Chapter 25

Money Creation
Key Concepts
Summary
Practice Quiz
Internet Exercises
2000 South-Western College Publishing
1
In this chapter, you will
learn to solve these
economic puzzles:
Exactly
What how
areisthe is
major money
tools the
Why
created there
in the nothing
economy?
Federal Reserve
federal about uses
the to
That
control is, how
the supply does
of the
money?
federal funds rate?
money supply increase?
2
In the Middle Ages, what
was used for Money?
Gold was the money
of choice in most
European nations

3
 Who were the
Founders of our
Modern-day Banking?
Goldsmiths, people
who would keep other
peoples gold safe for
a service charge
4
 What was the first
Currency?
People would use the
receipts they received from
goldsmiths as paper money

5
 How did the early
Goldsmiths act as the
First Banks?
Some goldsmiths made
loans and received
interest for more gold
than the actual gold held
in their vaults
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 What is Fractional
Reserve Banking?
A system in which banks
keep only a percentage
of their deposits on
reserve as vault cash and
deposits at the Fed
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 What are
Required Reserves?
The minimum balance that
the Fed requires a bank to
hold in vault cash or on
deposit with the Fed
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 What is a
Required Reserve Ratio?
The percentage of deposits
that the Fed requires a
bank to hold in vault cash
or on deposit with the Fed
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 What are
Excess Reserves?
Potential loan balances held
in vault cash or on deposit
with the Fed in excess of
required reserves
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 Typical Bank - Balance Sheet 1
Assets Liabilities
Required $5 million Checkable $50 million
Reserves Deposits
Excess 0
Reserves
Loans $45 million
Total $50 million Total $50 million
Note: The Fed requires the bank to keep
10% of its checkable deposits in reserve.
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 What are
Total Reserves?
Total Reserves = required
reserves + excess reserves

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Required Reserve Ratio of the Fed
Required Reserve
Type of Deposit
Ratio
Checkable deposits
0 - $46.5 million 3%
Over $46.5 million 10%
Source: Federal Reserve Bulletin,
April 1999, Table 1.15, p. A8

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Best National Bank - Balance Sheet 2
Assets Liabilities in M1
Required $10,000 Brad Rich $100,000 0
Reserves Account

Excess
Reserves +$90,000

Total $100,000 Total $100,000

Note: The Fed requires the bank to keep

10% of its checkable deposits in reserve.

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Best National Bank - Balance Sheet 3
Assets Liabilities in M1
Required $19,000 Brad Rich $100,000
Reserves Account

Excess $81,000 Connie Jones +$90,000

Reserves Account $90,000

Loans +$90,000
Total $190,000 Total $190,000

Note: The Fed requires the bank to keep

10% of its checkable deposits in reserve.
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Best National Bank - Balance Sheet 4
Assets Liabilities in M1
Required $10,000 Brad Rich $100,000 0
Reserves Account

Excess 0 Connie Jones 0

Reserves Account
Loans $90,000
Total $100,000 $100,000

Note: The Fed requires the bank to keep

10% of its checkable deposits in reserve.
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 Yazoo Bank - Balance Sheet 5
Assets Liabilities
Required +$9,000 Better Health +$90,000
Reserves Span Account
Excess +$81,000
Reserves

Total $90,000 Total $90,000

Note: The Fed requires the bank to keep

10% of its checkable deposits in reserve.
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 Expansion of the Money Supply
Increase in Increase in
Increase in
# Bank Deposits Required Excess
Reserves Reserves
1 Best Natl Bank $100,000 $10,000 $90,000
2 Yazoo Natl Bank 90,000 9,000 81,000
3 Bank A 81,000 8,100 72,900
4 Bank B 72,900 7,290 65,610
5 Bank C 65,610 6,561 59,049
6 Bank D 59,049 5,905 53,144
7 Bank E 53,144 5,314 47,830

Total all other banks 478,297 47,830 430,467

Total increase $1,000,000 $100,000 $900,000
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 What is the
Money Multiplier?
The maximum change in the
money supply due to an
initial change in the excess
reserves banks hold
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 What is the Money
Multiplier equal to?
1 / required reserve ratio

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Actual money supply change

M1 = ER x m
Initial change in excess reserves
Money multiplier

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 Can the Multiplier be
smaller than indicated?
Yes, because of cash
leakages and the chance
that banks will not use
all of their excess
reserves to make loans
22
What would the Fed do if
we had Inflation?
Decrease the money supply
What would the Fed do if
we had unemployment?
Increase the money supply
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What is Monetary Policy?
The Feds use of -
open market operations
in discount rate
in required reserve ratio
24
 What are Open
Market Operations?
The buying and selling of
government securities by
the Federal Reserve System

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 Federal Reserve System - Balance Sheet 6
Assets Liabilities
Government Fed notes
securities $472 $492

Loans to banks Deposits 34

1
Other liabilities
Other assets 75 and net worth 22

Total $548 Total $548

Source: Federal Reserve Bulletin, April 1999, Table 1.18, p. A10

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 Federal Reserve Bank - Balance Sheet 7
Assets Liabilities Initial
in M1
Government +$100,000 Reserves of +$100,000 +$100,000
securities Best Natl
bank

Note: The Fed conducted open market

operations in order to increase the
money supply by purchasing $100,000
in government securities.

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 Federal Reserve Bank - Balance Sheet 8
Assets Liabilities Initial
in M1
Government -$100,000 Reserves of -$100,000 -$100,000
securities Best Natl
bank

Note: The Fed conducted open market

operations in order to decrease the
money supply by selling $100,000 in
government securities.

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 Fed
$ Fed buys government
Fed sells government $ securities and banks
securities and banks gain reserves
loose reserves
Banks
$
$
Public
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 What is the
Discount Rate?
The interest rate the
Fed charges on loans
of reserves to banks

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What would the Fed do if
we have Inflation?
A higher discount rate
discourages banks from
borrowing reserves and
making loans
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What would the Fed do if
we have Unemployment?
A lower discount rate
encourages banks to
borrow reserves and
make more loans
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What is the Federal
Funds Market?
A private market in
which banks lend
reserves to each other
for less than 24 hours
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What is the Federal
Funds Rate?
The interest rate banks
charge for overnight
loans to other banks

34
What would the Fed do if
we had Inflation?
A higher federal funds rate
discourages banks from
borrowing reserves and
making loans
35
What would the Fed do if
we had Unemployment?
A lower federal funds
rate encourages banks
to borrow reserves and
make more loans
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 What is a Required
Reserve Requirement?
The Fed determines how
much a financial
institution must keep in
reserve as a percentage of
its total assets
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What is the Required
Reserve Ratio?
That percentage the Fed
stipulates that financial
institutions must keep in
reserve to meet its
reserve requirement
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If the Reserve Ratio
is one tenth, what is
the multiplier?
1 1/10 = 10

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If the Reserve Ratio is
one twentieth, what is
the multiplier?
1 1/20 = 20

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What would the Fed do
if we had Inflation?
Increase the reserve ratio
What would the Fed do if
we had Unemployment?
Decrease the reserve ratio
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 Is changing the Reserve
Ratio a popular
Monetary Tool?
No, changing the reserve
ratio is considered a heavy-
handed approach and is
thus infrequently used
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 What are the
Shortcomings of
Monetary Policy?
Money multiplier inaccuracy
Nonbanks
Which money definition
should the Fed control?
Lag effects
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Key Concepts

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 Key Concepts
Who were the Founders of our Modern-
day Banking?
What is Fractional Reserve Banking?
What are Required Reserves?
What is a Required Reserve Ratio?
What are Excess Reserves?
What are Total Reserves?
What is the Money Multiplier?
What is the Money Multiplier equal to?
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 Key Concepts cont.
What is Monetary Policy?
What are Open Market Operations?
What is the Discount Rate?
What is the Federal Funds Rate?
What is a Required Reserve Requirement?
What is the Required Reserve Ratio?
What are the Shortcomings of Monetary
Policy?
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Summary

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 Fractional reserve banking, the
basis of banking today, originated with
the goldsmiths in the Middle Ages.
Because depository institutions
(banks) are not required to keep all
their deposits in vault cash or with the
Federal Reserve, banks create money
by making loans.

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 Required reserves are the
minimum balance that the Fed
requires a bank to hold in vault
cash or on deposit with the Fed.
The percentage of deposits that
must be held as required reserves
is called the required reserve ratio.

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 Excess reserves exist when a
bank has more reserves than
required. Excess reserves allow a
bank to create money by exchanging
loans for deposits. Money is reduced
when excess reserves are reduced
and loans are repaid.

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 The money multiplier is used to
calculate the maximum change
(positive or negative) in checkable
deposits (money supply) due to a
change in excess reserves. As a
formula:
$ multiplier = 1/required reserve ratio.

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 Monetary policy is action
taken by the Fed to change the
money supply. The Fed uses three
basic tools: (1) open market
operations, (2) changes in the
discount rate and (3) changes in
the required reserve ratio.

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 Open-market operations are the
buying and selling of government
securities by the Fed through its
trading desk at the New York
Federal Reserve Bank. Buying
government securities creates extra
bank reserves and loans, thereby
expanding the money supply. Selling
government securities reduces bank
reserves and loans, thereby
contracting the money supply.
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 Fed
$ Fed buys government
Fed sells government $ securities and banks
securities and banks gain reserves
loose reserves
Banks
$
$
Public
54
 Changes in the discount rate occur
when the Fed changes the rate of
interest it charges on loans of reserves
to banks. Dropping the discount rate
makes it easier for banks to borrow
reserves from the Fed and expands the
money supply. Raising the discount rate
discourages banks from borrowing
reserves from the Fed and contracts the
money supply.
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 Changes in the required reserve
ratio and the size of the money
multiplier are inversely related. Thus, if
the Fed decreases the required reserve
ratio the money multiplier and money
supply increase. If the Fed increases the
required reserve ratio the money
multiplier and money supply decrease.

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 Monetary policy limitations include
the following: (1) The money multiplier
can vary. (2) Nonbanks, such as
insurance companies, finance
companies, and Sears, can offer loans
and other financial services not directly
under the Feds control. (3) The Fed
might control M1 while the public can
shift funds to M2, M3, or another
money supply definition. (4) Time lags
occur.
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Chapter 25 Quiz

2000 South-Western College Publishing 58

1. If a bank has total deposits of $100,000
with $10,000 set aside to meet reserve
requirements of the Fed, its required
reserve ratio is
a. $10,000.
b. 10 percent.
c. 0.1 percent.
d. 1 percent.
B. Required reserve ratio = required
deposits total deposits x 100 =
$10,000 $100,000 x 100
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2. Assume a simplified banking system in which
all banks are subject to a uniform required
reserve ratio of 30 percent and demand deposits
are the only form of money. A bank that
receives a new deposit of $10,000 is able to
extend new loans up to a maximum of
a. $3,000.
b. $7,000.
c. $10,000.
d. $30,000.
B. Excess reserves can be loaned. Excess reserves
= total reserves - required reserves = $10,000 -
(0.3 x $10,000) = $10,000 - $3,000 = $7,000
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3. The Best National Bank operates with a 10
percent required reserve ratio. One day a
depositor withdraws $400 from his or her
checking account at the bank. As a result, the
banks excess reserves
a. fall by $400.
b. fall by $360.
c. fall by $40.
d. rise by $400.
B. Excess reserves = total reserves -
required reserves = -$400 - (0.10 x $400)
= -$400 + $40 = -$360

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4. If an increase of $100 in excess reserves in
a simplified banking system can lead to a
total expansion in bank deposits of $400,
the required reserve ratio must be
a. 40 percent.
b. 400 percent.
c. 25 percent.
d. 4 percent.
e. 2.5 percent.
C. $ multiplier = in bank deposits
initial in excess reserves = 400 $100 =
4 = 1 required reserve ratio = 1
money multiplier x 100.

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5. In a simplified banking system in which all
banks are subject to a 25% required reserve
ratio, a $1,000 open sale by the Fed would cause
the money supply to
a. increase by $1,000.
b. decrease by $1,000.
c. decrease by $4,000.
d. increase by $4,000.
C. Money supply change ( M1) = initial in
excess reserves x money multiplier (MM).
MM = 1 required reserve ratio = 1 25/100 = 4 .
M1 = $1,000 x 4 = -$4,000.
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6. In a simplified banking system in which all
banks are subject to a 20% required reserve
ratio, a $1,000 open market purchase by the
Fed would cause the money supply to
a. increase by $100.
b. decrease by $200.
c. decrease by $5,000.
d. increase by $5,000.
D. Money supply change ( M1) = initial
change in excess reserves x money
multiplier (MM)
MM = 1 required reserve ratio = 1 20/100
=5
M1 = $1,000 x 5 = $5,000.
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7. The cost to a member bank of borrowing
from the Federal Reserve is measured by the
a. reserve requirement.
b. price of securities in the open market.
c. discount rate.
d. yield on government bonds.
C. The Fed provides a discount window at each
of the Federal Reserve districts banks to
make loans of reserves to banks and change
an interest rate called the discount rate.

65
 Exhibit 5
Balance Sheet of Best National Bank
Assets Liabilities
$ Checkable $100,000
Required Reserves
deposits
Excess Reserves

Loans 80,000

Total $100,000 Total $100,000

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8. The required reserve ratio in Exhibit 5 is
a. 10%.
b. 15%.
c. 20%.
d. 25%.
C. Excess reserves = total reserves -
required reserves = $80,000 = $100,000 -
required reserves = $20,000
Required reserve ratio = required deposits
total deposits = $20,000 $100,000 x
100 = 20%

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9. If the bank in Exhibit 5 received $100,000 in
new deposits, its new required reserves would
be
a. $10,000.
b. $20,000.
c. $30,000.
d. $40,000.
B. Required reserves = required reserve ratio
x new deposits = .20 x $100,000 = $20,000

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10. Suppose Brad Jones deposits $1,000 in the
bank shown in Exhibit 5. The result would
be
a. a $200 increase in excess reserves.
b. a $200 increase in required reserves.
c. a $1,200 increase in required reserves.
d. zero change in required reserves.
B. Required reserves = required reserve
ratio x new deposits = .20 x $1,000 = $200

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11. If all banks in the system are identical to
Best National Bank in Exhibit 5. A $1,000
open market sale by the Fed would
a. 5.
b. 10.
c. 15.
d. 20.
A. Money multiplier = 1 required
reserve ratio = 1 20/100 = 5

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12. Assume all banks in the system are identical
to Best National Bank in Exhibit 5. A $1,000
open market sale by the Fed would
a. expand the money supply by $1,000.
b. expand the money supply by $15,000.
c. contract the money supply by $1,000.
d. contract the money supply by $5,000.
D. Money supply change ( M1) = initial
change in excess reserves x money
multiplier (MM)
MM = 1 required reserve ratio = 1 20/100
=5
M1 = $1,000 x 5 = -$5,000.
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END

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