•Monetary aggregates
•Checkable deposits
•Balance sheets
•Money creation
•Money multiplier
•Tools of the Fed
These are measures of the
money supply. We add
together all assets that are
liquid enough to be classified
as money
The narrow measure of the money
supply; includes only the most liquid
assets
M1 equals
Plus:
Plus:
Currency and coin in circulation
Checkable deposits
Travelers’ checks
About 60 percent
of Federal Reserve
notes now
circulate abroad
A broader measure of the money
supply favored by many economists.
M2 equals
Plus:
Plus:
Plus:
Plus:
M1
Miscellaneous near monies
Small denomination time deposits
Savings deposits
Money market deposit accounts
Measures of the money supply (July 2007)
6
By bringing together both sides of the money
market , banks serve as intermediaries or gobetweens. Banks reduce the transactions costs
of channeling saving to creditworthy
borrowers.
•Coping with asymmetric
information.
•Reducing risk through
diversification.
To start a bank we must obtain a
charter from a state government
or from the Federal Reserve
Home Bank’s balance sheet
Assets
Liabilities
Building and furniture
Stock in district Fed
$450,000
50,000
Net worth
$500,000
Total
$500,000
Total
$500,000
Note that:
Assets = Liabilities + Net Worth
9
Home Bank’s balance sheet after $1,000,000
deposit into checking account
Assets
Liabilities
Cash
Building and furniture
Stock in district Fed
$1,000,000
450,000
50,000
Checkable deposits
Net worth
$1,000,000
500,000
Total
$1,500,000
Total
$1,500,000
Remember that deposits are an asset for
depositors but a liability for the bank.
10
Banks must maintain a reserve account
at the regional Federal Reserve bank
•Required reserves: The dollar amount of reserves a
bank is required to hold as cash in vault or on account
at the Fed.
•Required reserve ratio: The ratio of reserves to
deposits that banks by regulation are obligated to
hold.
•Excess reserves: Bank reserves exceeding required
reserves
Banks must be ready for
customers’ withdrawals, so
liquid bank assets are
desirable. At the same time,
less liquid assets such as
commercial and real estate
loans are more profitable.
•Banks create money when they
make loans and credit the accounts
of loan recipients.
•Money creation (lending) is limited
by banks’ holdings of excess
reserves.
•Reserve do not earn interest; hence
banks seek to minimize reserve
holdings
Suppose the Fed pays
$1,000 to a securities
dealer for a bond. The
transaction is handled by
the dealer’s bank—Home
Bank
Changes in Home Bank’s balance sheet after Fed
buys a $1,000 bond from Securities dealer
Assets
Reserves at Fed
Liabilities
+$1,000
Checkable deposits
+$1,000
oThe Fed credits home Bank’s reserve account by $1,000.
oHome Banks’ liabilities increase by $1,000.
15
Assume the legal reserve ratio is .10
or 10 percent.
The preceding
transaction will create a
$900 excess reserve for
Home Bank. Loans and
deposits can be
expanded by that
amount.
Round 2: Changes in Home Bank’s balance sheet
after lending $900 to you
Assets
Loans
Liabilities
+$900
Checkable deposits
+$900
Thus the money supply initially increases by
$900 as a result of this loan.
17
1. Suppose you write a $900 check to
your university to pay fees.
2. Your university deposits the check
into its account at Merchants Trust
bank.
3. When the check clears, the Fed debits
Home Banks’ reserve account for
$900 and credits Merchant Bank’s
reserve account for $900.
4. Thus the transaction creates a $810
excess reserve for MerchantsTrust.
Merchants Trust makes a $810 loan
to an English major starting an online
note-taking service called “Note
This.”
Round 3: Changes in Merchants Trust’s balance
sheet after lending $810 to English Major
Assets
Loans
Liabilities
+$810
Checkable deposits
+$810
Note that as a result of this loan the money
supply has increased by $810.
20
1. The English major writes an $810
check to the college bookstore.
2. The college bookstore deposits the
$810 check into its account at Fidelity
Bank
3. When the check clears, the Fed debits
Merchant Trust’s reserve account for
$810 and credits Fidelity Bank’s
reserve account for $810.
4. Thus the transaction creates a $729
excess reserve for Fidelity Bank.
Fidelity Bank is now
positioned to make
loans totaling $729
Summary of money creation resulting from
Fed’s purchase of $1,000 US Government
Bond
Bank
1. Home Bank
2. Merchants Trust
3. Fidelity Bank
All remaining rounds
Totals
(1)
Increase in
Checkable
Deposits
(2)
Increase in
Required
Reserves
(3)
Increase in
Loans
=(1)-(2)
$1,000
900
810
7,290
$100
90
81
729
$900
810
729
6,561
$10,000
$1,000
$9,000
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The multiple by which the money supply
changes as a result of a fresh change in fresh
reserves of the banking system.
Change in the money supply = change in fresh reserves x 1/r
Where r is the required reserve ratio
Simple
money
multiplier
In our case:
Change in the money supply = $900 x 1/.10 = (4900)(10)= 9,000
It should be clear now that
when Fed buys
government securities in
large quantities, there are
strong effects in terms of
bank excess reserves and
lending capacity.
Federal Reserve Bank balance sheet as of
August 22, 2007 (billions)
Assets
Liabilities
US Treasury securities
Foreign currencies
Bank buildings
Discount loans to
depository institutions
Other assets
$789.9
36.9
2.1
Total
$866.8
2.3
35.9
Federal Reserve notes
outstanding
Depository institutions reserves
US Treasury balance
Other liabilities
Net Worth
$774.5
13.1
5.3
39.5
34.4
Total
$866.8
26