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Unformatted text preview: 16 T HE F ED , M ONEY , AND C REDIT FOCUS OF THE CHAPTER This chapter develops the concept of fractional reserve banking, and explores the process by which the Federal Reserve controls the money supply. SECTION SUMMARIES 1. Money Stock Determination the Money Multiplier The money supply is made up mostly of deposits at financial institutions, which the Fed cannot control directly. Those institutions, however, keep some of their money on reserve at the Fed, and occasionally borrow money from it. The Federal Reserve can decide how many reserves those banks are required to keep on hand. It can determine the rate of interest it charges on the money it lends to banks (called the discount rate ). Moreover, it can control the number of bills and coins circulating in the economy. Thus it has a number of instruments that it can use to control the money supply. The currency (bills and coins) circulating through the economy and the reserves kept for banks by the Fed make up the monetary base , also called high-powered money . The cash that are held by the public are considered a part of the money supply. The currency which banks keep on reserve is not . The money multiplier ( mm ) is defined as the ratio of the money supply to the stock of high- powered money (the monetary base), and is given by the formula: mm 1 + cu re + cu , where cu is the currency-deposit ratio the ratio of currency to bank deposits and re is the reserve ratio the ratio of bank reserves to bank deposits. 173 174 C HAPTER 16 The money supply ( M ) is therefore given by the equation M = 1 + cu re + cu H , where H is the stock of high-powered money. An increase in reserve ratio makes the money multiplier smaller, increasing the amount of high-powered money required to support a given money supply. An increase in the currency-deposit ratio makes the money multiplier bigger, so that a given stock of high-powered money can support a larger money supply. Banks often hold more money in reserve than they are required to they loan out less than they could. Because reserves do not earn interest, banks try to minimize the amount of excess reserves they hold. They try especially hard when interest rates are high; because of this, increases in the interest rate can, to a limited extent, reduce the reserve ratio and increase the money multiplier. The Federal Deposit Insurance Corporation (FDIC)...
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- Spring '09