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This is how the banking system creates a multiple of

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Unformatted text preview: osits, has gained excess reserves of $900. It, therefore, will try to make a new loan for $900 and fund this loan by creating new deposits of $900. The new money created up to this stage is $1,000 + $900 or $1900. The new borrower will draw on his new deposit to make purchases and the check will end up in other banks; the $900 in excess reserves will be transferred to those other banks and they in turn will make new loans or investments by creating additional new deposits. At each stage of the process, excess reserves available to be “lent out” are smaller than at the last stage by 10 percent, meaning that the amount of new loans and deposits created at each stage gets progressively smaller. Eventually, there will be no excess reserves left because the accumulated value of all new deposits created will require reserves backing equal to the amount of new reserves that started the whole process. In our example, excess reserves are used up when total new deposits created reach $10,000. This is how the banking system creates a multiple of new deposits when it receives new reserves. Conversely, when the banking system loses reserves, it goes through a series of reductions in loans and investments, destroying deposits in the process until they are brought back into line with the amount of reserves available to back them. TOOLS OF MONETARY POLICY The Federal Reserve can change the amount of deposits banks issue (and hence the size of the money supply) by altering the amount of reserves available that economists call the supply of reserves. The principal tool the Fed uses to add reserves to, or drain them from, the banking system is open market operations. These consist of buying or selling government securities in the open market. The Fed also can affect the supply of reserves indirectly by changing the discount rate, the rate it charges depository institutions when they borrow from Federal Reserve Banks. Finally, the Federal Reserve can change bank's need, or demand, for reserves by changing reserve requirements – the fraction of deposits that must be matched by reserves – within limits set by...
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This note was uploaded on 12/30/2010 for the course SOC 101 taught by Professor Zhung during the Spring '10 term at Punjab Engineering College.

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