Macroeconomics
ECON 2301
Spring 2009
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 16
Announcement: Extra Credit
Opportunity #1
 Attend the panel discussion, "The new New
Deal: The ins and outs of the Bailout,“ Tuesday,
April 28, 2009, 7 p.m. in the University Center
Ballroom.
 To earn up to 4 points of extra credit, email me
your summary, in 50-100 words, before the start
of class on Tues., May 5.
Announcement: Extra Credit
Opportunity #2
 The Federal Open Market Committee will
hold its next meeting April 28-29.
 To earn up to 4 points of extra credit:
On or around April 29, 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 Tues.,
May 5.
Chapter 16: Money Creation & Deposit
Insurance
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
16-5
Learning Objectives (cont'd)
 Determine the maximum potential extent to
which the money supply will change following a
Federal Reserve purchase or sale of government
securities
 Discuss the ways in which the Federal Reserve
conducts monetary policy
 Explain the essential features of federal deposit
insurance
16-6
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
16-10
Depository Institution
Reserves (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 three distinguishable types of
reserves: legal, required and excess.
16-11
Depository Institution
Reserves (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
 Legal Reserves
Anything that the law permits banks to claim as
reserves—for example, deposits held at Federal
Reserve district banks and vault cash
 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
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
16-14
Depository Institution
Reserves (cont'd)
 Excess Reserves
The difference between legal reserves and required
reserves
Excess reserves = Legal reserves – Required reserves
16-15
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
16-16
The Relationship Between Legal 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
16-17
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
16-18
Balance Sheet 16-1 Typical
Bank
Reserve Ratio = 10%
16-19
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.
16-20
Balance Sheet 16-2 Typical
Bank
Transactions deposits in Typical Bank immediately
increase by $100,000, bringing the total to $1.1 million.
16-21
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
16-22
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?
Copyright © 2008
Pearson Addison
Wesley. All rights
reserved.
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
Table 16-1 Maximum Money Creation with
10 Percent Required Reserves
16-45
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
16-46
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.
16-47
The Money Multiplier
 Money Multiplier
Gives 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
16-48

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
16-49
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
16-50
Ways in Which the Federal Reserve Changes
the Money Supply
1. Open market operations
2. Reserve requirement
3. Discount rate
16-51
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
16-52
Ways in Which the Federal Reserve Changes
the Money Supply (cont'd)
 Today’s discount rate policy is to
set discount rate above the federal funds
rate.
 Question
Why would the Fed do this?
16-53
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.
16-54
Table 16-2 Required Reserve
Ratios in Selected Nations
16-55
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
16-56
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.
16-57
Federal Deposit Insurance
 When businesses fail, they create hardships for creditors,
owners and customers.
 When a depository institution fails even greater hardship
results as many individuals and businesses depend on the
safety and security of banks.
 Bank Runs
Attempts by many of a bank’s depositors to convert
transactions and time deposits into currency out of fear
that the bank’s liabilities may exceed its assets
16-58
Figure 16-4 Bank Failures
Source: Federal Deposit Insurance Corporation
16-59
Federal Deposit Insurance (cont’d)
 Federal Deposit Insurance Corporation (FDIC)
A government agency that insures the deposits held in
banks and most other depository institutions; all U.S.
banks are insured this way.
 How deposit insurance causes increased risk
taking by bank managers
Lack of correlation between risk taking and insurance
premiums.
16-60
Federal Deposit Insurance
(cont'd)
 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.
16-61
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.
16-62
Issues and Applications: Smart Cards, Digital
Cash, and the Money Supply
 The microchips embedded in smart cards give
them a technical edge over debit cards.
 At present, about 300 million smart cards are used
around the globe.
 In a world in which people widely use digital cash
the money multiplier would be larger.
16-63
Figure 16-5 The Distribution of
the World’s Smart Cards
16-64
Summary 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
16-65
Summary 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 maximum potential change in the money
supply following a Federal Reserve purchase or
sale of U.S. government securities
The multiplier
16-66
Summary of Learning Objectives
(cont'd)
 The Fed influences the money supply through
Open market operations, the discount rate, and
the reserve requirement
 The FDIC was established in 1933 to prevent
bank runs.
Difficulties include adverse selection and
moral hazard
16-67
Assignment to be completed
before class April 28:
Study Chapters 14, 15 & 16 & be
prepared to ask questions during
our review.