Banking Reserves and Monetary Policy Study Notes

Overview of Banking Reserves

  • Reserves in banking can be classified into two categories:
    • Required Reserves:
    • Deposits that must be kept on hand and cannot be loaned out.
    • Ensures banks have liquid money for withdrawals.
    • Excess Reserves:
    • Reserves that can be loaned out to create more money.

Fractional Reserve Banking

  • Definition:
    • The banking system where banks hold a fraction of deposits as reserves and loan out the remaining.
  • Purpose:
    • To create more money and facilitate economic activity.

Money Creation Process

  • Banks create money using fractional reserve banking by loaning out a percentage of deposits.
  • Total reserves must equal the sum of required reserves and excess reserves:
    • Total Reserves = Required Reserves + Excess Reserves

Example Calculation of Reserves

  1. Required Reserve Ratio:

    • Example given with a required reserve ratio of 10% to 20%.
    • If a bank has $10,000 in checkable deposits:
      • Required Reserves at 20%:
      • 0.20imes10,000=2,0000.20 imes 10,000 = 2,000
      • Excess Reserves:
      • 10,000−2,000=8,00010,000 - 2,000 = 8,000 or 0.80imes10,000=8,0000.80 imes 10,000 = 8,000

  2. Hypothetical Bank Example:

    • Assume a bank (named Single) starts with deposits of $10,000,000 and initially holds that as reserves.
    • The reserves are listed as both an asset and a liability on the balance sheet since they belong to depositors who could withdraw at any time.

  3. Loan Application Scenario:

    • Bank receives a loan application for $9,000,000:
    • This alters the balance sheet:
      • Reserves decrease from $10,000,000 to $1,000,000 (after loaning out $9,000,000).
      • An entry for the loan is then added to assets.
    • Required Reserve Ratio Calculation:
      • After lending, ext{Required Reserve Ratio} = rac{1,000,000}{10,000,000} = 10 ext{%}

Concept of Money Multiplier

  • Money Multiplier:
    • Describes the total amount of money that can be created in the banking system when loans are made from excess reserves.
    • Formula:
    • extMoneyMultiplier=1extRequiredReserveRatioext{Money Multiplier} = \frac{1}{ ext{Required Reserve Ratio}}
  • Process of loans generating more money through multiple iterations, approximating how much new money is created:
    • E.g., if the reserve ratio is limited to 10%, the multiplier would indicate that excess reserves can be multiplied by 10. If it’s 20%, then 5 times the original excess reserves.

Changes in Monetary Policy and Reserve Requirements

  • Federal Reserve Action:
    • As of March 2020, the Federal Reserve eliminated reserve requirements, allowing banks to loan out 100% of their deposits.
    • This affects money supply significantly during economic downturns, like COVID-19, by allowing more money to circulate in the economy.

Monetary Policy Objectives

  • Definition:
    • Monetary policy involves decisions made by the central bank regarding the money supply to achieve macroeconomic goals such as low unemployment and inflation.
  • Goals of Monetary Policy:
    • Increase or decrease money supply to influence interest rates, spending, and economic activity.
  • Graphical Analysis:
    • Money supply curve is vertical, representing a fixed amount at any given time.
    • Supply increase leads to decreased interest rates, which encourages high consumer and business spending; a decrease in supply leads to increased interest rates discouraging spending.

Demand for Money

  • Demand Curve:
    • The demand for money is negatively correlated with interest rates.
    • Higher interest rates generally result in lesser demand for money, as individuals prefer to save rather than spend.
  • Prompt for Demand Increase:
    • Non-interest factors that increase demand such as income level. For instance, if people's incomes increase, they demand more money for purchases.

Structure and Functions of the Federal Reserve

  • Federal Reserve's Dual Mandate:

    • To control both unemployment levels and inflation rates.
    • Typical inflation target is around 2% with a natural rate of unemployment around 5%.

  • Board of Governors:

    • Consists of seven members, appointed for 14-year terms to reduce political influence on monetary policy.
    • Chairman of the Federal Reserve is Jerome Powell, acting as the public face of the Federal Reserve.

  • Regional Banks:

    • 12 regional Federal Reserve Banks manage local financial institutions.

Banking Safety Measures

  • Deposit Insurance:
    • Provided through the FDIC (Federal Deposit Insurance Corporation), which insures deposits up to $250,000 to promote consumer confidence in banks.
  • Preventing Bank Runs:
    • The Fed acts as a lender of last resort to prevent bank insolvency and financial panic.

Conclusion and Summary

  • The lecture focused on how banks create money through fractional reserve banking, current monetary policy actions taken by the Federal Reserve, and the measures in place for consumer protection and economic stability.