18Chapter-Mankiw

# 18Chapter-Mankiw - CHAPTER 18 Money Supply and Money Demand...

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Questions for Review 1. In a system of fractional-reserve banking, banks create money because they ordinarily keep only a fraction of their deposits in reserve. They use the rest of their deposits to make loans. The easiest way to see how this creates money is to consider the balance sheets for three banks, as in Figure 18–1. Suppose that people deposit the economy’s supply of currency of \$1,000 into Firstbank, as in Figure 18–1(A). Although the money supply is still \$1,000, it is now in the form of demand deposits rather than currency. If the bank holds 100 percent of these deposits in reserve, then the bank has no influence on the money supply. Yet under a system of fractional-reserve banking, the bank need not keep all of its deposits in reserve; it must have enough reserves on hand so that reserves are available when- ever depositors want to make withdrawals, but it makes loans with the rest of its deposits. If Firstbank has a reserve–deposit ratio of 20 percent, then it keeps \$200 of the \$1,000 in reserve and lends out the remaining \$800. Figure 18–1(B) shows the bal- ance sheet of Firstbank after \$800 in loans have been made. By making these loans, Firstbank increases the money supply by \$800. There are still \$1,000 in demand deposits, but now borrowers also hold an additional \$800 in currency. The total money supply equals \$1,800. Money creation does not stop with Firstbank. If the borrowers deposit their \$800 of currency in Secondbank, then Secondbank can use these deposits to make loans. If Secondbank also has a reserve–deposit ratio of 20 percent, then it keeps \$160 of the 171 A. Balance Sheet — Firstbank Assets Reserves \$1,000 B. Balance Sheet — Firstbank Assets Reserves \$200 Loans \$800 C. Balance Sheet — Secondbank Assets Reserves \$160 Loans \$640 Deposits \$1,000 Deposits \$1,000 Deposits \$800 Liabilities Liabilities Liabilities Money Supply = \$1,000 Money Supply = \$1,800 Money Supply = \$2440 Figure 18–1 CHAPTER 18 Money Supply and Money Demand

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\$800 in reserves and lends out the remaining \$640. By lending out this money, Second- bank increases the money supply by \$640, as in Figure 18–1(C). The total money sup- ply is now \$2,440. This process of money creation continues with each deposit and subsequent loans made. In the text, we demonstrated that each dollar of reserves generates (\$1/ rr ) of money, where rr is the reserve–deposit ratio. In this example, rr = 0.20, so the \$1,000 originally deposited in Firstbank generates \$5,000 of money. 2. The Fed influences the money supply through open-market operations, reserve require- ments, and the discount rate. Open-market operations are the purchases and sales of government bonds by the Fed. If the Fed buys government bonds, the dollars it pays for the bonds increase the monetary base and, therefore, the money supply. If the Fed sells government bonds, the dollars it receives for the bonds reduce the monetary base and therefore the money supply. Reserve requirements are regulations imposed by the Fed that require banks to maintain a minimum reserve–deposit ratio. A decrease in the reserve requirements lowers the reserve–deposit ratio, which allows banks to make
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## This note was uploaded on 02/22/2012 for the course ECON 602 taught by Professor Smith during the Spring '12 term at FSU.

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18Chapter-Mankiw - CHAPTER 18 Money Supply and Money Demand...

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