Thursday, October 25, 2007

Topic 7 - Money Creation and Deposit Insurance (Chapter 16)

I) A banks balance sheet
a) Assume only commercial banks exist to make things operate. A commercial bank operates by accepting deposits for checkings, savings, cds, etc and using that money to make loans. The bank makes a profit by charging a higher interest rate for the loans it lends than the interest rate it pays for deposits. So to understand the rest of this you need to get that the bank attracts deposits and makes its money by lending those deposits out.
b) The federal reserve requires the bank to hold part of these deposits at the Fed as reserve, in case people decide to show up to the bank one day and get their deposits back.
c) Required reserves - the amount of money the bank must hold as reserve at the Fed
d) excess reserves - any "extra" money the bank holds as reserve. (Total reserves = reserves - required reserves).
e) Deposits (called transactions deposits in the book, are the banks liabilities).
f) reserves and the loans the bank has are its assets.
g) Balance sheet accounting on page 397

II) Money creation
a) in the above example money was not created. It was merely transferred from one place to another. However, as you can see, fluctuations in the money supply can influence inflation. So how is money created?
b) The only institution that can increase or decrease the amount of money in an economy is the Fed.
c) Open market operations
1) Fed buys a US government security (creates 100,000 of reserves, and hence money). The bank buys the security and deposits the money in the bank's reserve account. Hence money supply goes up because this money never existed before
2) Fed sells a US government security (takes away 100,000 of reserves, and hence money). By selling a security the bank is giving the Fed money in exchange for the security.

III) Money multiplier
a) If the Fed buys a US security and creates $100,000 in money, the bank will turn around and lend that money out to an individual or a business. That person in turn will spend the money, creating more deposits at other banks and on and on. This is the entire purpose of the balance sheets on 401-403. The idea is that there is a ripple effect and we have another "multiplier," this time with money.
b) Money Multiplier = 1/(required reserve ratio)
c) This is the potential multiplier. In real life it may be reduced by the following forces
1) leakages

IV) Tools the federal reserve has to implement monetary policy
a) required reserve ratio
b) discount rate - interest rate the Federal reserve charges for reserves it lends to institutions
c) Fed funds rate* - interest rate banks charge to each other for reserves it lends out.

V) FDIC insurance to prevent bank failures

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