Chapter 12: Money creation and the Federal Reserve

When is money created?

when financial institutions accept deposits and make loans

Banks (financial institutions) act as a bridge between __________ and __________.

savers; borrowers

a bank's ability to make loans (to create money) is __________ to a certain percentage of its __________.

limited; total customer deposits

When a bank receives a deposit, a portion of it is held in __________. The rest is __________, which begins money creation.

reserve; lent out

Banks create money by lending __________.

excess reserves

Loans equation

deposits - reserves

reserves equation

deposits x reserve requirement (percent as a decimal)

Suppose $1,000 is deposited in Bank A, and the reserve requirement is 20%. What is the reserve value and the loan value?

reserves = 1,000 x 0.20 = $200

loans = $1000 - $200 = $800

If the reserve value is $200 and loan value is $800, what would the balance sheet look like?

Assets- reserves (+$200), loans (+800)

liabilities- deposits (+1,000)

The $800 that is lent out will end up in another bank. The second bank will then lend out 80%. What is the reserve value and the loan value?

reserves = $800 x 0.20 = $160

loans = $800 - $160 = $640

If the reserve value is $160 and the loan value is $640, what would the balance sheet look like?

Assets- reserves (+$160), loans (+640)

liabilities- deposits (+800)

The process continues with another round, the bank lending out 80% of $640. What is the reserve value and loan value?

reserves = $640 x 0.20 = $128

loans = $640 - $128 = $512

If the reserve value is $128 and the loan value is $512, what would the balance sheet look like?

Assets- reserves (+$128), loans (+$512)

liabilities- deposits (+640)

What does the money multiplier measure?

the maximum amount the money supply can increase when new deposits enter the system

Multiplier equation

1/ reserve requirement

What happens to the money multiplier if the reserve requirement is low?

money multiplier is high

If the process continues all the way through, the $1,000 original deposit turns into __________ in deposits (increase in money supply)

$5000

Increase in money supply equation

(initial deposit) x (money multiplier)

A new $100 deposit can lead to a __________ increase in the money supply when the reserve requirement is 10%.

$1,000

How does the Federal Reserve Bank expand the money supply?

by adding reserves electronically to banks in exchange for bonds and other assets

Banks will then make loans against these __________.

excess reserves

How is the expansion process compounded?

by the money multiplier

What is a leakage?

the departure of money from the lending cycle because of an action taken by a bank, an individual, or a business

What do leakages cause?

the actual money multiplier to be lower than the potential money multiplier

What are the causes of money leakages?

-banks choosing to hold excess reserves

-individuals and businesses holding money in cash

-cash held by foreign consumers, businesses, and governments

What does the leakage-adjusted money multiplier do?

takes leakages into account in the money multiplier formula

Leakage multiplier equation

1/ (reserve requirement + excess reserves + cash holdings)

How to differentiate the money multiplier and the leakage multiplier?

the leakage multiplier is referred to as the actual multiplier and the money multiplier is referred to as the potential multiplier

What is the Federal Reserve System?

the central bank of the United States, established by the Federal Reserve act of 1913

Characteristics of the Fed

the fed is an independent central bank

What is the Federal Reserve System not subject to?

executive branch control

What is the Federal Reserve System subject to?

oversight from Congress

What is the structure of the Fed?

-The Board of Governors

-12 regional Federal Reserve Banks

-Federal Open Market Committee

What is the Board of Governors?

-based in Washington, DC

-7 members appointed by the president and confirmed by the senate for a single 14-year term

What is the Federal Open Market Committee?

-composed of the board of governors and 5 of the 12 regional bank presidents (with the New York Fed president as a permanent member)

Functions of Regional Fed Banks?

-provide a nationwide payments system

-distribute coins and currency

-regulate and supervise member banks

-serve as the banker for the U.S. Treasury

The Federal Open Market Committee oversees __________, the main tool of monetary policy.

open market operations

During an economic crisis, what can the Fed provide?

loans when no one else can (or will)

The 2008 financial crisis would __________ without the Fed's intervention.

likely have been worse

The Fed __________ to banks and other financial institutions, dramatically altering the Fed's balance sheet.

lent more then $2 trillion

What 3 primary tools does the Fed use for conducting monetary policy?

-reserve requirements

-discount rate

-open market operations

What is reserve requirements?

required ratio of deposit funds held in reserve

What is the discount rate?

interest rate charged by the fed to banks

What are open market operations?

the buying and selling of bonds on the open market

What is the federal funds rate?

the interest rate that financial institutions charge each other for overnight loans used as reserves

The federal funds rate is a __________ that affects many other interest rates.

closely watched interest rate

The Fed sets the __________, then alters the __________ to achieve its target.

target federal funds rate; supply of money

4 major lags in monetary policy

-information lags

-recognition lags

-decision lags

-implementation lags

What is the average time for monetary policy to affect the economy?

12 to 18 months

If the reserve requirement is 10%, how much total money (including the initial deposit) will a new deposit of $500 potentially inject into the economy?

a. $50

b. $500

c. $2,500

d. $5,000

d. $5,000

increase in money supply = initial deposit x money multiplier

=$500 x (1/0.1)

=$500 x 10

=$5,000

If the reserve requirement is 10% but banks hold and extra 10% in reserves, how does this affect the money multiplier?

a. it falls from 10 to 5

b. it falls from 20 to 10

c. it rises from 5 to 10

d. it rises from 10 to 20

a. it falls from 10 to 5

multiplier = 1/0.1 = 10

Leakage multiplier = 1/(0.1+0.1) = 5