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)