October 26 notes

October 26 notes - Process of Money Creation and...

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Unformatted text preview: Process of Money Creation and Destruction • Key Question: Can Banks “Create” Money? Assumptions • Legal Reserve Requirement Ratio = 10% • Banks hold No Excess Reserves ^Only what is required of them • No Currency Drain Stage A • A parent gives John Doe $1000 in cash • John opens a checking deposit account at Bank A Bank A’s Balance Sheet Effects of the Deposit of Currency Bank A R + 1000 • Important Note: Required Reserves = +$100 Excess Reserves = +$900 DD + 1000 What Can Bank A Do? • Reserves Earn Little or No Interest • Invest in Earning Assets Earn a Relatively High Return Types: Make Loans Purchase Securities • Bank A makes a Loan of $900 in cash to Mary Smith to purchase an auto Bank A’s Balance Sheet Effects of the Loan R + 1000 - 900 + 100 LN Bank A DD + 900 Important Note: • No Excess Reserves • “Fully Loaned Up” + 1000 Effects on Deposits and Money So far, how much in Deposits & Money has been created? DD 1000 Bank A M CU DD Will the process stop? No! 1000 1000 0 Stage B • Mary Smith purchases an auto from an auto dealer using the $900 in cash • Auto dealer deposits $900 in cash in Checking Deposit at Bank B Bank B’s Balance Sheet Effects of the Deposit of Currency Bank B R + 900 • Important Note: Required Reserves = $90 Excess Reserves = +$810 DD + 900 What Can Bank B Do? • Reserves Earn Little or No Interest • Invest in Earning Assets • Bank B makes a Loan to Jimmy Jones of $810 in cash to help pay tuition at Hopkins Bank B’s Balance Sheet Effects of the Loan Bank B R + 900 - 810 + 90 LN + 810 Important Note: • No Excess Reserves • “Fully Loaned Up” DD + 900 Effects on Deposits and Money So far, how much in Deposits & Money has been created? DD 1000 900 Bank A Bank B M CU DD Will the process stop? No! 1000 1000 900 900 Stage C • Jimmy Jones uses the $810 to help with tuition payments • Hopkins deposits $810 in cash into its checking deposit at Bank C Bank C’s Balance Sheet Effects of the Deposit of Currency Bank C R + 810 • Important Note: Required Reserves = $81 Excess Reserves = +$729 DD + 810 What Can Bank C Do? • Reserves Earn Little or No Interest • Etc. Observations • To acquire Earning Assets, Banks can Make Loans Purchase Securities • Actual process by which Banks acquire Earning Assets differs from case to case • But the end result is essentially the same Principle • By investing excess reserves and acquiring Earning Assets, Banks create Deposits • By selling off Earnings Assets and acquiring Excess Reserves, Banks destroy Deposits Question • Initial Deposit and Injection of Reserves of $1000 has lead to a multiple creation of Deposits • How much? Will the process stop? How much will be created in deposits? Deposit Creation DD 1000 900 810 ..... Bank A Bank B Bank C 9 92 1000 (1000) ( ) (1000) .... 10 10 9 92 93 [1 ( ) ( ) ....] x 1000 10 10 10 Infinite Geometric Progression Sum of an Infinite Geometric Progression 1aa 2 a 3 0a1 a 4 .... 1 1a DD 9 [1 10 [ 1 9 1 10 92 () 10 93 () 10 ....] x 1000 x 1000 1 x 1000 1 10 <--Legal reserve requirement ratio 10 x 1000 10, 000 Intuition • Initial Injection of Reserves of $1000 was entirely Excess Reserves • Deposit Creation ends when Excess Reserves are entirely used up as required reserves • When the Legal Reserve Requirement Ratio = 10%, this will occur when DD have increased by $10,000 Money Creation DD 10, 000 M CU DD 1000 10, 000 9000 A Generalization **Need for problem set! DD 1 x 1000 10 x 1000 1 10 1 xR dx R Legal Reserve Requirement Ratio 1 d Deposit Multiplier R Initial Injection of Reserves Principle • Each Bank can only create DD up to its Excess Reserves • The Banking System as a whole can create DD many times the Initial Injection of Reserves Limits to Deposit Creation • What factors limit Deposit Creation? – Size of the Reserve Requirement Ratio – Banks hold Excess Reserves – Cash Drain Types of Injections of Reserves • Deposits of Currency into Banks • Monetary Policy conducted by the Fed Major ways of increasing and decreasing the money supply is done by the Federal Reserve ...
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This note was uploaded on 01/20/2012 for the course ECON 180.101 taught by Professor Maccini during the Fall '08 term at Johns Hopkins.

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