Introduction. Learning Objectives. Chapter 16. Money Creation, the Demand for Money, and Monetary Policy

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1 Copyright 2011 by Pearson Education, Inc. Chapter 16 Money Creation, the Demand for Money, and Monetary Policy All rights reserved. Introduction Prior to October 2008, U.S. banks typically held about $2 billion in reserves over and above those that they were required to hold by the Federal Reserve System Since October 2008, banks holdings of reserves in excess of those they are required to hold have jumped to more than $600 billion How does the Federal Reserve implement its requirement for banks to hold reserves? Why have banks holdings of excess reserves increased so much? What difference does it make whether banks hold $2 billion in additional reserves or in excess of $600 billion? Reading this chapter will help you answer these questions 16-2 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 funds transferred from a transactions account at a another depository institution Explain why the money supply changes when someone deposits in a depository institution funds transferred from the Federal Reserve System 16-3

2 Learning Objectives (cont'd) Determine the maximum potential extent to which the money supply will change following a Federal Reserve monetary policy action Identify the key factors that influence the quantity of money that people desire to hold Describe how Federal Reserve monetary policy actions influence market interest rates 16-4 Chapter Outline Banks and Money The Relationship Between Total Reserves and Total Deposits Money Expansion in the Banking System The Money Multiplier The Demand for Money How the Fed Influences Interest Rates 16-5 Did You Know That Many U.S. residents shifted deposits among banks during the latter half of 2008? People with deposits in troubled banks moved their funds to banks that they regarded to be safe After the deposit reshufflings, however, the quantity of money was virtually unchanged 16-6

3 Banks and Money As early as 1000 B.C., uncoined gold and silver were being used for money in Mesopotamia Later, goldsmiths started issuing paper notes indicating that the bearers held gold or silver of given weights and on deposit with the goldsmith These notes could be exchanged for goods and were the first paper currency 16-7 Banks and Money (cont d) Fractional Reserve Banking A system in which depository institutions hold reserves that are less than the amount of deposits Originated when goldsmiths issued notes that exceeded the value of gold and silver on hand 16-8 Banks and Money (cont d) Depository Institution Reserves What do you think? Can banks pay off all of their depositors? How is it possible that they can pay them off eventually but not pay them off simultaneously? 16-9

4 Banks and Money (cont d) In a fractional reserve banking system, banks do not keep sufficient reserves on hand to cover 100% of their depositors' accounts There are two distinguishable types of reserves: required and excess Banks and Money (cont d) Reserves In the U.S. Federal Reserve System, deposits held by Federal Reserve district banks for depository institutions, plus depository institutions vault cash Banks and Money (cont d) Required Reserves The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed 16-12

5 Banks and Money (cont d) Question Do banks set their own reserve rate? Answer No, the Federal Reserve sets the reserve requirement Currently it is 10% on most transactions deposits Banks and Money (cont d) Required Reserve Ratio The percentage of total transactions deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed Required reserves = Transactions deposits Required reserve ratio Banks and Money (cont d) Excess Reserves The difference between actual reserves and required reserves Excess reserves = Actual reserves Required reserves 16-15

6 International Example: In Germany, Fractional Reserve Banking Moves to the Auto Showroom In 2008 and 2009, savers in Germany began shifting funds from traditional depository institutions to place them on deposit with the banking arm of auto manufacturers because the German government: had guaranteed deposits at all banks, including the auto makers banks deposits gave special subsidies to auto manufacturers, which used some of these funds to offer higher rates of interest on deposits than the rates offered by traditional institutions The Relationship Between Total Reserves and Total Deposits Balance Sheet Statements of assets (what is owned) and liabilities (what is owed) How a single bank reacts to an increase in reserves We will examine the balance sheet of a single bank The Relationship Between Total Reserves and Total Deposits (cont'd) We assume 1. Reserve ratio is 10% 2. Transactions deposits are the bank s only liabilities and loans are the bank s assets 3. An individual bank can lend as much as legally allowed 4. Every time a loan is made, the proceeds are put into a deposit account (nothing withdrawn) 5. Zero excess reserves are kept 6. Banks have zero net worth 16-18

7 The Relationship Between Total Reserves and Total Deposits (cont'd) Net Worth The difference between assets and liabilities Balance Sheet 16-1 Typical Bank Reserve Ratio = 10% Balance Sheet 16-2 Typical Bank Transactions deposits in Typical Bank immediately increase by $100,000, bringing the total to $1.1 million

8 The Relationship Between Total Reserves and Total Deposits (cont'd) Following the deposit What are the required reserves of Typical Bank? Required reserves =.10 $1,100,000 = $110,000 Does Typical Bank have excess reserves? Excess reserves = $200,000 $110,000 = $90, The Relationship Between Total Reserves and Total Deposits (cont'd) 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? By law holds a certain amount of required reserves Balance Sheet 16-3 Typical Bank Typical Bank lends $990,000, but the borrowers do not leave this amount on deposit at Typical Bank

9 The Relationship Between Total Reserves and Total Deposits (cont'd) 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? The Relationship Between Total Reserves and Total Deposits (cont'd) Effect on the money supply New reserves for the banking system as a whole are not created when debit-card or check payments are transferred from one bank and deposited in another bank The Federal Reserve System can however, create new reserves the subject of our next section Example: Why the Decline in Clearing of Paper Checks Is Bad News for Airplane Pilots Until recently, the Federal Reserve used a fleet of 47 Lear jets and small cargo planes to transport checks cleared by Federal Reserve banks Also, clearinghouses operated by private banks used to contract with private air couriers to ship checks As increasingly more transactions deposit payments initiated via debit cards have replaced paper checks, the demand for air freight services has declined 16-27

10 Money Expansion by the Banking System The Federal Open Market Committee (FOMC) Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds Money Expansion by the Banking System (cont'd) Open Market Operations The purchase and sale of existing U.S. government securities (such as bonds) in the open private market by the Federal Reserve System Money Expansion by the Banking System (cont d) Consider the entire banking system; for practical purposes, we can look at all depository institutions taken as a whole To understand how money is created, we must understand how depository institutions respond to Fed actions that increase reserves in the entire system 16-30

11 Balance Sheet 16-4 Bank 1 This shows Bank 1 s original position before the Fed s purchase of a $100,000 U.S. government security Balance Sheet 16-5 Bank 1 Fed transfers $100,000 to Bank 1 immediately increasing the money supply by the same amount. Bank 1 has excess reserves of $90, Balance Sheet 16-6 Bank 1 Figure 16-6 shows Bank 1 expands its loans by $90,

12 Balance Sheet 16-7 Bank 2 (Changes Only) The borrower deposits $90,000 in Bank 2, and Bank 2 now has money to lend out Balance Sheet 16-8 Bank 2 (Changes Only) Bank 2 makes a loan for $81,000, the amount of its excess reserves Money Expansion by the Banking System (cont'd) Recall The Fed bought a bond and deposited it at Bank 1, immediately increasing the money supply by $100,000 The deposit creation process (in addition to the $100,000) occurs because of the fractional reserve banking system Banks will lend out any excess reserves as they can earn interest income on new loans 16-36

13 Balance Sheet 16-9 Bank 3 (Changes Only) Assume the firm borrowing $81,000 from Bank 2 spends these funds, which are deposited in Bank Balance Sheet Bank 3 (Changes Only) We assume Bank 3 will want to lend all of those non-interest-earning assets (excess reserves of $72,900) Money Expansion by the Banking System (cont'd) Question Looking over our balance sheets, how much do you think the money supply increased after the Fed s $100,000 purchase of government securities and the three bank loans? 16-39

14 Money Expansion by the Banking System (cont'd) $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? Table 16-1 Maximum Money Creation with 10 Percent Required Reserves Figure 16-1 The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio Is 10 Percent 16-42

15 Money Expansion by the Banking System (cont'd) Only when additional new reserves and deposits are created by the Federal Reserve System does the money supply increase The reverse process occurs when there is a decrease in reserves because the Fed sells $100,000 in government securities The Money Multiplier Money Multiplier A number that, when multiplied by a change in reserves in the banking system, yields the resulting change in the money supply The Money Multiplier (cont d) Potential money multiplier The reciprocal of the required reserve ratio, assuming no leakages into currency and no excess reserves. It is equal to 1 divided by the required reserve ratio 16-45

16 The Money Multiplier (cont'd) Potential money multiplier = 1 Required reserve ratio Actual change in the money supply = Actual money multiplier Change in total reserves The Money Multiplier (cont'd) Example Fed buys $100,000 of government securities Reserve ratio = 10% Potential change in the money supply 1 = $100,000 x = $1,000, The Money Multiplier (cont'd) Forces that reduce the money multiplier Leakages Currency drains when deposits increase, the public will want to hold more currency outside of banks Excess reserves to the extent that the banks want to keep positive excess reserves, the money multiplier will be smaller 16-48

17 The Money Multiplier (cont'd) Real-world money multipliers M1 multiplier = M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s The Money Multiplier (cont'd) Ways in Which the Federal Reserve Changes the Money Supply Open market operations Reserve requirement Discount rate The Money Multiplier (cont'd) Discount Rate The interest rate that the Federal Reserve charges for reserves it lends to depository institutions 16-51

18 The Money Multiplier (cont'd) 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 The Money Multiplier (cont'd) Today s discount rate policy The discount rate is kept at 1 percentage point above the market-determined federal funds rate Increasing (decreasing) the discount rate increases (decreases) the cost of borrowed funds for depository institutions that borrow reserves The Money Multiplier (cont d) Changes in the reserve requirements An increase (decrease) in the required reserve ratio Makes it more (less) expensive for banks to meet reserve requirements Reduces (expands) bank lending 16-54

19 The Money Multiplier (cont'd) Question What if the Fed changes reserve requirements it imposes? What if reserve requirements go from 10 to 20%? Answer Then the money multiplier changes from 10 to The Money Multiplier (cont d) Changing interest rates on reserves In 2008, the Fed started paying interest on all reserves What happens if the Fed raises the interest rate on reserves? The value of the money multiplier reduces as banks desired holdings of excess reserves increase The Money Multiplier (cont'd) Sweep Accounts and the Decreased Relevance of Reserve Requirements Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed This feature allows banks to hold fewer reserves as savings deposits are exempt from reserve requirements 16-57

20 The Money Multiplier (cont'd) Sweep Account A depository institution account that entails regular shifts of funds from transactions deposits that are subject to reserve requirements to savings deposits that are exempt from reserve requirements Figure 16-2 Sweep Accounts and Reserves of U.S. Depository Institutions at Federal Reserve Banks The Money Multiplier (cont'd) Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity 16-60

21 Example: Why Sweep Accounts Help Boost Profits at Banks Brokerage Units Major banks, like Bank of America, J.P. Morgan Chase and Citibank now own stock brokerage firms These brokerage subsidiaries typically direct a portion of their customers funds to sweep accounts at their own savings-bank subsidiaries Sweep accounts widen banks profits because market interest rates on deposits in sweep accounts are about 0.75 to 1 percentage point lower than the rates that the brokerage firms pay to other customers holding mutual funds with these firms The Demand For Money Money is the product of a social contract in which we all agree to 1. Express all prices in terms of a common unit of account, which in the United States we call the dollar 2. Use a specific medium of exchange for market transactions The Demand for Money (cont'd) Something that changes the amount of money in circulation will have some affect on many transactions and thus on elements of GDP Something that affects the amount of money in existence is going to affect all markets 16-63

22 The Demand for Money (cont'd) Holding money To use money, one must hold money If people desire to hold money, there is a demand for money The Demand For Money The demand for money, what people wish to hold People have certain motivation that causes them to want to hold money balances There is a demand for money by the public, motivated by several factors Transactions demand Precautionary demand Asset demand The Demand for Money (cont'd) Money Balances Synonymous with money, money stock, and money holdings 16-66

23 The Demand for Money (cont'd) Transactions Demand Holding money as a medium of exchange to make payments The level varies directly with nominal GDP The Demand for Money (cont'd) Precautionary Demand Holding money to meet unplanned expenditures and emergencies The Demand for Money (cont'd) Asset Demand Holding money as a store of value instead of other assets such as certificates of deposit, corporate bonds, and stocks 16-69

24 The Demand for Money (cont'd) The demand for money curve Assume the amount of money demanded for transactions purposes is proportionate to income Precautionary and asset demand are determined by the opportunity cost of holding money (the interest rate) Figure 16-3 The Demand for Money Curve When the interest rate rises the opportunity cost of holding money increases and the quantity of money demanded falls The location of M d is determined by the level of income How the Fed Influences Interest Rates The Fed seeks to alter consumption, investment, and aggregate demand as a whole by altering the rate of growth of the money supply 16-72

25 How the Fed Influences Interest Rates (cont'd) The Fed has three tools at its disposal as part of its policymaking action Open market operations Discount rate changes Reserve requirement changes How the Fed Influences Interest Rates (cont'd) Open market operations Fed purchases and sells government bonds issued by the U.S. Treasury At first, there is some equilibrium level of interest rate (and bond prices) An open market operation must cause a change in the price of bonds How the Fed Influences Interest Rates (cont'd) Relationship between the price of existing bonds and the rate of interest The market price of existing bonds (and all fixedincome assets) is inversely related to the rate of interest prevailing in the economy Question So what happens to the yield on a bond when the price of a bond increases (decreases)? 16-75

26 Figure 16-4 Determining the Price of Bonds, Panel (a) Contractionary Policy Fed sells bonds Supply of bonds increases Bond prices fall Figure 16-4 Determining the Price of Bonds, Panel (b) Expansionary Policy Fed buys bonds Supply of bonds falls Bond prices rise How the Fed Influences Interest Rates (cont'd) Example You pay $1,000 for a bond that pays $50/year in interest Bond Yield = $50 = 5% $1,

27 How the Fed Influences Interest Rates (cont'd) Example Now suppose you pay $500 for the same bond Bond Yield = $50 = 10% $ How the Fed Influences Interest Rates (cont'd) The market price of existing bonds (and all fixed-income assets) is inversely related to the rate of interest prevailing in the economy Issues and Applications: Ballooning Excess Reserves and a Shrinking Money Multiplier The actual money multiplier is typically smaller than the potential money multiplier One reason for the actual money multiplier to be typically smaller than the potential money multiplier is that: Banks hold excess reserves, such that they lend fewer funds 16-81

28 Issues and Applications: Ballooning Excess Reserves and a Shrinking Money Multiplier (cont d) Panel (a) of Figure 16-5 displays the excess reserve holdings of U.S. banks since 2008 Panel (b) of Figure 16-5 shows that there was an associated reduction in the money multiplier in this timeframe Figure 16-5 Excess Reserves and the Money Multiplier in the United States Figure 16-5 Excess Reserves and the Money Multiplier in the United States (cont d) 16-84

29 Summary Discussion of Learning Objectives How the Federal Reserve assesses reserve requirements Establishes a required reserve ratio, currently 10% Why the money supply does not change when someone deposits in a depository institution funds transferred from another depository institution Because total deposits remain unchanged for the banking system as a whole Summary Discussion of Learning Objectives (cont'd) Why the money supply does change when someone deposits in a depository institution funds transferred from the Federal Reserve System There is an immediate increase in total deposits in the banking system as a whole The money supply increases by the amount of the initial deposit Summary Discussion of Learning Objectives (cont'd) The maximum potential change in the money supply following a Federal Reserve purchase or sale of U.S. government securities The money multiplier Occurs when there is no leakage or excess reserves during the process of the money creation Altering the discount rate relative to the federal funds rate can encourage changes in borrowed reserves 16-87

30 Summary Discussion of Learning Objectives (cont'd) Key factors that influence the quantity of money that people desire to hold When nominal GDP rises People generally make more transactions They require more money They desire to hold more money The interest rate is the opportunity cost for holding money as a precaution against unexpected expenditures The quantity of money demanded declines as the market interest rate increases Summary Discussion of Learning Objectives (cont'd) How the Fed s Open Market Operations Influence Market Interest Rates The market price of existing bonds and the prevailing interest rate are inversely related The market interest rate rises when the Fed sells bonds The market interest rate declines when the Fed purchases bonds 16-89