Macroeconomics
ECON 2301
Fall 2009
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 16
Reminder: Papers due Nov. 16
 Email your 2nd research paper to
marilyn.spencer@tamucc.edu before class starts, Nov. 16.
 Be sure to include your paper, a page for your citations,
and the text of the article you based your paper on, all in
ONE FILE.
 Choose another article in the online popular press, on one
of these topics focusing on the US economy:
unemployment, labor force, worker productivity, inflation
or deflation, or any current federal government program to
stimulate the economy.
Announcement: Extra Credit
Opportunity #9
 The Federal Open Market Committee held
its last meeting November 3-4.
 To earn up to 4 points of extra credit:
Read or listen to a news story that summarizes
the most important outcomes of their meeting.
Email me your summary of that news story, in
50-100 words, before the start of class on Wed.,
Nov. 18.
Announcement: Students Who
Completed the JA Option
 You must sign up, in class by Nov. 18, for
your presentation.
 I am circulating sign-up sheets now through
Nov. 18.
 If you fail to sign up in class by Nov. 18,
you will not be allowed to present, so you
will forfeit presentation credit.
Chapter 16: Money Creation & Deposit
Insurance
Learning Objectives - By the time you finish
this chapter, you should be able to:
Describe how the Federal Reserve assesses reserve
requirements on banks and other depository institutions
2. 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
3. Explain why the money supply changes when someone
deposits in a depository institution funds transferred from
the Fed
4. Determine the maximum potential extent to which the
money supply will change following a Fed purchase or sale
of government securities
1.
Discuss the ways in which the Federal Reserve conducts
monetary policy
16-6of federal deposit insurance
6. Explain the essential features
5.
Did You Know That…
 Through actions initiated by a central bank such
as the Federal Reserve, depository institutions
together create money?
 In this chapter, we shall examine the money
multiplier process, which explains how an
injection of new money into the banking system
leads to an eventual multiple expansion in the
total money supply.
16-7
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.
16-8
Figure 16-1 Money Supply
Growth versus the Inflation Rate
16-9
Links Between Changes in the Money Supply
and Other Economic Variables (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
 In a fractional reserve banking system, banks do not keep
sufficient reserves on hand to cover 100% of their
depositors' accounts.
16-10
Depository Institution
Reserves (cont'd)
 There are three distinguishable types of
reserves: legal, required and excess.
 Reserves: In the U.S. Federal Reserve System, deposits
held by Federal Reserve district banks for depository
institutions, plus depository institutions’ vault cash
16-11
Depository Institution
Reserves (cont'd)
1. Legal Reserves: Anything that the law permits banks
to claim as reserves—for example, deposits held at
Federal Reserve district banks and vault cash
2. Required Reserves: The value of reserves that a
depository institution must hold in the form of vault cash
or deposits with the Fed
3.
Excess Reserves: The value of reserves that a depository
institution holds in the form of vault cash or deposits with
the Fed – beyond the amount of reserves that the bank is
required to hold.
Excess Reserves = Legal Reserves - Required Reserves
16-12
Depository Institution
Reserves (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.
16-13
Depository Institution
Reserves (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
 Excess Reserves: The difference between legal
reserves and required reserves
Excess reserves = Legal reserves – Required reserves
16-14
The Relationship Between Legal
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.
 Net Worth: The difference between assets and liabilities
16-15
The Relationship Between Legal Reserves
and Total Deposits – application:
 For this application, 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
16-16
The Relationship Between Legal Reserves
and Total Deposits (cont'd)
Description of a Balance Sheet
Assets
Liabilities
What is owned
What is owed
Reserves
Deposits
Loans
Net Worth = Assets – Liabilities
16-17
Balance Sheet 16-1 Typical
Bank
Reserve Ratio = 10%
16-18
The Relationship Between Legal
Reserves and Total Deposits (cont'd)
Balance Sheet: Typical Bank
Assets
Liabilities
Assume a depositor deposits in Typical Bank a $100,000
debit-card payment drawn on a transactions account at
another depository institution.
16-19
Balance Sheet 16-2 Typical Bank
Transactions deposits in Typical Bank immediately
increase by $100,000, bringing the total to $1.1 million.
16-20
The Relationship Between Legal
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 = $90,000
16-21
The Relationship Between Total Reserves and Total
Deposits (cont'd)
 Following a deposit
What will a “Typical Bank” do with its excess
reserves?
• Loan them out
Could a “Typical Bank” safely loan out more
than its excess reserves?
• By law each bank is required to hold a certain
amount of required reserves
Balance Sheet 16-2 Typical Bank (cont'd)
Typical Bank has:
required reserves of $110,000 and
excess reserves of $90,000.
16-23
The Relationship Between Legal 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
16-24
Balance Sheet 16-3 Typical Bank
Typical Bank lends $90,000, but the
borrowers do not leave this amount on
deposit at Typical Bank.
16-25
The Relationship Between Legal 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?
16-26
The Relationship Between Legal 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.
16-27
The Fed’s Direct Effect on the Overall Level
of Reserves
 The Federal Open Market Committee (FOMC)
can instruct the New York Federal Reserve Bank
trading desk to buy or sell bonds
 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
16-28
Balance Sheet 16-4
The Fed buys $100,000 of U.S.
government securities.
16-29
Balance Sheet 16-4
The reserves and the money
supply increase by $100,000.
16-30
Balance Sheet 16-5
Now the Fed sells $100,000
of U.S. government securities.
16-31
The Fed’s Direct Effect on the Overall
Level of Reserves (cont'd)
The bank’s reserves and money
supply both fall by $100,000.
16-32
Money Expansion
by the Banking System
 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.
16-33
Balance Sheet 16-6 Bank 1
This shows Bank 1’s original position before the Fed’s
purchase of a $100,000 U.S. government security.
16-34
Balance Sheet 16-7 Bank 1
Fed transfers $100,000 to Bank 1 immediately
increasing the money supply by the same amount.
Bank 1 has excess reserves of $90,000.
16-35
Balance Sheet 16-8 Bank 1
Figure 16-8 shows Bank 1
expands its loans by $90,000.
16-36
Balance Sheet 16-9
Bank 2 (Changes Only)
The borrower deposits $90,000 in Bank 2,
and Bank 2 now has money to lend out.
16-37
Balance Sheet 16-10
Bank 2 (Changes Only)
Bank 2 makes a loan for $81,000,
the amount of its excess reserves.
16-38
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.
16-39
Balance Sheet 16-11
Bank 3 (Changes Only)
Assume the firm borrowing $81,000 from Bank 2
spends these funds, which are deposited in Bank 3.
16-40
Balance Sheet 16-12
Bank 3 (Changes Only)
We assume Bank 3 will want to lend
all of those non-interest-earning
assets (excess reserves of $72,900).
16-41
E-Commerce Example: Remote Capture
Speeds the Check Clearing Process
 Traditional check-clearing typically takes
one to three days to complete.
 Internet based institutions pioneered a
concept called remote capture.
 Remote capture cuts the time to just an hour.
16-42
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?
16-43
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?
16-44
E-Commerce Example: What Goes On Inside
Envelope-Free Automated teller Machines
 The latest in bank automated teller machines (ATMs) is the
envelope-free machine. These ATMs allow customers to
insert a check for deposit directly into a slot in the machine
 The new ATMs are equipped with digital cameras that
record a digital image of the deposited check, which the
bank can transmit immediately to an electronic checkclearing network.
 What does a bank gain from speeding its access to funds
that its customers deposit at ATMs?
Table 16-1 Maximum Money Creation with
10 Percent Required Reserves
16-46
Figure 16-2 The Multiple Expansion in the Money Supply
Due to $100,000 in New Reserves When the Required
Reserve Ratio Is 10 Percent
16-47
Money Expansion by the
Banking System (cont'd)
 The money supply increases only when additional
new reserves and deposits come into the banking
system created by
(1) the Federal Reserve System
or
(2) money from outside the country.
 The reverse process occurs when there is a decrease
in reserves because the Fed sells government
securities, or money is sent out of the country.
16-48
The Money Multiplier
 Money Multiplier: the
maximum potential
change in the money supply due to a change
in reserves
Potential money multiplier =
Actual D
in money
supply
=
1
Required reserve ratio
Actual money
multiplier
16-49

D in
total reserves
The Money Multiplier (cont'd)
 Example
Fed buys $100,000 of government securities
Reserve ratio = 10%
Potential change
1
in the money = $100,000
= $1,000,000
x
.10
supply
16-50
The Money Multiplier (cont'd)
 Forces that reduce the money multiplier
Leakages
• Currency drains
• Excess reserves
 Real-world money multipliers
M1 multiplier = 2.5–3.0
M2 multiplier = 6.5 in the 1960s to over 12 in the 2000s
16-51
Ways in Which the Federal Reserve Changes
the Money Supply
1. Open market operations (as seen above)
2. Reserve requirement
3. Discount rate
16-52
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
fixed-income 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)?
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%
$1,000
Now suppose someone later pays $500 for the
same bond.
Bond Yield = $50
$500
= 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.
Ways in Which the Federal Reserve Changes
the Money Supply (cont'd)
 Discount Rate: The interest rate that the Federal
Reserve charges for reserves it lends to depository
institutions
 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
16-57
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.
 Question
Why would the Fed do this?
 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
Ways in Which the Federal Reserve Changes
the Money Supply (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 5.
16-60
Table 16-2 Required Reserve
Ratios in Selected Nations
16-61
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.
 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
16-62
Sweep Accounts and the Decreased
Relevance of Reserve Requirements (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.
16-63
Federal Deposit Insurance
 Deposit insurance, adverse selection, and
moral hazard
Adverse selection arises when there is
asymmetric information.
• Information possessed by one side of a transaction
but not the other
• The side with more information will be at an
advantage.
16-64
Federal Deposit Insurance (cont'd)
 Deposit insurance, adverse selection, and moral hazard
Moral hazard arises as a result of information
asymmetry after a transaction has occurred.
 The results of moral hazard
The S&L crisis of the mid-1980s
• More than 1,500 savings and loan associations
failed.
• The estimated taxpayer cost was $200 billion.
16-65
Summary of Learning Objectives
1. How the Federal Reserve assesses
reserve requirements
 Establishes a required reserve ratio,
currently 10%
2. 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
16-66
Summary of Learning Objectives (cont'd)
3. 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
4. The maximum potential change in the money
supply following a Federal Reserve purchase or
sale of U.S. government securities
The multiplier
16-67
Summary of Learning Objectives (cont'd)
5. The Fed influences the money supply through
Open market operations,
the discount rate
the reserve requirement
6. The FDIC was established in 1933 to prevent
bank runs.
Difficulties include adverse selection and moral
hazard
16-68
Assignment to be completed
before class November 16:
Read Chapter 19 & also read these end-of-chapter
Problems:
14th ed:19-1, 19-5, 19-11, 19-12 & 19-15 on pp.
496-499.
15th ed:19-1, 19-4, 19-9, 16-10 & 16-13, on pp.
496-499.