How Banks CreateHow Banks Create MoneyMoney [[MSMS]]MSMS = = CurrencyCurrency + + DDDD of of PublicPublic

Banks Banks [thru loans][thru loans] C Create reate MMore ore DDDD

1. Fractional Reserve Banking SystemFractional Reserve Banking System – a fraction of DD are kept in reserve(say, 10%) at either the bank’s vault or at the Fed.

2. Vault cashVault cash – cash held by a bank (banks rarely keep more than 2%2% of their in cash)

3. Required Reserve(RR)Required Reserve(RR) –specified percentage of DD that banks must keep as RR.

4. Excess reservesExcess reserves – total reserves(TR) – RR. ER is what can be loaned out. Also some ER is used to meet sudden withdrawal demands.

5. Actual(Total) reservesActual(Total) reserves – RR + ER.

6. Deposit MultiplierDeposit Multiplier – one/RR or 1/.10 or $1/10 cents or 10

MultipliersMultipliers 1/RR[$1/5 cents = 20]

1/5% = 20 1/25% = 4 1/10% = 10 1/33.3%= 3 1/12.5% = 8 1/40 = 2.5 1/20% = 5 1/50% = 2

7. BalanceBalance SheetSheet–statement of assets & liabilities[assets=liabilitiesassets=liabilities].

8. Discount RateDiscount Rate – when banks borrow from the Fedbanks borrow from the Fed. [symbolic-emergencies] “wholesale price of money”

9. Federal Funds RateFederal Funds Rate – banks borrow from other banksbanks borrow from other banks for overnight loans.

10. Prime RatePrime Rate – when a bank’s prime customersprime customers [good credit] get loans. “retail price of money”

11. Buying BondsBuying Bonds – ““buying”buying” bonds means ““biggerbigger”” supply of money and “lower interest rates”. [So, more “C”, “Ig”, and “Xn” ]

12. Selling BondsSelling Bonds – ““selling”selling” bonds means ““smaller”smaller” supply of money and “higher interest rates”. [So, less “C”, “Ig”, and “Xn”]

FRACTIONAL RESERVE BANKINGFRACTIONAL RESERVE BANKING

RRRR Excess ReservesExcess Reserves

Total (Actual) ReservesTotal (Actual) Reserves

PMC = M x ER, so 10 x .90 =$9PMC = M x ER, so 10 x .90 =$9TMS = PMC[$9] + DD[$1] = $10TMS = PMC[$9] + DD[$1] = $10[[MSMS = = CurrencyCurrency + + DDDD of of PublicPublic]]

YOU YOU depositdeposit $1 $1 with A with A 10% RR10% RR

.1010 90 cents90 cents

One DollarOne Dollar One bank’s loan becomesOne bank’s loan becomesanother bank’s another bank’s DDDD..

Excess ReservesExcess Reserves

Total(Actual) ReservesTotal(Actual) Reserves

PMC = M x ER, so 10 x $1 = $10PMC = M x ER, so 10 x $1 = $10TMS [$10] = PMC[$10]TMS [$10] = PMC[$10]

[[MSMS = = CurrencyCurrency + + DDDD of of PublicPublic]]

Your Bank Borrows $1 From The Fed [10% RR]Your Bank Borrows $1 From The Fed [10% RR]

RRRR

One DollarOne Dollar

BankBank

00 One DollarOne Dollar

FedFed

900.00900.00 One year “all u caneat” hot wings at

Hooters

Dog that can YoYo

$1,000 DD [MSMS=CurrencyCurrency+DDDD of PublicPublic]

MSMS grows by multiple of 1010

810.00810.00

729.00729.00

656.10656.10

$1,000.00$1,000.00

900.00900.00

810.00810.00

729.00729.00

DD + PMC = TMS

$100.00$100.00

$90.00$90.00

$81.00$81.00

$72.90$72.90

$1,000.00 $1,000.00 ++ $9,000.00 $9,000.00 = $10,000.00$10,000.00

$$9,000.009,000.00PMC = ER[$900] x M[10] PMC =PMC =

New Deposits[New Reserves]

DDDD

New RequiredNew RequiredReservesReserves

RR=10%RR=10%

DDDD Created ByNew Loans

[equal to new ER]BankBank

AA

BB

CC

DD

$729.00 for a “cat bodyguard”

Smoking cat

900.00900.00

800.00800.00

$1,000 DD [MSMS==CurrencyCurrency++DDDD ofof PublicPublic]

MSMS grows by multiple of 55

640.00640.00

512.00512.00

409.60409.60

$1,000.00$1,000.00

800.00800.00

640.00640.00

512.00512.00

DD + PMC = TMSDD + PMC = TMS

$200.00$200.00

$160.00$160.00

$128.00$128.00

$102.40$102.40

$1,000.00$1,000.00 + + $4,000.00$4,000.00 = = $5,000.00$5,000.00

$4,000.00$4,000.00PMC = ER[$800 x M[5]PMC = ER[$800 x M[5] PMC =PMC =

New DepositsNew Deposits[New Reserves][New Reserves]

DDDD

New RequiredNew RequiredReservesReserves

RR=20%RR=20%

DDDD Created By Created ByNew LoansNew Loans

[equal to new ER][equal to new ER]BankBank

AA

BB

CC

DD

800.00800.00

750.00750.00

$1,000 DD [MSMS==CurrencCurrencyy++DDDD ofof PublicPublic]

562.00562.00

422.00422.00

317.00317.00

237.00237.00

$1,000.00$1,000.00

750.00750.00

562.00562.00

422.00422.00

317.00317.00

DD + PMC = TMSDD + PMC = TMS

$250.00$250.00

$188.00$188.00

$140.00$140.00

$105.00$105.00

$80.00$80.00

$1,000.00$1,000.00 + + $3,000.00$3,000.00 = = $4,000.00$4,000.00

$$3,000.003,000.00PMC = ER[$750] x M[4]PMC = ER[$750] x M[4] PMCPMC = =

New DepositsNew Deposits[New Reserves][New Reserves]

DDDD

New RequiredNew RequiredReservesReserves

RR=25%RR=25%

DDDD Created By Created ByNew LoansNew Loans

[equal to new ER][equal to new ER]BankBank

AA

BB

CC

DD

EE

750.00750.00

MSMS grows bygrows by multiple ofmultiple of 44

1. Joe BikerJoe Biker deposits $10,000 in his bank.

2. Suzie Rah RahSuzie Rah Rah borrows $8,000

RR = 20%

3. SuzieSuzie pays $8,000 for a used car.GoNow Auto deposits the $ in 2nd Bank.

4. 2nd Bank lends Sports Shop $6,400.

5. Eventually the MS will be $$5050,,000000

Joe

$$1010,,000000+$+$4040,,000000=$=$5050,,000000

MSMS$10,000 $8,000$18,000

MSMS$10,000 $8,000 $6,400$24,400

MSMS = = DDDD + + CurrencyCurrency of the of the PublicPublic[A DD of $10,000 will increase MS by another $40,000($50,000 MS]

RR=20%

MSMS is$10,000

NOTES:Banks create moneyby lending ER and destroy money byloan repayment.Purchasing bondsfrom the public alsocreates money.

MULTIPLE DEPOSIT EXPANSION PROCESSMULTIPLE DEPOSIT EXPANSION PROCESSRR= 20%RR= 20%

BankBankAcquired reservesAcquired reserves

and depositsand depositsRequiredRequiredreservesreserves

ExcessExcessreservesreserves

Amount bankAmount bankcan lend - Newcan lend - Newmoney createdmoney created

AABBCCDDEEFFGGHHIIJJKKLLMMNNOther banksOther banks

$100.00$100.00 80.0080.00 64.0064.00 51.2051.20 40.9640.96 32.7732.77 26.2226.22 20.9820.98 16.7816.78 13.4213.42 10.7410.74 8.598.59 6.876.87 5.505.50 21.9721.97

$20.00$20.00 16.0016.00 12.8012.80 10.2410.24 8.198.19 6.556.55 5.245.24 4.204.20 3.363.36 2.682.68 2.152.15 1.721.72 1.371.37 1.101.10 4.404.40

$80.00$80.00 64.0064.00 51.2051.20 40.9640.96 32.7732.77 26.2226.22 20.9820.98 16.7816.78 13.4213.42 10.7410.74 8.598.59 6.876.87 5.505.50 4.404.40 17.5717.57

$80.00$80.00 64.0064.00 51.2051.20 40.9640.96 32.7732.77 26.2226.22 20.9820.98 16.7816.78 13.4213.42 10.7410.74 8.598.59 6.876.87 5.505.50 4.404.40 17.5717.57 $400.00$400.00 PP MMCC in the banking system [MxER]

TMS = $500.00TMS = $500.00

11stst 1010

$$357357ofof

the the $400$400

Maximumcheckable-

depositexpansion

= ERER x

MMMM RRRR

11

=

THE Money [Deposit] MULTIPLIERTHE Money [Deposit] MULTIPLIER

The The MMMM is the reciprocal of the is the reciprocal of the RRRR..

MMMM

Potential moneyPotential moneyCreation in theCreation in theBanking SystemBanking System

[PMC][PMC]

AP EconAP Econ [[MSMS = = Currrency Currrency + + DDDD of of PublicPublic]]

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(PMC(PublicPublic)+DD=TMS; PMC()+DD=TMS; PMC(FedFed)=TMS)=TMS

1. The $40 million deposit$40 million deposit of Currency into DDDD would result in MS staying at ($8/$40/$160) million. [MS composition changed from currency to DD]

2. The $40 million deposit$40 million deposit of currency into checking accounts will create ERER of ($20/$32/$40) million.

3. The Potential Money CreationPotential Money Creation of the banking system through loans is ($40/$160/$$200) mil. The Potential TMSPotential TMS [all DDDD of the public] could be as much as ($40/$160/$200) mil.

4. The RRRR applies to checkable deposits at (banks/S&Ls/ credit unions/ all depository institutions). 5. If the Duck National Bank has ER of $6,000ER of $6,000 & DDDD of $100,000of $100,000 what is the size of the bank’s TRTR if the RR is 25%RR is 25%? ($25,000/$75,000/$31,000) [RR($____)+ER($___)+TR($____)

Excess ReservesExcess Reserves prior to new currency deposit ( prior to new currency deposit (DDDD) = ) = $0$0Ben Bigbucks Ben Bigbucks depositsdeposits in the banking system = in the banking system = $40$40 millionmillionLegal Reserve RequirementLegal Reserve Requirement [RR] = 20%[RR] = 20%

25,00025,000 6,0006,000 31,00031,000

[[MSMS = = CurrrencyCurrrency++DDDD of of PublicPublic]]

6. A stranger depositsdeposits $1,000$1,000 in a bank that has a RR of 10%RR of 10%.. The maximum possible change in the dollar value of the local bank’s loans would be $______. PMCPMC[MM XX ERER] in the banking system is $_____. Potential TMSPotential TMS could become as high as $_______.7. Suppose a commercial bank has DDDD of of $100,000$100,000 and the RR is 10%RR is 10%. If the bank’s RR RR && ER are equal ER are equal, then its TRTR are ($10,000/$20,000/$30,000).8. Total Reserves (minus/plus) RR = ERER.9. Suppose the Thunderduck Bank has DDDD of of $500,000$500,000 & the RR is 10%RR is 10%. If the institution has ER of $4,000ER of $4,000 then its TRTR are ($46,000/$54,000/$4,000).10. If ERER in a bank are $4,000are $4,000, DDDD areare $40,000$40,000, & the RR is 10%RR is 10%, then TRTR are ($4,000/$8,000). 11. The main purpose of the RRmain purpose of the RR is to (have funds for emergency withdrawals/ influence the lending ability of commercial banks). 12. If I write you a check for $1check for $1 & we both have our checking accts at the Poorman Bank, the bank’s balance sheet will (increase/decrease/be unchanged).13. Banks (create/destroy) money when they make loansmake loans and repaying bankrepaying bank loansloans (create/destroy) money.14. When a bank loan is repaidbank loan is repaid the MSMS is (increased/decreased).15. The Fed Funds rateFed Funds rate is a loan by one bank (to another bank/from the Fed).

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(PMC(PublicPublic)+DD=TMS; PMC()+DD=TMS; PMC(FedFed)=TMS)=TMS

900900 9,0009,00010,00010,000

17. If borrowers take a portion of their loans as cashloans as cash, the maximum amount by which the banking system increases the MSMS by lending will (increase/decrease).

[[MSMS = = CurrrencyCurrrency++DDDD of of PublicPublic]]

Leakages Leakages (limitations)(limitations) of the Money Creating Process of the Money Creating Process 1. Cash leakages [taking part of loan in cash] 1. Cash leakages [taking part of loan in cash] 2. ER (banks don’t loan it or we don’t borrow]2. ER (banks don’t loan it or we don’t borrow]

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(PMC(PublicPublic)+DD=TMS; PMC()+DD=TMS; PMC(FedFed)=TMS)=TMS

16. If the RR was loweredRR was lowered [say, from 50% to 10%], the size of the monetary multipliermonetary multiplier [MMMM] would (increase/decrease).

Money SupplyMoney Supply == DDDD + + CurrencyCurrency of theof the PublicPublic “PMC” “PMC”“TMS”

ER Loans Crea. In “Potential”

$100[$100[1010%% RRRR]] [1st Bank] [1st Bank] System Total MSBanksBanks//PublicPublic DDDD [ [$100$100]] $90$90 $90 $900 $1,000$90 $900 $1,000

Fed Fed //PublicPublic//BBanksanks DDDD[[$100$100] ] $90$90 $90 $900 $1,000$90 $900 $1,000 [[**FedFed buys bonds frombuys bonds from publicpublic who put the money in theirwho put the money in their DDDD]]

BBanksanks//FedFed FedFed LLoanoan[$[$100100]] $100$100 $100 $1,000 $1,000$100 $1,000 $1,000 [or sells bonds to[or sells bonds to FedFed] ]

“ “PMC” “PMC”PMC” “PMC” “TMS” “TMS” ERER Loans Loans CCrea.rea. In “Potential” In “Potential”

$100 [$100 [2020%% RRRR] ] [1[1stst Bank] Bank] [[11stst Bank] Bank] SystemSystem Total MSTotal MSBanksBanks//PublicPublic DDDD [$100] [$100] $80$80 $80 $400 $500 $80 $400 $500

FedFed//PublicPublic//BBanksanks DDDD [[$100$100]] $80$80 $80 $400$80 $400 $500 $500 [[**Fed Fed buys bonds frombuys bonds from publicpublic who put the money in theirwho put the money in their DDDD]]

BanksBanks//FedFed FedFed LLoanoan[$100[$100] ] $100$100 $100 $500$100 $500 $500 $500 [or sells bonds to[or sells bonds to FedFed]]

[RR[RR++ERER==TR; TRTR; TR--RRRR==ER; TRER; TR--ERER==RR; MxERRR; MxER==PMC; PMC(PMC; PMC(PublicPublic)+1)+1stst DDDD=TMS; PMC(=TMS; PMC(FedFed)=TMS])=TMS]

MSMS = = CurrencyCurrency + + DDDD of of PublicPublic[Money borrowed from the [Money borrowed from the FedFed [or gained thru bond sales][or gained thru bond sales] is ER & can be loaned out] is ER & can be loaned out]9. RR is 25%; 9. RR is 25%; Econ BankEcon Bank borrows $25,000 from the borrows $25,000 from the FedFed; its ER are increased by; its ER are increased by$______. P$______. Potential otential MMoneyoney C Creationreation in thein the system is system is $_______. P$_______. Potential otential TMS is $_______.TMS is $_______.10. RR10. RR is is 5050%%; a ; a bankbank borrows $20,000 borrows $20,000 from thefrom the FedFed; ; thisthis one bank’sone bank’s ER ER are increasedare increased

by $by $_____. P_____. Potentialotential MMoney oney CCreationreation in thein the system system is is $______. P$______. Potential otential TMS TMS is $______is $______

11. RR is 20%; the 11. RR is 20%; the Duck BankDuck Bank sells $10 M of bonds to the sells $10 M of bonds to the FedFed; Duck Bank’s ER are; Duck Bank’s ER are increasedincreased by by $___million. P$___million. PMC in theMC in the system is $__________. TMS is $__________. system is $__________. TMS is $__________.12. RR is 20%; 12. RR is 20%; FedFed buys $50,000 of securities from buys $50,000 of securities from Keynes BankKeynes Bank. Its ER are . Its ER are increased by $___________. Potential Money Creation in the banking system isincreased by $___________. Potential Money Creation in the banking system is $______________. Potential TMS is $___________.$______________. Potential TMS is $___________.13.13. 25% RR; 25% RR; FedFed buys $400 million of bonds from the buys $400 million of bonds from the Friar BankFriar Bank. This one. This one bank’s ER are increased by $_____million.bank’s ER are increased by $_____million.14. RR is 50%; the 14. RR is 50%; the FedFed sells $200 million of bonds to a sells $200 million of bonds to a bankbank; its ER are; its ER are (increased/decreased) by $_______. Potential Money Creation in the(increased/decreased) by $_______. Potential Money Creation in the banking system is (increased/decreased) by $________.banking system is (increased/decreased) by $________.15. RR is 10%; a 15. RR is 10%; a bankbank borrows $10 million from the borrows $10 million from the FedFed; this one bank’s; this one bank’s ER are increased by $_______ million. PMC in the banking system is ER are increased by $_______ million. PMC in the banking system is $_______million. Potential TMS is $_______million. $_______million. Potential TMS is $_______million.

BanksBanks and the and the FedFed

25,00025,000 100,000100,000 100,000100,000

20,00020,000 40,00040,000 40,00040,000

1010 50 million50 million 50 million50 million

50,00050,000250,000250,000 250,000250,000

400 400

200 M200 M400 M400 M

1010100 100 100 100

RR+ERRR+ER==TR; TR-RR=ER; TR; TR-RR=ER; TR-ER=RR;TR-ER=RR; M M x x ERER==PMC; PMC(PMC; PMC(PublicPublic)+1)+1stst DDDD==TMS; PMC(TMS; PMC(FedFed))==TMSTMS

BanksBanks & & PublicPublic (all(all DDDD of of PublicPublic are subject to theare subject to the RR; RR; rest is ER & can be loaned out)rest is ER & can be loaned out)

1. No ER & RR is 20%; 1. No ER & RR is 20%; DDDD of $10 M is made in the of $10 M is made in the Thunder BankThunder Bank. . MSMS is is $___million. ER increase by $___million. Potential Money Creation in the $___million. ER increase by $___million. Potential Money Creation in the banking system is $_____M. Potential TMS is $____million.banking system is $_____M. Potential TMS is $____million.2. T2. There are nohere are no ER ER & & RR is 25% & RR is 25% & $16,000$16,000 is deposited is deposited in thein the Duck BankDuck Bank. . MSMS is is $_______. This one bank can increase its loans by a maximum of $_______. This one bank can increase its loans by a maximum of $_______. Potential Money Creation $_______. Potential Money Creation in thein the banking system is $_______. banking system is $_______. Potential Total Money Supply could be $__________.Potential Total Money Supply could be $__________.3. 3. Econ BankEcon Bank has has ER of $5,000; ER of $5,000; DDDD are are $100,000$100,000; RR; RR is is 25%. TR 25%. TR areare $_______. $_______.4. 4. DDDD are are $10,000$10,000; ER ; ER are $are $1,000; TR 1,000; TR are $are $3,000; RR 3,000; RR areare _________. _________. [TR-ER[TR-ER==RR].RR].

5. 5. Nomics BankNomics Bank has ER of $10,000; DD of $100,000; RR of 40%. TR are _________. has ER of $10,000; DD of $100,000; RR of 40%. TR are _________. With ER above, Potential Money Creation in the banking system is $__________.With ER above, Potential Money Creation in the banking system is $__________.6. 6. Friar BankFriar Bank has DD of $100,000; RR is 20%; RR & ER are equal. TR are $________. has DD of $100,000; RR is 20%; RR & ER are equal. TR are $________.7. 7. If ER in a If ER in a bankbank are $10,000; are $10,000; DDDD are are $200,000$200,000, , & the& the RR are 10%. TR are $_______. RR are 10%. TR are $_______.8. 8. NNo o ER & RRER & RR is is 25%. 25%. DDDD of of $100,000$100,000 is madeis made. MS. MS is is $_______. This single bank $_______. This single bank cancan

increase its loans by $_______. PMC increase its loans by $_______. PMC in thein the systemsystem is $________. TMS is $________. TMS is is $________.$________.

10 10 8840 40 50 50

16,00016,00012,00012,000 48,00048,000

64,00064,00030,00030,000

$2,000$2,000$50,000$50,00025,00025,000

40,00040,00030,00030,000

100,000100,00075,00075,000 300,000300,000 400,000400,000

BanksBanks and theand the PublicPublic

MSMS = = currencycurrency + + DDDD of of PublicPublic

[RR[RR++ERER=T=TR; TR-RRR; TR-RR==ER; TRER; TR--ERER==RR; MxERRR; MxER==PMC; PMC(PMC; PMC(PublicPublic)+1)+1stst DDDD==TMS; PMC(TMS; PMC(FedFed))==TMS]TMS]

MSMS = = CurrencyCurrency + + DDDD of the of the PublicPublic [When FedFed buys securities from PublicPublic, they will put the money in their DDDD]16. RR is 50%; FedFed buys $10 M of bonds from the PublicPublic. MSMS is increased by _______. ER are increased by ____. PMC in the system is _______. Potential TMS is _______.17. RR is 25%; FedFed buys $100 M of bonds from the PublicPublic. The MSMS is increased _______. ER are increased by ______. PMC in the system is _______. Potential TMS is ________.18. RR is 50%; FedFed sells $200 M of bonds to the PublicPublic. The MSMS is (incr/decr) by __________. ER are (incr/decr) by _________. PMC in the banking system is (increased/decreased) by _______. Potential TMS is (incr/decr) by __________.19. RR is 20%; FedFed buys $5 million of securities from the PublicPublic. The MSMS is increased by _______. ER are increased by _______. Potential Money Creation in the banking system is _______. Potential TMS is _________.20. RR is 10%; FedFed buys $50 million of bonds from the PublicPublic. The MSMS is increased by _______. ER are increased by _______. PMC in the banking system is __________. Potential Total Money Supply is __________.

$10 M$10 M$5 M$5 M $10 M$10 M $20 M$20 M

$$100100 M M$75 M$75 M $300 M$300 M $400 M$400 M

$200 M$200 M $100 M$100 M$200 M$200 M $400 M$400 M

$5 M$5 M $4 M$4 M$20 M$20 M $25 M$25 M

$50 M$50 M $45 M$45 M$450$450 M M $500 M$500 M

FedFed and theand the PublicPublic

All of tAll of the $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMShe $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMS

of $50,000. [of $50,000. [MMMM of 10 x $10,000 = $50,000] of 10 x $10,000 = $50,000]

1. RR is 20%RR is 20% & Econ Bank borrows $10,000 $10,000 from the Fed. The impact of this loan on the bank’s ER and then TMS are: [Remember again: MSMS = = CCurrencyurrency + + DDDD of of publicpublic](A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000.

1. The RR is 20%RR is 20% & Joe Smith depositsdeposits $10,000 $10,000 in the Econ Bank that he has been saving in a coffee can in a tree. The impact of this impact of this transaction on the ER transaction on the ER of the Econ Bank & the potential increase in potential increase in the the money supplymoney supply would be: [Remember: MSMS = = CCurrencyurrency + + DDDD of of publicpublic](A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000.

TThe he MS [CashMS [Cash or or DD DD of theof the public] public] was was $10,000 cash. When he deposited $10,000 cash. When he deposited the $the $10,000, 10,000, the the EconEcon Bank could loan out ER of $8,000. The $8,000 x MBank could loan out ER of $8,000. The $8,000 x MMM of 5 became $40,000 for TMS of $50,000. of 5 became $40,000 for TMS of $50,000. So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of $50,000.$50,000.

Money Creation Problems from the 2005 Macro MC ExamMoney Creation Problems from the 2005 Macro MC Exam(87%)(87%) 40. Under a fractional reserve banking systemfractional reserve banking system, banks are required to a. keep part of their demand deposits as reserves b. expand the money supply when requested by the central bank c. insure their deposits against losses and bank runs d. pay a fraction of their interest income in taxes e. charge the same interest rate on all their loans(72%)(72%) 41. If a commercial bank has no ER and the RR is 10%, what is the value of new loans this single bank can issue if a new customer deposits $10,000? a. $100,000 b. $90,333 c. $10,000 d. $9,000 e. $1,000

AssetsAssets LiabilitiesLiabilities Total Reserves: $15,000 DD: $100,000

Securities: $70,000Loan: $15,000

(37%)(37%) 42. A commercial bank is facing the conditions given above. If the RR is 12%RR is 12% and the bank does not sell any of its securities, the maximum amount ofmaximum amount of additional lendingadditional lending this bank can undertake is a. $15,000 b. $12,000 c. $3,000 d. $1,800 e. 0(53%)(53%) 43. Assume the RR is 20%RR is 20%, but banks voluntarily keep some excess reserveskeep some excess reserves. A $1 million increase in new reserves$1 million increase in new reserves will result in a. an increase in the MS of $5 million c. decrease in MS of $1 millionb. an increase in the MS of less than $5 million d. decrease in the MS of $5 millione. a decrease in the MS of more than $5 million

The TR: $15,000, Securities: $70,000, andThe TR: $15,000, Securities: $70,000, and Loan: $15,000 total up to the $100,000 DD.Loan: $15,000 total up to the $100,000 DD.This bank This bank would havewould have to keep $12,000 of to keep $12,000 of their $100,000 in RR. With TR of $15,000, their $100,000 in RR. With TR of $15,000, they have $3,000 in ER to loan.they have $3,000 in ER to loan.

They could increase MS by $5 M, but They could increase MS by $5 M, but they are keeping some in ER, so MS they are keeping some in ER, so MS will increase by less than $5 million.will increase by less than $5 million.

No

min

al

Inte

res

t R

ate

No

min

al

Inte

res

t R

ate

Amount Amount of of moneymoneydemanded (billions)demanded (billions)

DDtt

1010

7.57.5

55

2.52.5

000 50 100 100 150 200 250 300

1010%%

8%8%

6%6%

4%4%

2%2%

00

Da [M2Da [M2]] – – storestore of of value moneyvalue moneyMoney that we don’t need for daily, weekly,or monthly transactions. We will invest moreof it the higher the interest rate. We will holdless because the opportunity cost increases.

++ ==TransactionsTransactionsDemand, DDemand, Dtt

THE Total DEMAND FOR THE Total DEMAND FOR MONEYMONEY

Ra

te o

f in

tere

st,

i (

pe

rce

nt)

Amount Amount of money of moneydemanded (billions)demanded (billions)

1010

7.57.5

55

2.52.5

00 DDaa0 50 100100 150 200 250

Interest Rate

Opportunity Cost

Da [hold less]

Interest Rate

Opportunity Cost

Da [hold more]

0 50 100100 150 200

55%%

MM11

DaDa

DaDa varies inverselyinverselywith the interest rate.

AssetAssetDemand, DDemand, Daa

CDsCDs or or

11%%

DtDtIndependent

of the interest

rate

““Walking around”Walking around”moneymoney

Total demandTotal demandfor money, Dfor money, Dmm

+ =TransactionsTransactionsDemand, DDemand, Dtt

AssetAssetDemand,Demand, DDaa

Total demandTotal demandfor money, Dfor money, Dmm

0 50 100100 150 200 250 300

No

min

al

Inte

res

t R

ate

Amount of moneydemanded [billions]

DDtt

10

7.5

55

2.5

0 50 100 100 150 200 250 300

Ra

te o

f in

tere

st,

i (

pe

rce

nt)

Amount of moneydemanded [billions]

10

7.5

5

2.5

DDaa

Ra

te o

f in

tere

st,

i (

pe

rce

nt)

Money marketMoney market0 50 100 150 200 200 250 300

10

7.5

5

2.5

0

MSMS11

E55

1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100).2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100).3. Da slopes down because lower in. rates (incr/decr) the cost of holding money.

DDmm

MSMS MSMS22

No

min

al I

nte

rest

Ra

te

50 100 150 200200 250 300

7.5

5

2.5

0

Dm

E

MS

[at “E”, money supplied ($200) = money demanded ($200)]

Due to a recessionrecession, suppose the money supply is increasedincreased from $200 billion to $250 billion.

Money Market

The The Dm Dm curve represents the quantity of money curve represents the quantity of money people are willing to hold at various interest rates.people are willing to hold at various interest rates.

# of Bonds

No

min

al In

tere

st R

ate

0 50 100 150 0 50 100 150 200200 250250 300 300

10

7.5

55

2.52.5

Dm

E

MS1

MSMS2

[at “E”, money supplied ($200) = money demanded ($200)]

A temporary surplus ofsurplus of $50 billion$50 billion beyond which the people wish to hold,

They react by buyingbuying bondsbonds [pushing bondpushing bond prices upprices up] to meet thedesired level of liquidity.

Money Market

Pri

ce o

f B

on

ds

P1

PP22

S1SS22

E

1%

GDPGDP

No

min

al In

tere

st R

ate

0 500

DDmm

EE

MSMS11 MSMS22

Money MarketMoney Market

PLPL

SRASSRAS

ADAD

Liquidity TrapLiquidity Trap – in a stagnant economystagnant economy with interest rates near or at zerointerest rates near or at zero, anincrease in MSincrease in MS fails to stimulate AD, so recession or depression gets worserecession or depression gets worse.With low returns expected on financial investments, people hoard their moneypeople hoard their money.. Banks are unwilling to lend in a slack economy. Fiscal policy is needed hereFiscal policy is needed here.

YYDD

LRASLRAS

ADAD

7.5

55

2.5

Nom

inal In

tere

st

Rate

0 50 100 150 200 200 250 300

DDmm

EE

MSMS

[at “E”, money supplied ($200) = money demanded ($200)][at “E”, money supplied ($200) = money demanded ($200)]

Due to inflationinflation, suppose the money supply is

decreased from $200 billion$200 billion to $150 billion$150 billion.

Money MarketMoney Market

No

min

al In

tere

st R

ate

No

min

al In

tere

st R

ate

0 50 100 0 50 100 150150 200 250 300 200 250 300

10

7.57.5

55

DDmm

EE

MSMS11MSMS22

A temporary shortage of moneyshortage of money will require the sale of some assets [bonds-which will make their price fallbonds-which will make their price fall] to meet the money shortage need.

Money MarketMoney Market

SS11 SS22

Pri

ce o

f B

on

ds

Pri

ce o

f B

on

ds

PP11

PP22

# of T-bills# of T-bills

(a) Draw a correctly labeled graph of the money marketgraph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate

 

1. 1. [3 pts][3 pts] Assume that Assume that declining stock market declining stock market prices prices in the U.S. cause many in the U.S. cause many U.S. financial investorsU.S. financial investors to to sell their stocks sell their stocks and and increase increase theirtheir money holdings money holdings..

MSMSDDM1M1

No

min

al

Inte

res

t R

ate

rr11

rr22Answers for 1. (a) (i) [2 points]Answers for 1. (a) (i) [2 points]1.1. (a) (i) (a) (i) In an effort to preserve wealth,In an effort to preserve wealth,

investors sell off stocks when market investors sell off stocks when market prices begin to decline. These newprices begin to decline. These newmoney holdings will increase the money holdings will increase the asset asset [speculative][speculative] demand for money. demand for money.In the volatile market, investors will In the volatile market, investors will

hold morehold more money while determining money while determining future needs. future needs. [2 pts: 1 pt for correct [2 pts: 1 pt for correct graph and 1 pt for Dm shifting right.]graph and 1 pt for Dm shifting right.]

DDM2M2

Answers for 1. (a) (ii) Answers for 1. (a) (ii) [1 point for saying the interest rate increases][1 point for saying the interest rate increases]1.1. (a) (ii) The nominal interest rate would increase because the demand(a) (ii) The nominal interest rate would increase because the demand

for money increases as the for money increases as the DDMM curve shifts up, as shown above. curve shifts up, as shown above.

MM Quantity of MoneyQuantity of MoneyTutorial: These Tutorial: These will will shift the real Dm curve.shift the real Dm curve.1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Changes in institutions [ability to get interest on

checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are not appealing.