Money Creation

Money creation

Changes in money supply that comes as a result of banks making loans

Required reserves (RR)

Money that banks are required to hold ( cannot loan out)

Excess reserves (ER)

Money that can be used by banks

Total reserves

RR + ER

RR ratio

Percentage of money in Demand deposits (DD) that must be held as Required reserves

E.g., If a bank has 100,000 in DD & RR is 10%, it must hold 10,000 in required reserves. ( .10×100,000)

Banks

To make profit they make loans and charge higher interest than the interest on saving or checking

Banks have an incentive to make loans

If money Supply goes up banks make more loans

Money Multiplier

1/RR ratio*Change in ER

Formula that determines the maximum amount of money that can be created in the banking system for a given amount of reserves

Assumption made for class

MS = C+DD

Banks loan out all available ER (banks don’t buy other assets)

People don’t hold cash

3 banks

RR=10%

How does monetary policy fix problems of recession/inflation?

Monetary policy fixes recession or inflation by changing the money supply and interest rates.

In a recession, the Fed uses expansionary policy—it increases money creation and lowers interest rates to boost borrowing and spending.

In inflation, it uses contractionary policy—reducing money supply and raising interest rates to slow spending and stabilize prices in the money market.

T account for banks

Assets: Total reserves (TR), Loans, Bonds

Liabilities: Demand Deposits (DD)

Assets = Liability