KW_Macro_Ch_13_Sec_03_Determining_the_Money_Supply

KW_Macro_Ch_13_Sec_03_Determining_the_Money_Supply -...

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>> Money, Banking, and the Federal Reserve System Section 3: Determining the Money Supply chapter 13 If banks didn’t exist, the quantity of currency in circulation would be equal to the money supply. And since all U.S. currency in circulation—coins, $1 bills, $5 bills, and so on—is issued by the government, the money supply would be determined directly by whoever controls the minting and printing presses. But banks do exist, and they affect the money supply in two ways. First, they take some currency out of circulation: dollar bills that are sitting in bank vaults, as opposed to sitting in people’s wallets, aren’t considered part of the money supply. Second, and much more important, is that banks, by offering deposits, create money, allowing the money supply to be larger than the quantity of currency. Let’s look at how banks create money and what determines the amount of money they create. How Banks Create Money To see how banks create money, it’s useful to examine what happens when someone decides to deposit currency in a bank. So let’s consider the example of Silas, a miser, who keeps shoeboxes full of currency under his mattress. Suppose he realizes that it
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2 CHAPTER 13 SECTION 3: DETERMINING THE MONEY SUPPLY would actually be safer, as well as more convenient, to deposit that cash in the bank and withdraw funds or write checks when necessary. And suppose he takes his money, $1,000 in cash, and deposits it into a checkable account at First Street Bank. What effect will this have on the money supply? Panel (a) of Figure 13-3 shows the initial effect of his deposit. First Street Bank cred- its Silas with $1,000 in his account, so checkable bank deposits rise by $1,000. Meanwhile, Silas’s cash goes into the vault, so First Street’s reserves also rise by $1,000. Figure 13-3 Assets Liabilities Loans No change Reserves + $1,000 Checkable deposits +$1,000 (a) Initial Effect Befo r e Bank Makes New Loans (b) Effect Afte r Bank Makes New Loans Assets Liabilities Loans + $900 Reserves – $900 No change Effect on the Money Supply of Turning Cash into a Checkable Deposit at First Street Bank When Silas deposits $ 1,000 (which had been stashed under his mattress) into a checkable bank account, there is initially no effect on the money supply: currency in circulation falls by $ 1,000, but checkable bank deposits rise by $ 1,000. The corre- sponding entries on the bank’s T-account (panel a) show deposits initially rising by $ 1,000 and the bank’s reserves initially rising by $ 1,000. In the second stage (panel b), the bank holds 10% of Silas’s deposit ( $ 100) as reserves and lends out the rest ( $9 00) to Mary. As a result, its reserves fall by $9 00 and its loans increase by $9 00. Its liabilities, including Silas’s $ 1,000 deposit, are unchanged. The money supply, the sum of bank deposits and curren- cy in circulation, has now increased by $9 00—the $9 00 now held by Mary.
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This initial transaction has no effect on the money supply. Currency in circulation
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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KW_Macro_Ch_13_Sec_03_Determining_the_Money_Supply -...

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