Money that is available

(money supply) affects Output1. GDP = C + Ig + G + Xn2. Increased spending

increases output3. Increased money supply increases

spending

=* *M V P Q

Velocity PriceQ Output

- the actual amount of money in circulation- the number of time each $ is spent in a year (considered to be stable)

- the actual output of goods and services

- the level of prices

Money

M V PQ

=* *M V P Q

MoneyVelocity Price

Q =output

• If V and P are constant, then an increase in M will lead to a proportional increase in Q GDP increases.• but if V and Q are constant(at full employment), then an increase in M will lead to a proportional increase in P =Inflation.

• P Q Total Sales (GDP)=*

1. Printing Money2. Making Loans

a. Key Ingredients: • Deposits – Household savings• Required Reserves – money

held at the bank or at the FRS (around 10%)

• Excess Reserves – loan able funds = Deposits – Required ReservesA depository institution can

make loans up to the value of its excess reserves

A depository institution can make loans up to the value of

its excess reserves

• The U.S. banking system is a fractional reserve system where banks maintain only a fraction of their assets as reserves to meet the requirements of depositors.

• Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (by creating additional checking deposits).

Fractional Reserve Banking

Main Street Bank Situation:Demand deposits = $50,000Reserve requirement = 10 %Actual reserves at bank = $10,000Excess Reserves:Demand deposits = $50,000Reserve requirement= 10 %Actual reserves = $10,000- Required reserves = $5,000

= Excess reserves = $5,000

Excess Reserves ($5,000) can be loaned

By making a loan, the bank has created money.

The original deposits are still in Main Street Bank, but now there is an additional $5,000 out floating around.

The Bank of the James which has a reserve ratio of 10 percent on its deposits, has calculated the following numbers as of the end of business today: total deposits = $13,500,000; reserve account = $3,750,000; and vault cash = $2,250,000. Determine the following for this bank:

Actual reserves = __________________Required reserves = _________________Excess reserves = __________________

3,750,000 + 2,250,000 = 6,000,000

13,500,000 x .10 = 1,350,000

6,000,000 -1,350,000 = 4,650,000

How much in new loans can Madison Heights National Bank make if its deposits are $45,000,000, vault cash is $5,500,000, and reserve account balance is $7,750,000? MHNB’s reserve requirement is 8%.New loans = _____________________

5,500,000 + 7,750,000 = 13,250,000

45,000,000 x .08 = 3,600,000

13,250,000 -3,600,000 = 9,650,000

9,650,000

What is the amount that must be borrowed by the Smith Mountain Lake Marine Bank to cover its anticipated reserve shortfall if it has a reserve requirement of 12 percent, deposits of $27,500,000, vault cash of $2,500,000, a reserve account of $3,250,000, and it has just made a new loan of $2,500,000 that has not yet cleared?New borrowing = ___________________

2,500,000 + 3,250,000 = 5,750,000

27,500,000 x .12 = 3,300,000

5,750,000 -3,300,000 = 2,450,000

-50,000

If the Excess Reserves are loanedThe borrowed money is spent and

deposited at another bank.The second bank’s reserves are now up

$5,000- it must keep 10% or $500- it can then loan out $4,500 ($5,000 – $500)

This process can be repeated at each step. 10% of the money is lost at each stepThe more that is required to be held in reserve, the less money can be created

The lower the reserve requirement, the greater the amount of money that can be created

Bank

New cash deposits:

Actual Reserves New

Required Reserves

Potential demand deposits created by

extending new loans

Initial deposit (bank A) Second stage (bank B) Third stage (bank C) Fourth stage (bank D) Fifth stage (bank E) Sixth stage (bank F) Seventh stage (bank G)

$1,000.00 $200.00 160.00

102.40 81.92 65.54 52.43

800.00 $800.00

512.00 128.00 640.00

640.00 512.00

409.60 409.60

327.68 327.68

262.14 262.14 209.71

Total $5,000.00 $1,000.00 $4,000.00

All others (other banks) 1,048.58 209.71 838.87

Creating Money from New Reserves

• When banks are required to maintain 20% reserves against demand deposits, the creation of $1,000 of new reserves will potentially increase the supply of money by $5,000.

From the table a deposit of $1000, with a 20% reserve requirement led to a $4000 expansion of the money supply

Is there a pattern here?

It just takes 3 easy steps

3. Subtract out the the initial change $5000 - 1000 = $4000

1. Find the reciprocal of the required reserve1/20% = 1/1/5= 5

2. Multiply the initial change by the multiplier$1000 * 5 = $5000

1. Deposit of $10,000

2. Required reserve 10%

3. Increase in the money supply?

How about if the reserve requirement was 20%?

1. ________2. ________3. ________

1. ________2. ________3. ________

1. Deposit of $16,000

2. Required reserve 25%

3. Increase in the money supply?

How about if the reserve requirement was 20%?

How about if the reserve requirement was 10%?

1. ________2. ________3. ________

1. ________2. ________3. ________1. ________2. ________3. ________

1. Loan making changes the money supply

2. Increases in loans leads to increased spending which increases the money supply.

3. BUT, decreases in loan making, or even paying back a loan decreases the money supply.

1. More or less voluntary transaction

2. The interest rate is important

3. Supply in the money for loansa. Households decide to save or spendb. Banks decide how to use the savings3. Demand for the loansa. Households how much to borrowb. Businesses compare interest rate to expected profit

• Households and Banks supply the money based on interest rates

• There is a direct relationship between interest rate and amount of $

InterestRate

Quantityof loans

S

D

Q

.05

Determining

the

Interest Rate

• Household and business demand for money is based on the interest

• There is an inverse relationship between interest and amount of $

• Expectation of poor economic conditions could shift the curve left

• This would decrease the equilibrium interest rate

Determining

the

Interest Rate

InterestRate

Quantityof loans

S

D

Q

.05

D (bad expections)

r =

.03 i =

Q

• A decrease in excess reserves decreases money for loans• This would shift the supply curve to the left and increase

interest

Determining

the

Interest Rate

InterestRate

Quantityof loans

S

D

Q

.05

S (reserves decreased)

r =

.07 i =

Q

Increasing Excess Reserves

Increases Ability to Lend

Decreases

Interest rate for Borrowi

ng

Increases

Borrowing

Increases

Level ofSpendin

g

IncreasesOutput

andEmploym

ent(or

Prices)

Decreasing Excess Reserves

Decreases Ability to Lend

IncreasesInterest rate for Borrowi

ng

Decreases

Borrowing

Decreases

Level ofSpendin

g

Decreases

Output and

Employment(or

Prices)

1. Monetary Policy Tools:a. The Reserve

Requirement-reducing it encourages loans and increases the money supply-increasing it discourages loans and decreases the money supply

b. The Discount Rate

3 rates1. Discount Rate2. Federal Funds Rate3. Prime Rate

federal reserve to member banksbank to bankbanks to best customers

b. The Discount RateRaising Discount Rate

discourages bank borrowing decreases money supply

Lowering Discount Rateencourages bank borrowing

increases money supply

c. Open Market OperationsBuying and Selling Securities (Bonds)

-selling bonds puts bonds out and take money out of circulation

-buying bonds puts money back in circulation and takes bonds in

What effect will this have on the economy??

What effect will this have on the economy??

c. Open Market OperationsBuy or Sell?

a. The Reserve Requirement

Raise or Lower?

Increase or decrease?

b. The Discount Rate

c. Open Market OperationsBuy or Sell?

a. The Reserve Requirement

Raise or Lower?

Increase or decrease?

b. The Discount Rate

c. Businesses and Household can afford fewer loans

Less investment

a. The Government competes for money

b. They offer a higher interest rate

+ quick implementation

- high rates may lead to higher prices

+ flexible changes in rates+ less political

- reserve ratios and interest rates might not be enough incentive

- FRS might now be too independent

What would be the effect of each of the following on Uptown Bank’s excess reserves and loan-making ability if the bank had $600 million in deposits, a 5% reserve requirement, and actual reserves of $40 million?a. The Federal Reserve sells $5 million in

government securities to Uptown Bank.b. The reserve requirement increases from 5% to

6%.c. The discount rate is increased.d. The reserve requirement is lowered from 5% to

4%, and the Federal Reserve buys $10 million in government securities.

a. Increase loan-making abilityb. Decrease loan-making abilityc. Have no effect

1. In the equation of exchange, an increase in M always causes an increase in Q, and a

decrease in M always causes a decrease in P.

2. If a bank has $100 million in actual reserves and $80 million in required reserves, it may make new loans of up to $20 million.

3. The size of the money multiplier is inversely related to the size of the reserve

requirement.4. With a reserve requirement of 25 percent,

an injection of $100 million of new excessreserves into the economy could cause the

money supply to expand by $400 million.

5.An increase in excess reserves in the economy would encourage spending.

6.Lowering the reserve requirement is a tight money policy.

7.Buying securities by the Fed would decrease excess reserves held by financial

depository institutions.8.Crowding out occurs when government borrowing forces up the interest rate and

discourages households and businesses from borrowing.