Banks and the Money Supply Flashcards

Banks and the Money Supply

• Bank Assets:
  • Cash in vault (reserves)
  • Loans made to customers, other banks
  • Bonds owned by the bank
• Bank Liabilities:
  • Checking account deposits
  • Other deposit accounts
  • Funds borrowed from other banks

Banks and the Money Supply: Profit and Reserves

• Profit:
  • Banks loan out deposited cash for interest.
• Government Requirement:
  • Governments require banks to hold some deposited cash in reserve.
• Reserve Requirement:
  • Minimum amount of reserves that banks must hold.
• Reserve Ratio:
  • Fraction of deposits that banks hold as reserves.
• Fractional-Reserve Banking:
  • Banks hold only a fraction of deposits as reserves.

Banks and the Money Supply: 100% Reserve Banking

• Simple Case of 100% Reserve Banking:
  • All deposits are held as reserves.
  • Example: If 100 is deposited, then 100 is held in reserve.
• Bank's Influence on Money Supply:
  • Banks do not influence the supply of money in a 100% reserve banking system.

The Money Multiplier: Example with 10% Required Reserve Ratio

• Example:
  • 10% Required Reserve Ratio
  • If 100 is deposited:
    • 100 \times 10\% = 10 is held in reserve.
    • 90 is loaned out.

The Money Multiplier: Loan Spending and Deposit

• Loan Spending:
  • The 90 in loans is spent by the borrowers.
• Subsequent Deposit:
  • Eventually, the spent money is deposited into a bank.
  • If 90 is deposited:
    • 90 \times 10\% = 9 is held in reserve.
    • 81 is loaned out.

The Money Multiplier: Further Loan Spending and Deposit

• Loan Spending:
  • The 81 in loans is then spent by borrowers.
• Subsequent Deposit:
  • Eventually deposited into a bank.
  • If 81 is deposited:
    • 81 \times 10\% = 8.10 is held in reserve.
    • 72.90 is loaned out.

The Money Multiplier: Impact on Money Supply (M1)

• Definition of M1:
  • M1 = \text{demand deposits} + \text{currency} + \text{traveler’s checks}
• Money Supply Expansion:
  • Initial deposit = 100
  • First National lending = 90
  • M1 = 100 + 90 = 190
  • Second National lending = 81
  • M1 = 81 + 100 + 90 = 271
  • Third National lending = 72.90
  • M1 = 72.90 + 81 + 100 + 90 = 343.90
  • Eventually, Total money supply = 1,000.00

The Money Multiplier: Formula and Calculation

• The Money Multiplier Defined:
  • Amount of money the banking system generates with each dollar of reserves.
• Formula:
  • \text{Money Supply} = (\text{initial deposit}) \times (\text{the money multiplier})
  • \text{Money Supply} = (\text{initial deposit}) \times (1 / \text{required reserve ratio})
• Example:
  • = $100 \times (1 / 0.10 ) = $1000

The Money Multiplier: Impact of Reserve Ratio

• Inverse Relationship:
  • The higher the reserve ratio…
    • …the smaller the money multiplier
    • …the smaller the money supply!
• Example:
  • Suppose the required reserve ratio had been 20%
  • \text{Money Supply} = $100 \times (1 / 0.20 ) = $500
  • (Not 1000)