Introduction. Learning Objectives. Learning Objectives. Economics Today Twelfth Edition. Chapter 15 Money Creation and Deposit Insurance

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1 Roger LeRoy Miller Economics Today Twelfth Edition Chapter 15 Money Creation and Deposit Insurance Introduction A quick response by the Federal Reserve to the September 11, 2001 terrorist attacks stabilized the U.S. financial system. What key decisions were made by Federal Reserve policymakers on that day? Copyright 2004 Pearson Addison Wesley. All rights reserved. Slide 15-2 Learning Objectives Learning Objectives Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions Understand why the money supply is unaffected when someone deposits in a depository institution a check drawn on another depository institution Explain why the money supply changes when someone deposits in a depository institution a check drawn on the Federal Reserve System Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities Slide 15-3 Slide

2 Learning Objectives Chapter Outline Describe the ways in which the Federal Reserve can potentially alter the money supply and explain the manner in which the Fed actually does conduct monetary policy Explain the essential features of federal deposit insurance Links Between Changes in the Money Supply and Other Economic Variables The Origins of Fractional Reserve Banking Depository Institution Reserves The Relationship Between Reserves and Total Deposits Slide 15-5 Slide 15-6 Chapter Outline Did You Know That The Fed s Direct Effect on the Overall Level of Reserves by the Banking System The Money Multiplier Payments System, Systemic Risks, and Deposit Insurance Nearly all funds on deposit in bank accounts are federally insured? Funds on deposit in money market mutual funds are uninsured? Slide 15-7 Slide

3 Links Between Changes in the Money Supply and Other Economic Variables There are links between changes in the money supply and changes in GDP. There are links between changes in the money supply and the rate of inflation. The Origins of Fractional Reserve Banking Fractional Reserve Banking A system in which depository institutions hold reserves that are less than the amount of deposits Origins from Mesopotamia Goldsmiths issued notes that exceeded the value of gold and silver on hand Slide 15-9 Slide The Origins of Fractional Reserve Banking Money Supply Growth versus the Inflation Rate What do you think? Can banks pay off all of their depositors? Slide Figure 15-1 Source: Economic Report of the President; Federal Reserve Bulletin; Economic Indicators, various issues. Slide

4 Depository Institution Reserves Depository Institution Reserves Question Do banks set their own reserve rate? Answer No. The Federal Reserve sets the reserve requirement. Currently it is 10% on most checkable deposits. Legal Reserves Anything that the law permits banks to claim as reserves Slide Slide Depository Institution Reserves Depository Institution Reserves Required Reserves The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed Required Reserve Ratio The percentage of total deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed Required reserves equal checkable deposits times the required reserve ratio Slide Slide

5 Depository Institution Reserves The Relationship Between Excess Reserves The difference between legal reserves and required reserves Excess reserves = legal reserves - required reserves How a single bank reacts to an increase in reserves We will examine the balance sheet of a single bank. Slide Slide The Relationship Between The Relationship Between Assumptions Reserve ratio is 10% Checkable deposits are the bank s only liabilities An individual bank can lend all it wants Loan proceeds are deposited into checkable accounts Zero excess reserves Banks have zero net worth What are owned Reserves Loans Description of a Balance Sheet What are owed Deposits Net Worth = - *Also assume Net Worth = zero Slide Slide

6 The Relationship Between The Relationship Between Total reserves $100,000 Required reserves $100,000 Excess reserves 0 Loans $900,000 Total $1,000,000 Reserve Ratio = 10% Checkable deposits $1,000,000 Total $1,000,000 Slide A customer of Typical Bank deposits $100,000 in Typical Bank The deposit is a check drawn on another bank Slide The Relationship Between The Relationship Between Total reserves $200,000 Required reserves $110,000 Excess reserves $90,000 Loans $900,000 Outcome Typical Bank s deposits and reserves increase by $100,000 Checkable deposits $1,100,000 Old deposits $1,000,000 New deposit $100,000 Slide Following the deposit What are the required reserves of Typical Bank? Required reserves =.10 x $1,100,000 = $110,000 Does Typical Bank have excess reserves? Excess reserves = $200,000 - $110,000 = $90,000 Slide

7 The Relationship Between The Relationship Between Total reserves $200,000 Required reserves $110,000 Excess reserves $90,000 Loans $900,000 Checkable deposits $1,100,000 Old deposits $1,000,000 New deposit $100,000 Outcome Typical Bank has required reserves of $110,000 and excess reserves of $90,000 Slide Following the deposit What will Typical Bank do with its excess reserves? Loan them out Could Typical Bank safely loan out more than its excess reserves? Slide The Relationship Between Total reserves $200,000 Required reserves $119,000 Excess reserves $81,000 Loans $990,000 Old loans $900,000 New loans $90,000 Checkable deposits $1,100,000 Old deposits $1,000,000 New deposit $100,000 Typical Bank s balance sheet following a loan to another customer Slide The Relationship Between What do you think? Did this loan expand the money supply? Hints Have the reserves of the banking system changed? What happened to the loan balance at the bank where the deposit came from? Slide

8 The Relationship Between Observations The amount of reserves in the banking system determines the lending potential of the banks, given the reserve ratio. If the reserves increase so does the lending potential of the banks, given the reserve ratio. The Fed s Direct Effect on the Overall Level of Reserves Federal open market committee Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds Slide Slide The Fed s Direct Effect on the Overall Level of Reserves Open Market Operations The purchase and sale of existing U.S. government securities in the open private market by the Federal Reserve System The Fed s Direct Effect on the Overall Level of Reserves +$100,000 U.S. government securities Balance Sheet: The Fed +$100,000 depository institutions reserves Slide The Fed buys $100,000 of U.S. government securities Slide

9 The Fed s Direct Effect on the Overall Level of Reserves Balance Sheet: Bank The Fed s Direct Effect on the Overall Level of Reserves Balance Sheet: The Fed +$100,000 reserves +$100,000 checkable deposit owned by bond dealer -$100,000 U.S. government securities -$100,000 depository institutions reserves Outcome The reserves and the money supply increase by $100,000 Slide The Fed sells $100,000 of U.S. government securities Slide The Fed s Direct Effect on the Overall Level of Reserves The Fed s Direct Effect on the Overall Level of Reserves -$100,000 reserves Balance Sheet: Bank -$100,000 checkable deposit balances How do depository institutions respond to Fed actions that increase the reserves for the entire banking system? The reserves and money supply fall by $100,000 Slide Slide

10 Total reserves $100,000 Required reserves $100,000 Excess reserves 0 Loans $900,000 Checkable deposits $1,000,000 Total reserves $100,000 Required reserves $100,000 Excess reserves 0 Loans $900,000 Checkable deposits $1,000,000 Total $1,000,000 Total $1,000,000 Total $1,000,000 Total $1,000,000 Beginning balances Slide Fed purchases $100,000 of securities from a Typical Bank customer The funds are deposited in Typical Bank Slide Total reserves $200,000 Old reserves $100,000 New reserves $100,000 Loans $900,000 Checkable deposits $1,100,000 Old deposits $1,000,000 New Deposits $100,000 Total reserves $200,000 Required reserves $110,000 Excess reserves $90,000 Loans $900,000 Checkable deposits $1,100,000 Old deposits $1,000,000 New Deposits $100,000 Outcome The money supply increases by $100,000 Slide Slide

11 Total reserves $200,000 Required reserves $110,000 Excess reserves $90,000 Loans $900,000 Checkable deposits $1,100,000 Total reserves $200,000 Required reserves $119,000 Excess reserves $81,000 Loans $990,000 Old loans $900,000 New loans $90,000 Checkable deposits $1,190,000 Old deposits $1,100,000 New deposits $90,000 Total $1,190,000 Total $1,190,000 After the Fed s purchase Typical Bank has excess reserves of $90,000 Typical Bank loans its excess reserves Does this loan impact the money supply? to another Typical Bank customer Slide Slide Total reserves $200,000 Required reserves $119,000 Excess reserves $81,000 Loans $990,000 Checkable deposits $1,190,000 Total reserves $200,000 Required reserves $119,000 Excess reserves $81,000 Loans $990,000 Checkable deposits $1,190,000 Total $1,190,000 Total $1,190,000 Total $1,190,000 Total $1,190,000 Outcome The money supply increases by $90,000, the amount of the loan Slide The Borrower uses the $90,000 to purchase a Burger King franchise Burger King Banks at Bank 2 Slide

12 Total reserves $200,000 Required reserves $119,000 Excess reserves $81,000 Reduction -$90,000 Checkable deposits $1,190,000 Burger King check -$90,000 New balance $1,100,000 Total reserves $110,000 Required reserves $110,000 Excess reserves 0 Loans $990,000 Checkable deposits $1,100,000 New balance $110,000 Required reserves $110,000 Excess reserves 0 Loans $990,000 Slide Outcome Deposits and reserves at Typical Bank fall by $90,000 Is Typical Bank loaned up? Slide Balance Sheet: Bank 2 (changes) Balance Sheet: Bank 2 (changes) Reserves +$90,000 Burger King deposit +$90,000 Reserves +$90,000 Required reserves +$9,000 Excess reserves +$81,000 Burger King deposit +$90,000 Total +$90,000 Total +$90,000 Total +$90,000 Total +$90,000 What impact will the Burger King deposit have on Bank 2? Outcome This deposit creates excess reserves of $81,000 in Bank 2 Slide Slide

13 Balance Sheet: Bank 2 (changes) Balance Sheet: Bank 2 (changes) Total reserves $90,000 Required reserves $17,100 Excess reserves $72,900 Loans +$81,000 Total $171,000 Checkable deposits $171,000 Old deposits $90,000 New deposits +$81,000 Total $171,000 Reserves $90,000 Reduction to cover check -$81,000 Total Reserves 9,000 Required reserves $9,000 Excess reserves 0 Loans $81,000 Checkable deposits $171,000 Oil Co. check -$81,000 Total checkable deposits $90,000 Bank 2 loans out the excess reserves of $81,000 Does the money supply change? Slide Total $90,000 Total $90,000 Assume the borrower spends the $81,000 with an oil well drilling firm that banks with Bank 3 Slide Balance Sheet: Bank 3 (changes) Balance Sheet: Bank 3 (changes) Reserves +$81,000 Required reserves +$8,100 Excess reserves +$72,900 Checkable deposits +$81,000 Reserves +$8,100 Required reserves +$8,100 Excess reserves 0 Loans +$72,900 Checkable deposits +$81,000 Total $90,000 Total +$81,000 Total +$81,000 Total +$81,000 Outcome Bank 3 s deposits and reserves Bank 3 s balance sheet after it makes the loan increase by $81,000 and the loan proceeds have cleared to Bank 4 Can Bank 3 make a new loan? If so, will it impact the money supply Slide Slide

14 How much has the money supply increased after the Fed s $100,000 purchase of government securities and the three bank loans? $100,000 Purchase by the Fed 90,000 Loan by Bank 1 81,000 Loan by Bank 2 72,900 Loan by Bank 3 $343,900 Total What do you think? Could Banks 4, 5, 6, etc. create even more money? How much can be created? Slide Slide Maximum Money Creation with 10 Percent Required Reserves Maximum New Loans Bank New Deposits (new reserves) New Required Reserves plus Investments (excess reserves) 1 $100,000 $10,000 $90, ,000 9,000 81,000 What would happen when: The Fed sells government securities? Borrowers pay back the loans? 3 81,000 8,100 72, ,900 7,290 65, All other banks 656,100 65, ,490 Totals $1,000,000 $100,000 $900,000 Slide Slide

15 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio is 10% The Money Multiplier Money Multiplier Gives the maximum potential change in the money supply due to a change in reserves Figure 15-2 Slide Slide The Money Multiplier The Money Multiplier Potential money multiplier = Actual change in the money supply = Actual money multiplier 1 required reserve ratio x Change in total reserves Example Fed buys $100,000 of government securities Reserve ratio = 10% Potential change in the money supply 1 = $100,000 x = $1,000, Slide Slide

16 The Money Multiplier The Money Multiplier Forces that reduce the money multiplier Leakages Currency drains Excess reserves Real-world money multipliers M1 multiplier = M2 multiplier = 6.5 in the 1960s and over 12 in the 2000s Slide Slide Ways in Which the Federal Reserve Changes the Money Supply Open market operations Borrowed reserves and the Discount Rate The interest rate that the Federal Reserve charges for reserves it lends to depository institutions Ways in Which the Federal Reserve Changes the Money Supply Federal Funds Market A private market in which banks can borrow reserves from other banks that want to lend them Federal Funds Rate The interest rate that depository institutions pay to borrow reserves in the interbank federal funds market Slide Slide

17 Ways in Which the Federal Reserve Changes the Money Supply Reserve requirement changes What do you think? How does a change in the reserve requirement change the money supply? Changes the maximum money multiplier M Policy Example: Sweep Accounts and the Relevance of Reserve Requirements Depository institutions have been using sweep accounts to transfer transactions balances into savings accounts. These savings balances are counted in M2 but not included in M1. Consequently, M1 is now a less reliable measure of liquidity. Slide Slide Payment Systems, Their Risks, and Deposit Insurance Financial trading systems Automated mechanisms that link buyers and sellers of government securities and corporate stocks and bonds Examples MATIF CORES Globex Permit people to engage in financial transactions 24 hours a day Payment Systems, Their Risks, and Deposit Insurance Payment system An institutional structure by which consumers, businesses, governments, and financial institutions exchange payments Payment intermediaries Go-betweens in clearing payments that arise from exchange Slide Slide

18 Payment Systems, Their Risks, and Deposit Insurance Electronic payment systems The electronic giro system Europeans use banks, post offices, and other payment intermediaries to transfer funds Automated clearing house A computer-based clearing and settlement facility for the transmital of funds instead of checks Point-of-sale and ATM networks Payment Systems, Their Risks, and Deposit Insurance Large-value payment systems Fedwire Owned by Federal Reserve All financial institutions with reserve deposits can use Fedwire Average daily volume over $1 trillion CHIPS (Clearing House Interbank Payments System) Owned by New York Clearing House association Average daily volume over $1 trillion Slide Slide Payment Systems, Their Risks, and Deposit Insurance Payment Systems, Their Risks, and Deposit Insurance Transactions and Payment Flows in Major National Payment Systems Country and Payment System Transactions (Millions) Value ($trillions) Germany ELS EAF Japan FEYCS BOJ-NET United Kingdom CHAPS United States Fedwire CHIPS Slide Payment-system risks Liquidity Risk The risk of loss from late receipt of payment Credit Risk The risk that the other party to an exchange may not honor its terms Systemic Risk The risk of settlement system breakdowns Slide

19 Deposit Insurance Bank Failures Federal Deposit Insurance Corporation (FDIC) A government agency that insures the deposits held in member banks All members of the Fed and qualifying banks can purchase insurance. SAIF and NCUSIF Slide Figure 15-3 Source: Federal Deposit Insurance Corporation Slide Deposit Insurance Deposit Insurance The rationale for deposit insurance Bank Runs Attempts by many of a bank s depositors to convert checkable and time deposits into currency out of fear for the banks solvency Bank runs are prevented when depositors know they can convert their deposits to currency because of deposit insurance. How deposit insurance causes increased risk taking by bank managers Deposit insurance premiums never have reflected all of the risks faced by a bank s loans Managers have an incentive to make higher risk loans Slide Slide

20 Deposit Insurance Deposit Insurance Deposit insurance, adverse selection, and moral hazard Asymmetric Information Information possessed by one side of a transaction but not the other The side with more information will be at an advantage Deposit insurance, adverse selection, and moral hazard Adverse Selection A problem created by asymmetric information prior to a transaction Individuals who are the most undesirable from the other party s point of view end up being the ones who are most likely to want to engage in a particular financial transaction, such as borrowing Slide Slide Deposit Insurance Deposit Insurance Deposit insurance, adverse selection, and moral hazard Moral Hazard A situation in which, after a transaction has taken place, one of the parties to the transaction has an incentive to engage in behavior that will be undesirable from the other party s point of view The results of moral hazard The S&L crisis of the mid-1980s Thrift Bailout Act of 1989 cost taxpayers $200 billion Slide Slide

21 Issues and Applications: The Fed s Response to Terrorism The Federal Reserve used repurchase agreements to infuse the financial system with liquidity. Member banks were able to come to the Fed s discount window for shortterm loans. Web Links The following Web links appear in the margin of this chapter in the textbook: Slide Slide Summary Discussion of Learning Objectives How the Federal Reserve assesses reserve requirements Why the money supply does not change when someone deposits in a depository institution a check drawn on another depository institution Summary Discussion of Learning Objectives Why the money supply does change when someone deposits in a depository institution a check drawn on the Federal Reserve The maximum potential change in the money supply following a federal resource purchase or sale of U.S. government securities Slide Slide

22 Summary Discussion of Learning Objectives The U.S. payment system and payment system risks Features of Federal Deposit Insurance End of Chapter Chapter 15 Money Creation and Deposit Insurance Slide Copyright 2004 Pearson Addison Wesley. All rights reserved. 22