintain idle balances of deposited money equal to some ratio of total money deposits. Idle balances are funds that have been deposited in banks but have not been loaned out to borrowers.

2 There are restrictions on how much of that money they can lend out to borrowers. Banks must hold some of this deposited money as reserves, which are the bank s deposits that are not lent out to borrowers. Bank regulatory agencies set limits on how much of their deposits that banks can lend out. The remaining money must be held as idle balances, which is called a required reserve. The required reserve is usually expressed as a specific percentage of bank deposits. This percentage is called the reserve ratio. Excess reserves are any idle balances that are held by a bank that are greater than the required reserve. Excess reserves can be lent out to borrowers. Example: Lots of people have deposit accounts (savings, checking, CDs, etc.) at Bank USA. If you add up all the money deposited into these accounts, it is $500 Billion. The central bank has imposed a reserve ratio of 20%, which means Bank USA has to hold $100 Billion in idle balances as a required reserve. Bank USA has lent out $350 Billion to borrowers, so it has $150 Billion in reserves. Since the required reserve is $100 Billion and Bank USA has $150 Billion in reserves, it has $50 Billion in excess reserves. This $50 Billion can be lent out to borrowers. EQ: How Do Banks Create Money? In a fractional reserve banking system, banks as a group are able to create money. Money creation is a chain reaction of lending and depositing of money resulting in an increase in an economy's money supply.

3 EQ: How Do Banks Create Money? Every time money is deposited in the bank: A fraction of it is held in reserve. The remainder is lent out to borrowers. The money lent is then deposited in another bank. That bank keeps a fraction and lends the rest. This cycle continues until the fraction becomes $0. EQ: How Do Banks Create Money? Someone deposits $1,000 in Bank 1. Bank 1 is required to keep 10% in reserve. Bank 1 loans out $900, keeping $100 in reserve. The borrower of the $900 then deposits it in Bank 2. Bank 2 is required to keep 10% in reserve. Bank 2 loans out $810, keeping $90 in reserve. The borrower of the $810 then deposits it in Bank 3. Bank 3 is required to keep 10% in reserve. Bank 3 loans out $729, keeping $81 in reserve. And so on... In the end, the total amount of money deposited could potentially grow to $10,000. So, banks can create an additional $9,000 in the money supply out of an initial deposit of $1,000. EQ: How Do Banks Create Money? This process can also happen in reverse. Money destruction is a decrease in the money supply of an economy due to checkable deposits deteriorated by withdrawals of funds from banks. It is basically the money creation chain reaction working backwards. EQ: What is the Potential Deposit? The potential deposit multiplier is a number that can be multiplied by an initial bank deposit to calculate the maximum potential change in money supply resulting from the money creation process. Why do we say potential? Just because the banks can lend a certain percentage of deposits does not mean that they will lend that amount of money.

4 EQ: What is the Potential Deposit? In our example, we said that a deposit of $1,000 could potentially result in total bank deposits of $10,000. The potential deposit multiplier was 10. Because $1, $10,000. EQ: What is the Potential Deposit? To calculate the potential deposit multiplier: Divide 1 by the reserve ratio. Potential Deposit In our example, the reserve ratio was 10%. 1 Reserve Ratio Potential Deposit 1 Reserve Ratio EQ: What is the Potential Deposit? To determine by how much the money supply could potentially grow: Multiply an initial deposit by the potential deposit multiplier. Subtract the initial deposit from this product. The result is the potential increase in money supply. In our example: The initial deposit was $1,000 The potential deposit multiplier was 10 $1, $10,000 $10,000 $1,000 $9,000 The money supply can potentially grow by $9,000. EQ: What is the Monetary Base? Consider our example where a $1,000 deposit became $10,000 in deposits through the money creation process. If you add up all of the money kept as reserves by all of the banks involved at the end of the process, the total in reserves equals $1,000. It is not coincidence that the total reserves equals the initial deposit of $1,000. The initial $1,000 is part of the monetary base. The other $9,000 was created by banks.

5 EQ: What is the Monetary Base? 2 types of money in the money supply: 1. Money officially generated by the central bank. a. Currency in circulation (wallets, cash registers, etc). b. Currency in bank vaults. c. Money deposited by banks into the central bank. 2. Money created by banks in the moneycreation process. When you add up all of both types of money, the sum is the total money supply in the economy. EQ: What is the Monetary Base? The monetary base is the official money created by the central bank. The monetary base is a measure of the money supply that only includes the most liquid currencies and deposits. It is the sum of: All currency circulated in the hands of the public, plus Bank deposits on reserve with the Fed, plus Cash in the vaults of commercial banks. EQ: What is the Monetary Base? The monetary base is the official money created by the central bank off of which all bank-created money is based. The way the central bank increases and decreases the money supply is by directly increasing or decreasing the monetary base, triggering Money creation to increase the money supply. Money destruction to decrease the money supply. EQ: What is the Money? The central bank can increase or decrease the monetary base in order to increase or decrease the money supply. How much will the money supply increase when the monetary base is increased? The money multiplier is a factor that can be multiplied by the change in the monetary base that will indicate the total change in the money supply. It is the ratio of the change in the money supply to an initial change in the monetary base.

6 EQ: What is the Money? Calculating the money multiplier: Given the change in the monetary base and the change in the money supply: Money Change in Money Supply Change in Monetary Base If the monetary base increases by $2 Billion and the money supply increases by $7.5 Billion: Money Change in Money Supply $7.5 Billion Change in Monetary Base $2 Billion 3.75 EQ: What is the Money? Calculating the change in the money supply: Given the money multiplier and the change in the monetary base: Change in Money Supply Change in Monetary Base Money If the monetary base increases by $4 Billion and the money multiplier is 2.75: Change in Money Supply Change in Money Monetary Base $4B 2.75 $11Bil