U4 M25 Money Creation Slides HM

Page 1: Review Question

• Do Now: Mod 26 Review QuestionQuestion: Which of the following is NOT a role of the Federal Reserve System?a. controlling bank reservesb. printing currency (Federal Reserve notes)c. carrying out monetary policyd. supervising and regulating bankse. holding reserves for commercial banksCorrect Answer: B

Page 2: Introduction to Unit 4: The Financial Sector

• Definition of a Bank: A bank is a financial intermediary that uses liquid assets (in the form of bank deposits) to finance illiquid investments of borrowers.

• Banks create liquidity as they do not need to keep all deposits in highly liquid assets.

• Generally, not all depositors will withdraw funds simultaneously, allowing banks to offer liquidity while investing in illiquid assets (e.g., mortgages, business loans).

Page 3: Bank Operations

• Limits on Lending: Banks cannot lend all deposited funds because they must be able to satisfy withdrawal requests.

• Liquid Assets: Substantial liquid assets must be maintained, either as currency in bank vaults or deposits at the Federal Reserve.

• Bank Reserves: Currency in vaults and deposits at the Federal Reserve are called bank reserves and are not part of currency in circulation.

Page 4: Overview of Key Modules

• Modules discussed:

  • Module 25: Banking and Money Creation

  • Module 26: The Federal Reserve System

  • Module 27: Central Banks & Monetary Policy

  • Module 28: The Money Market

Page 5: Learning Goal

• Module 25 Learning Goal: Understand how banks make money

• Video Link: Unit 4, Module 25: Money Creation

Page 6: Fractional Reserve Banking

• Concept: Banks hold a fraction of deposits to cover withdrawals and lend out the remaining funds.

• Risk: If many customers withdraw at once, it leads to a bank run.

• Impact: Fractional reserve banking allows for the creation of money and an increase in the money supply.

Page 7: Bank Run Example

• Video Link: Bank Run at IndyMac

Page 8: Bank Balance Sheets - Terminology

• Demand Deposit: Money in a checking account at a bank.

• Reserves: Funds a bank keeps unloaned, either due to Fed requirements or bank policy.

  • Required Reserves: Legally required percentage banks must retain.

  • Excess Reserves: Amount available for loans.

• Balance Sheet: Records a bank’s assets, liabilities, and net worth.

• Demand deposits are liabilities for the bank and assets for depositors.

Page 9: Bank Balance Sheets

• A balance sheet must be ‘balanced’ with total assets equal to total liabilities.

• Required Reserve Ratio: Traditionally 10% (0.1), now zero as of March 2020.

• Example Structure:

  • Loans: $8,000

  • Demand Deposits: $5,000

  • Required Reserves: $500

  • Owner’s Equity: $5,000

  • Excess Reserves: $1,500

Page 10: Security Reminder

• Security Reminder: Ski masks should be removed before entering the bank.

Page 11: Bank of Lamon Example

• Initial Deposit: Mr. Thompson deposits $1,000.

• Reserve Requirement: 10%

• Assets and Liabilities:

  • Demand Deposits: $1,000

  • Required Reserves: $100

  • Excess Reserves: $900

Page 12: Loans from Bank of Lamon

• Loan Granted: Shake Shack granted a $900 loan.

• Change in Assets: Loan alters asset structure but does not initially affect money supply.

Page 13: Money Creation Through Loans

• Impact on Lenny’s Bank: Shake Shack deposits $900 in Lenny’s Bank.

• Total Liabilities Increase: From $1,000 to $1,900 due to the loan process, increasing money supply.

Page 14: Money Multiplier Concept

• Definition: Money Multiplier indicates total dollars created in the banking system per each $1 addition to the monetary base.

• Formula: Money Multiplier = 1 / Reserve Requirement.

Page 15: Money Multiplier Example

• Example Calculation:

  • If Reserve Ratio = 0.20 and monetary base = $2 Billion, compute changes carefully.

  • Initial Deposit Impact: A $1,000 deposit leads to additional money creation across banks (totaling $1,710 after multiple loans).

• Problems come in two types

  • how much is the Money Supply now is or how much did it change by

Page 16: Brain Break Reminder

• Brain Break Video: Safety awareness in banking scenarios.

Page 17: Money Supply Measurements

• Exam Note: AP Exams may include questions on M1 vs. M2 money supply.

Page 18: Definitions of M1 and M2

• M1 Components:

  • Currency outside U.S. Treasury, Fed Banks, and vaults.

  • Demand deposits at commercial banks and other liquid deposits.

• M2 includes: M1 plus small denomination time deposits and money market funds.

  • takes a few days or weeks to turn into cash

  • don’t need to know what it used for

    • if things are in M2 more so than M1 (if businesses or people needed money quickly they might not be able to get it)

Page 19: Banking Example #1

• Mi Tierra Bank Balance Sheet:

  • Required Reserves: $10,000

  • Demand Deposits: $100,000

  • Excess Reserves: $5,000

  • Loans: $85,000

  • Owner's Equity: $0

• Questions: a) Reserve requirement, b) Effects of withdrawals, c) Covering required reserves.

Page 20: Banking Example #1 Solutions

• (a) Reserve requirement is 10%.

• (b) Total reserves decrease by $5,000; no change in M1 measure; excess reserves decrease to $500.

• (c) Possible actions include borrowing from Fed or other banks.

Page 21: Banking Example #2

• Sewell Bank Balance Sheet:

  • Required Reserves: $2,000

  • Demand Deposits: $10,000

  • Reserves, loans, government securities detailed.

• Questions: Required reserve ratio, effects of Fed bond purchases, maximum money supply change.

Page 22: Banking Example #2 Solutions

• (a) Required reserve ratio = 0.2.

• (b) Excess reserves increase by $5,000; demand deposits change is zero.

• (c) Calculated increase in money supply is $25,000.

• (d) Purchase of bonds raises bond prices (increased money supply lowers interest rates).

• (e) Cash deposits do not change the immediate money supply.

Page 23: M1 Measurement Changes

• Previous Components: Various definitions centered around demand deposits and currency.

• Current Components: Included demands deposits and other liquid deposits.

Page 24: M2 Measurement Changes

• Previous Components: Included savings, small denomination deposits, and mutual funds.

• Current Components: Same as previous but updated definitions.

Page 25: Explanation of New M1 and M2

• Important Footnotes: Definitions of currency circulation, reserve balances, and total reserves with explanations regarding bank processes.