MIT14_02F09_lec16_17

MIT14_02F09_lec16_17 - Fed Policy and Money Markets 1...

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d P l i d M M kt Fed Policy and Money Markets 1
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Outline How the banking system works? What is the Fed and how does it work? What is a monetary policy? hat about the current credit crunch? What about the current credit crunch? 2
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Money Supply We have mentioned before that money supply is affected by: 1. The Central Bank (the Federal Reserve System in the United States) is the government institution responsible for monetary policies 2. Depositary Institutions (Banks) are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public 3. The public includes every person or firm (except banks) that holds money in currency or deposits. 3
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The Banking System: An Introduction Bank Assets and Liabilities: Assets: Loans (TL) + Reserves (TR) Liabilities: Deposits (TD). Reserves = liquid assets held by the bank to meet the demand for ithdrawals by depositors or to pay checks withdrawals by depositors or to pay checks How do banks make money? They Lend. How much do they lend? Must keep a minimum amount of reserves quired by law 4 ( required by law ).
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The Banking System: An Introduction Fractional reserve banking: banks hold only a fraction of their deposits in reserve. Reserve-deposit ratio = required reserves/deposits = m Fractional reserve banking m<1 (100% reserve banking m=1) ssume banks lend all they can: R = m*TD Assume banks lend all they can: TR = m*TD, TD = TL + TR (money held within the banking system) Δ TD = Δ TL + Δ TR 5
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The Banking System: An Example Suppose I put $500 in the bank (remove it from under my mattress). We call the $500 that starts the process the ‘Initial Deposit’ (ID) *** Suppose that no one else in the economy holds cash Suppose that no one else in the economy holds cash. *** Suppose banks lend to their limit. Suppose that m = 0.1. What happens in the banking system (assume nobody wants to hold currency): Step 1: Deposits increase by $500 (initial deposit). Step 2: Then, Deposits increase by another $450. tep 3: hen Deposits increase by another $405 Step 3: Then, Deposits increase by another $405. Step 4: ………….(keep increasing) Step infinity: ………….(keep increasing) 6 Why do deposits keep increasing? LOANS!!!!
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The Banking System: An Example Step 1 : Assets Liabilities TR $ 500 TD $500 TR* = .1*500 = 50 →Δ TL = TR – TR* = 450 Step 2 : Assets Liabilities TR $ 500 TD $950 TL $ 450 R*= .1*950 = 95 L = TR R*= 405 TR .1 950 95 Δ TL TR TR 405 Step 3 : Assets Liabilities TR $ 500 TD $ 1355 TL $ 855 TR* = .1* 1355 = 135.5 TL = TR – TR* = 364.5 7 Loans and deposits expand up to a point TR* = TR, that is, TD = TR / m = 5000 !
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The Money Multiplier Total Change in Deposits: = ID + ID (1-m) + ID(1-m) 2 + … = ID (1 + (1 ) + (1 ) 2 ) ID (1 + (1-m) + (1-m) + … ) = ID (1/m) Money Multiplier μ m = 1/m TD = (1/m) ID Some caveats: – There are holding of currency out of the banking system – Banks may hold excess reserves 8
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Money Supply and Monetary Base MS = Money Supply TC = Total Currency in Circulation (outside banking system) BASE = Monetary base MS = TC + TD Δ MS = Δ TC + Δ TD S C →Δ MS = Δ TC + Δ TR + Δ TL BASE = TC + TR (liabilities of the Central Bank that can be used
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MIT14_02F09_lec16_17 - Fed Policy and Money Markets 1...

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