Ch15Spring2011

Ch15Spring2011 - CHAPTER 15 CHAPTER MONEY CREATION MONEY...

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Unformatted text preview: CHAPTER 15 CHAPTER MONEY CREATION MONEY Spring, 2011 1 GRAPH OF EQUILIBRIUM INTEREST GRAPH RATE: RATE: Determined in the Money Market Interest Rate Money Supply Determined. by FED Equilibrium rate of interest. i(e) Demand for Money Money 2 IMPACT OF CHANGE IN INTEREST IMPACT RATE ON INVESTMENT EXPENDITURES EXPENDITURES Interest Rate i(1) i(2) I(p) I(p) 3 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 4 HOW THE FED CONTROLS THE HOW MONEY SUPPLY MONEY AD-AS model allows equilibrium AD-AS GDP ) to be determined for any given rate of interest. Interest rate determines investment spending, and hence aggregate demand. AD and AS functions then determine the equilibrium level of real GDP and the price level. The equilibrium interest rate is determined by the demand for and the supply of money. and 5 INTRODUCTION Financial institutions are for-profit Financial corporations. corporations. Accept deposits Make loans Make Goal is to maximize profits. Goal BUT, the result of these profit-maximizing BUT, transactions is that: transactions The money supply changes Interest rates change Investment changes Y(e) changes This chapter shows the impact on the This money supply of private sector, profitmoney maximizing transactions 6 THE PROCESS OF MONEY CREATION History of fractional reserve banking History The gold standard The role of goldsmiths Centralized deposits of gold The introduction of checking The accounts accounts Fractional reserves: only some % Fractional of new deposits must be held as required reserves. Fractional reserve banking today: Fractional Not to protect checking deposits FDIC insures deposits As an instrument of monetary As control control 7 THE PROCESS OF MONEY CREATION P. 76 Bank A: Balance Sheet 1 Bank Assets Assets Required Res. $05M Excess Res $45M Loans $00M --------------Total $50M Liabilities Liabilities Deposits $50M -------$50M Assets: What the bank owns: Required Reserves Required Loans (collateral value) Loans Liabilities: What the bank owes: Funds to depositors Funds Total reserves = Required reserves + Total Excess reserves Excess 8 THE PROCESS OF MONEY CREATION P. 378 Legal reserve requirement: % of deposits that cannot be cannot loaned out. Note: Example below assumes all banks subject to same legal reserve requirement (see text p. 353) requirement Accepting a new deposit: Accepting Best Bank: Balance Sheet #2, p. 363 Best Assets Liabilities Assets Liabilities Req. Res. $10,000 B. Rich Dep. 100,000 Req. Ex. Res. $90,000 Ex. -------------------------Totals $100,000 $100,000 Totals 9 THE PROCESS OF MONEY CREATION PP. 364-365 Best Bank: Balance Sheet #3, p. 379 Best Assets Liabilities Liabilities Req. Res. $19,000 Rich Dep. $19,000 Excess Res.$81,00 Jones Dep. Loans $90,000 Loans ----------------------Totals $190,000 $100,000 $100,000 $090,000 $090,000 ----------$190,000 Best Bank: Balance Sheet #4, p. 380 Best Assets Req. Res. $10,000 Req. Excess Res. $00,000 Excess Loans $90,000 Loans --------------------Total $100,000 Total Liabilities Liabilities Rich Dep. $100,000 $100,000 Jones Dep. $000,000 $000,000 -----------$100,000 10 THE PROCESS OF MONEY CREATION PP. 350-351 Funds re-deposited in Bank B Yazoo Bank : Balance Sheet #5, p. 380 Assets Req. Res. $09,000 Ex. Res. $81,000 $81,000 ----------------------Totals $90,000 Liabilities Liabilities New deposit $90,000 ----------$90,000 Yazoo Bank Bal. Sheet #6 (no text page) Assets Req. Res. $9,000 Req. Loans $81,000 Loans --------------------Total $90,000 Total Liabilities Liabilities New Deposit $90,000 11 -----------$90,000 THE PROCESS OF MONEY CREATION P. 381 Expansion of the Money Supply Rd 1 2 3 4 5 6 ∆ ∆ ∆ in Dep. In Req. Res. in Excess Res. in $100,000 $100,000 $090,000 $081,000 $072,900 . . Totals:----------Totals:----------$1,000,000 $1,000,000 $10,000 $09,000 $08,100 . . . -----------$100,000 $90,000 $81,000 $72,900 . . $00,000 -----------$900,000 Note: A $100,000 increase initial deposits Note: leads to a $1,00,000 increase in the money supply. New loans created $900,000 in new deposits. $900,000 12 THE MONEY MULTIPLIER Money multiplier is equal to reciprocal of the reserve requirement: If Res. Req. = 10%, money multiplier is equal to 10 in above example. equal IMPORTANT Assumptions: IMPORTANT No leakages into cash No Banks are willing to loan out all willing excess reserves Banks are able to loan out all able excess reserves excess 13 MONEY CREATION: Page 1 Money is created on the basis of: (1) Excess reserves (1) (2) The money multiplier In above example, $900,000 deposits created by the banking system: $90,000 in initial excess reserves $90,000 Money multiplier = 1/Res. Req. = 1/10% = 10 $90,000 * 10 = $900,000 $900,000 in new deposits increases the amount of Req. Res by $90,000, and this is the amount of initial excess reserves. Excess reserves “converted” into requird reserves. reserves. 14 MONEY CREATION: Page 2 Rework the above example with a 20% reserve requirement: Initial deposit = $100,000 Initial Initial Res. Req.= $20,000 Initial Initial Excess Res. $80,000 Money multiplier = 1/20% = 1/5 = 5 Money Money creation -= $80,000 * 5 = $400,000 $400,000 Rationale: $80,000 in initial excess reserves must be converted to $80,000 in required reserves. So there are no more excess reserves and the expansion (relending) process stops. process 15 NUMERICAL EXAMPLE: NUMERICAL Expanding the Money Supply Suppose the private commercial banking Suppose system has $800 in deposits and no excess reserves when the legal reserve requirement is 25%. By how much can the money supply expand if the legal reserve requirement is reduced to 20%? reserve ANSWER: $200 ANSWER: Calculation process for expansion 1. Find the amount of excess reserves 1. ($40). ($40). 2. Calculate the value of the money 2. multiplier. (1/20% = 5) multiplier. 3. Multiply excess reserves times the 3. money multiplier to get potential money-creating effect. (5 * 40 = $200) money-creating 16 Sample Problem: Expanding the Money Sample Supply Supply BANKING SYSTEM Assets Liabilities Assets Liabilities Req. Res. Loans Loans Ex. Res. $200 $200 $600 $600 $000 Deposits $800 Now let the legal res. req. drop to 20% Now BANKING SYSTEM BANKING Assets Req. Res. Lo Ex. Res. Liabilities $160 $600 $040 Deposits $800 Given the maximum value of the money Given multiplier (1/20% = 5), the amount of deposits yet to be created is 5 * $40 = $200. THE BANKING SYSTEM CREATES MONEY ON THE BASIS OF EXCESS RES. MONEY 17 CONTRACTING THE MONEY CONTRACTING SUPPLY: SUPPLY: Banking system can destroy deposits as Banking destroy well as create them. Deposits are destroyed on the basis of a shortage of required reserves. shortage Maximum contraction given by the product of: Shortage of Required Reserves AND Shortage The money multiplier. This product shows the amount of deposits This that have to be destroyed to eliminate the destroyed shortage of required reserves. If initial shortage is $10,000 and money multiplier is 5, then: $10,000 * 5 = $50,000 * $10,000 18 CONTRACTING THE MONEY CONTRACTING SUPPLY SUPPLY (continued) BANK A Assets Assets Req. Res. Req. Loans & Loans Investments Investments Liabilities Liabilities $10,000 Deposits $100,000 $90,0000 No excess reserves in the system. A check for No $10,000 is “cashed” at Bank A. $10,000 BANK A BANK Assets Req. Res. $000000 Loans & Loans Investments $90,000 Investments Liabilities Deposits $90,000 Note the deficiency of required reserves! Cashing a Note check does NOT reduce loans and investments! check 19 CONTRACTING THE MONEY SUPPLY (continued) . Note that bank sells off loans and investments of $9000 to replenish required reserves. Assets Assets Liabilities Liabilities Req. Res. $9000 Deposits $90,000 Loans & Loans Investments $81,000 Investments Note: deficiency in required reserves Note: resolved by calling in loans and investments. So some other bank will have a check clear against their deposits, and they will lose required reserves. and 20 CONTRACTING THE MONEY SUPPLY Page 4 Contracting the Money Supply Sales of Sales Rd Rd ∆ in Dep. ∆ In Req. Res. 1 -$10,000 -$10,000 2 -$09,000 3 -$08,100 4 . 5 . 6 . Totals:----------- $100,000 $100,000 - $01,000 - $00,900 -$00,810 . . . ------------$10,000 Securities . Securities - $9,000 -$8,100 - $7,290 . . . ------------$90,000 Sales of $9,000 worth of securities leads to Sales a $90,000 decrease in the money supply. 21 CONTRACTING THE MONEY CONTRACTING SUPPLY: Page 5 SUPPLY: Full contraction more likely to be achieved Full BECAUSE: Money contraction is not permissive: Money not Banks compelled by law to meet Banks reserve requirements Banks must call in loans, which Banks reduces deposits in other banks. Process continues until enough Process deposits are “destroyed” to eliminate the shortage of required reserves. required 22 NUMERICAL EXAMPLE: NUMERICAL Contracting the Money Supply Suppose the private commercial banking Suppose system has $800 in deposits and no excess reserves when the legal reserve excess requirement is 10%. By how much will the money supply contract if the legal reserve requirement is raised to 20%? reserve ANSWER: $400 Calculation process for expansion 1. Find the shortage of required 1. reserves. ($80) reserves. 2. Calculate the value of the money 2. multiplier. (5) multiplier. 3. Multiply the shortage of required 3. reserves times the money multiplier to get potential money-destroying effect. ($400) effect. 23 OPEN MARKET OPERATIONS: (continued) Bond prices and bond yields move in Bond opposite directions. opposite Example: GM Bond GENERAL MOTORS CORPORATION $1000 Bond Pays owner $60.00 per year Bond matures 2075 AD 24 OPEN MARKET OPERATIONS: (continued) Bond prices and bond yields: Bond Price Yield Yield $500 12% $1000 06% $1000 06% $2000 03% 03% Conclusion: Conclusion: As bond prices rise, yields fall As If FED enters market as a buyer: Prices rise, yields fall Wealth holders sell government Wealth bonds and buy other financial assets, whose prices rise and yields fall yields 25 FEDERAL RESERVE MONETARY FEDERAL POLICY POLICY • Instruments of Monetary Control 1. Open market operations 2. Changes in the discount rate 3. Changes in the reserve Changes requirement requirement • Keynesian monetary policy: Keynesian 1. 2. 3. 4. 5. 5. ∆ the money supply the ∆ the rate of interest the ∆ the level of Investment the ∆ the level of Y(e) Above assumes a downwardsloping demand schedule for sloping money (see Chapter 16) money 26 OPEN MARKET OPERATIONS: Open market operations: Involve the purchase and sale of Involve short-term government securities Are conducted by the Open Market Are Committee Committee A. With private sector firms that A. are profit oriented are Are intended to change the money Are supply and interest rates Are the most frequently-used tool of Are monetary policy If FED buys (sells) securities, their If prices rise and yields fall (rise) prices 27 OPEN MARKET OPERATIONS: Purchases from a Bank Bank A: Balance Sheet #1 ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Bonds $05M Now FED buys $5M bonds from Bank A: Bank A: Balance Sheet #2 Bank ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Loans Excess Reser. $05M 28 OPEN MARKET OPERATIONS: Purchases from a Non-Bank firm Bank A: Balance Sheet #1 ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Required Loans $35M Bonds $05M Now FED buys $5M bonds from XYZ Corporation: Bank A: Balance Sheet #2 Bank ----------------------------------------------------------------------------------------------------------Required Res. $11M Deposits $50M Required Loans $35M + Dep. $05M Loans Bonds $05M Bonds Excess Res. $04M ----------------Total $55M $55M 29 OPEN MARKET OPERATIONS: (continued) Summary of Open Market Operations Case #1: Shift AD schedule to the right Fed buys bonds Bond prices rise and yields fall Banks get more excess reserves Multiple expansion of the money Multiple supply occurs supply Bank interest rates fall Bank Investment rises Y(e) rises GDP gap is closed through GDP monetary policy 30 OPEN MARKET OPERATIONS: (continued) If FED enters the market as a seller, If prices fall and yields rise prices Other wealth holders readjust their Other portfolios to buy government bonds, so prices of other assets fall and yields rise rise Effect of open-market operations Effect spreads throughout the financial markets Equilibrium reestablished when yields Equilibrium have adjustment throughout the financial markets financial Everyone just willing to hold existing Everyone financial assets at existing prices and yields yields 31 EQUILIBRIUM INTEREST RATE EQUILIBRIUM CHANGED BY OPEN MARKET OPERATIONS OPERATIONS Increase in M lowers interest rate! i rate S1 (Fed) S2(FED) D1 M 32 32 DECLINE IN INTEREST RATE DECLINE INCREASES INVESTMENT INCREASES i rate I(p) $ 33 33 OPEN MARKET OPERATIONS: (continued) Case #2: Shift AD schedule to left Fed sells bonds Bond prices fall and yields rise Banks experience a shortage of Banks required reserves required Multiple contraction of the money Multiple supply occurs supply Bank interest rates rise Bank Investment falls Y(e) falls GDP gap is closed through monetary GDP policy policy 34 INCREASED I(p) SHIFTS AD INCREASED SCHEDULE TO THE RIGHT SCHEDULE Price Level AS1 AD3 AD2 AD1 GDP 35 CHANGES IN THE DISCOUNT RATE 1. The discount rate: Is the rate of interest The FED District Banks charge commercial banks when the borrow excess reserves. 2. Commercial banks gain an additional 2. Commercial asset (excess reserves) and an additional liability (loan from FED) 3. Why would commercial banks borrow 3. Why excess reserves? A. To make profitable loans 4. Why would discount rate impact 4. Why decisions of commercial banks to borrow excess reserves? borrow A. Affects profitability of loans! 36 CHANGES IN THE DISCOUNT RATE: (continued) Bank A: Balance Sheet #1 Bank ----------------------------------------------------------------------------------------------------------Required Res. $10M Deposits $50M Loans $40M Bank A unable to extend additional loans Bank because no excess reserves are available. available. Bank A now borrows $5M from FED Bank Bank A: Balance Sheet #2 Bank ------------------------------------------------------Req. Res. $10M Deposits $50M Loans $40M FED loan $05M Excess. Res . $05M -----------------------Total $55M $55 M 37 CHANGES IN THE DISCOUNT RATE CHANGES (continued) (continued) Summary of Discount Rate Case #1: Shift AD Schedule to the right Case ¢ 1. 1. 2. 3. 4. 5. 6. 6. 7. 8. 8. FED lowers discount rate Commercial banks borrow excess Commercial reserves reserves Excess reserves loaned out Multiple expansion of money Multiple supply occurs supply Interest rates fall Interest I(p) rises Y(e) rises Y(e) GDP gap is closed GDP 38 CHANGES IN THE DISCOUNT RATE (continued) Case #2: Shift AD schedule to the left FED rises discount rate Commercial banks reduce their Commercial borrowings of excess reserves borrowings Fewer loans are made by banks Money supply declines Interest rates rise Y(e) falls Y(e) GDP gap is closed The discount rate as a signal to the The financial community. 39 CHANGES IN THE REQUIRED RESERVE RATIO Changes in the required reserve ratio: Changes Cause changes in the amount of Cause excess reserves excess Which changes the base upon Which which multiple changes in the money supply occur money Cause changes in the money Cause multiplier, which is equal to the reciprocal of the reserve requirement. requirement. If the reserve ratio rises, the If reciprocal of the reserve ratio falls. Reserve Ratio Money Multiplier 10% 10 10 20% 05 20% 40 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Banking System: Balance Sheet #1 ------------------------------------------------------Required Res. $10M Deposits $50M Loans $40M Result:: Money multiplier = 1/20% = 5 Result:: No excess reserves available No ---------------------------------------------------------Banking System: Balance Sheet #2 -----------------------------------------------------Required Res. $05M Deposits $50M Loans $40M Excess Res. $05M Result: Money multiplier = 1/10% = 10 Excess reserves = $5M Excess 41 CHANGES IN THE REQUIRED RESERVE RATIO (continued) 1. What is ultimate possible impact on What money supply of reduction in reserve requirement? A. (Increase in excess reserves) * A. (Increase (money multiplier) = total potential change in the money supply B. $5M * 10 = $50M possible change B. $5M 1. 1. Lowering reserve requirement: Lowering A. Increases excess reserves A. B. Increases value of money Increases multiplier C. Both work to increase the money C. Both supply supply 42 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Raising the reserve requirement: Reduces excess reserves Or, creates a shortage of required Or, reserves reserves Reduces the value of the money Reduces multiplier multiplier Both work to reduce the moneycreating potential of the banking creating system system 43 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Case #1: Shift AD Schedule to the Right 1. 2. 3. 4. 5. 6. 6. 7. 8. 8. Lower the reserve requirement Creates additional excess Creates reserves reserves Raises money multiplier Causes money supply to rise Causes interest rates to fall Causes Increases I(p) Increases Y(e) Increases Closes GDP gap 44 CHANGES IN THE REQUIRED RESERVE RATIO (continued) Case #2: Shift AD Schedule to the Left Case Raise the reserve requirement Reduces excess reserves (or Reduces creates a shortage of required reserves) reserves) Reduces money multiplier Causes money supply to fall Causes interest rates to rise reduces(p) Reduces Y(e) Reduces Closes GDP gap 45 Review: Chapter 15 Review: 1. 1. Suppose the FED wants to Suppose increase aggregate expenditures. What policies should they follow? 2. 2. Suppose the FED wants to Suppose decrease aggregate expenditures. What policies should they follow? 3. 3. What factors could limit the What ability of monetary policy to change the level of aggregate expenditures? 46 46 ...
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This note was uploaded on 01/12/2012 for the course ECN 211 taught by Professor Kingston during the Spring '08 term at ASU.

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