The Supply of Money and the Federal Reserve System

1
The Supply of Money and the Federal Reserve System

• How Banks Create Money

2
We will use the following Terms

• Deposits the funds deposited by the public at
  commercial banks.
• Reserves Bank funds that must be kept on deposit
  with the Federal Reserve or in the banks vault
  as cash.
• Reserve Required Ratio (r) The percentage of
  deposits that must be held as reserves.
• New Money Money that was not previously
  deposited at banks and thus was not being used by
  banks to make loans.

3
Banks create money by making loans

• New Money you deposit at a bank is used by the
  bank to make loans,
• The borrower writes checks on this loaned money
• AND
• You also write checks on that same money

4
The bank does not keep all your money in its
vault.
loans
5,000
Your deposit 20,000
5,000
5,000
The bank makes loans and holds a portion as
reserve in vault.
reserve
5,000
5
The Bank has created Money

• Now you and other three individuals can write
  checks up to

Only 5,000 support 35,000 in spending!
The bank holds only 5,000
If all these payments must be made at the same
time, the bank does not have enough in reserves.
6
The FED imposes a minimum reserve requirement

• The percentage of reserves a bank must hold as
  reserves not loan out- is the reserve required
  ratio.
• This fraction can be used to determine the
  percentage of deposits a bank is allowed to lend.

7
Example Required reserves 20

• For each 100 deposited by the public (D), the
  bank must hold 20 (20) or
• The bank is allowed to make loans for up to 80
  (80)

RrD

• Required amount of reserves (R) is a fraction of
  the Deposits

8
When the bank makes that first loan with your
money,

• A Money Multiplier process is set in motion

9
New deposit
Bank
10
Note what Happens as New loans are made

• Each new loan generates a new deposit
• From each new deposit, the bank must hold 20 in
  its vault.

11
20,000 Deposit
Note that in each round a portion (r) of the
20,000 deposit goes into the vault as reserves.
Reserves
12
The entire 20,000 deposit becomes reserves
All Banks Reserves
20,000
Deposit20,000
All Banks Deposits
Each bank holds a portion of the new deposit as
reserves and makes loans that become New deposits
?
13
What happened to the amount of Deposits in the
economy?
What happened to the amount of Money in the
economy?
14
Note Change in Loans Change in Deposits except
for the original 20,0000
Change in Deposits
Change in Reserves
20,000
20,000(0.2)4,000
20,000(0.8)16,000
16,000(0.2)3,200
16,000(0.8)12,800
12,800(0.2)2,560
12,800(0.8)10,240
10,240(0.2)2,048
. . .
. . .
The deposit multiplier process in numbers
Loans
SUM of New Reserves 20,000 the original deposit.
SUM of New Deposits ?
15
So far we know that

• The new deposit becomes reserves
• The sum of reserves new deposit 20,000
• The Sum of the Loans Sum of the Deposits
  20,000
• Now we need to find out what the Sum of the
  Deposits is

16
How many additional Deposits and Loans are
generated by this 20,000 deposit?

• The Multiplier Formula

17
The Money Multiplier
The stream of deposits generated by the original
20,000 can be written as
20,000 20,000(0.8) 20,000(0.8)(0.8)
20,000(0.8)(0.8)(0.8)
or
20,000 20,000(0.8) 20,000(0.8)2 20,000(0.8)3
20,000(0.8)4
18
The Multiplier Formula

• This sum of terms can be written
• DD 20,000 1 (0.8) (0.8)2 (0.8)3 (0.8)4
  

If we keep adding termsthe limit of this sum is
19
The Change in Deposits is
D Deposits 5 x 20,000 100,000
20
The Money Multiplier
Money Multiplier
D R
D D
x
21
Money Multiplier

• Multiple by which deposits increase for every one
  dollar increase in reserves

22
The Change in Loans

• Is the same as the change in deposits minus the
  original deposit of 20,000

Since D R 20,000
D L D D 20,000
D L D D D R 100,000 20,000
23
The 20,000 deposit generates 80,000 additional
loan/deposits
All Banks Reserves
R20,000
Deposit20,000
R r(D)
All Banks Deposits
Each bank holds a portion of the new deposit as
reserves and makes loans that become deposits of
80,000
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At the end, banks are fully loaned up
R r(D)

• Banks can not make any more loans 20,000 in
  reserves, support a maximum of 100,000 in
  deposits

20,000 0.2 (100,000)
25
Banks are Fully Loaned Up
Deposits 100,000
The bank issues new loans holding the total of
loans outstanding at 80,000
Loans 80,000
Reserves 20,000
As loans are paid back,
20,000 in reserves allow banks up to 80,000 in
loans
26
What if some money leaks into currency?

• In our story, the original 20,000 deposit set in
  motion a chain of loans and deposits at several
  banks
• What if part of the loan is kept as cash and
  only part of it becomes a deposit at a bank?

The deposit expansion will be smaller than
previously calculated when we assumed that the
entire amount of the loans became bank deposits.
27
What if some banks decide to hold more reserves
than required?

• In our story, banks kept ONLY required amount of
  reserves
• What if one or more banks in the chain hold more
  reserves than required?

The deposit expansion will be smaller than
previously calculated when we assumed that banks
only hold the amount of reserves they are
required.
28
Currency Leak and Excess Reserves

• The deposit expansion depends on
• Excess Reserves The amount held as reserves by
  banks above the required level.
• Currency LeakThe portion of each loan that is
  NOT deposited at a bank but remains as cash.

29
The Money Multiplier

• Gives the largest change in deposits that can
  occur assuming
• No currency leak
• Banks hold no excess reserves

30
The Money Supply is

Ms Currency held outside banks Demand Deposits
The amount of money in circulation is the Money
Supply
31
When a 20,000 deposit generates loans

• And loans generate additional bank deposits
• The increase in the money supply (D Ms) is

The increase in deposits increase in the amount
of cash held by the public.
D Ms D deposits D currency outside banks
32
The Change in the Money Supply is
D Ms D deposits D currency outside banks
No currency leak No change
D Ms

100,000
D Ms D deposits 100,000
33
Ms 100,000 Until new money is deposited
Only new money is multiplied!
When checks are used to make a payment, the money
simply changes owner
34
Where does new money come from?

• From the FED
• Buying bonds from the public
• From Banks reserves.
• Banks can hold more than required reserves, when
  banks decide to make loans until they hold only
  the required amount, these excess reserves
  leave the vault and begin to circulate as
  loans.
• From currency held outside banks
• When money stored in a cookie jar is deposited
  in a bank.

35
New Money comes in the form of new Reserves

• New reserves originate with
• The FED new money.
• The public currency not previously available to
  banks for loans.
• Banks reserves money that was not circulating
  as loans before.

New Money
d6 5,000
36
Injecting new reserves into the banking system

• When new reserves become available for banks to
  loan out
• Loans increase.
• Deposits increase.
• The Money Supply increases.

37
The Money Supply
Ms Currency outside banks Demand Deposits

• The Fed manipulates the amount of money in
  circulation (Ms)in two ways
• Changing the required reserve ratio.
• Changing the amount of total reserves in the
  banking system.

38
Back to our Example
r 20
The publics bank Deposits
Reserves for the entire banking system
Ms Currency outside banks Demand Deposits
Zero
100,000
39
The Money Supply
i
Ms 100,000
The Fed determines the level of the Money Supply
by adjusting the required reserve ratio and the
amount of bank reserves. This is done
independently of the interest rate.
Interest Rate
Amount of Money
100,000
40
R r D 20 0.2 D D 100
R r D 30 0.2 D D 150
Federal Reserve Bank
r 20
Bank Reserves increase by New Deposit R 30
Bank Reserves at Fed R 20
Or DD DR (1/r) DD 10 (1/0.2) DD 50
New Money
10
D 150