ECN 111 Chapter 12 Lecture Notes

12.1 How Banks Create Money A. Creating a Bank 1. Obtaining a Charter A bank must first apply for a charter to the Comptroller of the Currency for a federally chartered bank or to the state treasurer’s office for a state chartered bank. 2. Raising Financial Capital The next step is to raise capital by selling shares. 3. Buying Equipment It is necessary to buy office equipment, software, and other essentials to get the bank started. 4. Accepting Deposits The bank will then need to advertise to the public that it is accepting deposits. 5. Establishing a Reserve Account a. The bank’s required reserves equal the required reserve ratio multiplied by the amount of deposits. b. Excess reserves equal actual reserves minus required reserves. The bank can loan only its excess reserves. 6. Clearing Checks Banks clear checks so that the bank whose depositor wrote the check loses deposits and reserves while the bank in which the check is deposited gains deposits and reserves. Clearing checks does not change the quantity of money. 7. Buying Government Securities Government securities provide a bank with an income and are a safe asset that is easily converted back into reserves when necessary. 8. Making Loans Commercial banks use their excess reserves to make loans to the public. a. Loans are an asset to the bank because the borrower is committed to repaying the loan on an agreed-upon schedule. b. When a borrower is granted a loan, the bank gives the borrowers the funds by creating a checkable deposit in the borrower’s name and depositing the amount loaned in the account. B. The Limits to Money Creation Excess reserves give a single bank the ability to make loans. As these loans are spent, they create additional checkable deposits in other banks that create more reserves for additional lending. The loan creation process is limited by the amount of initial excess reserves and the required reserve ratio. C. The Deposit Multiplier 1. The deposit multiplier is the number by which an increase in bank reserves is multiplied to find the resulting increase in bank deposits. 1 2. The deposit multiplier equals . R e q u i r e d r e s e r v e r a t i o 12.2. Influencing the Quantity of Money A. How Required Reserve Ratios Work 1. If the Fed increases the required reserve ratio, the banks must increase their reserves and decrease their lending, which decreases the quantity of money. 2. If the Fed decreases the required reserve ratio, the banks can decrease their reserves and increase their lending, which increases the quantity of money. B. How the Discount Rate Works 1. When the discount rate increases, banks are less willing to borrow reserves, so they decrease their lending and the quantity of money decreases. 2. When the discount rate decreases, banks are more willing to borrow reserves, so they increase their lending and the quantity of money increases. 3. Changes in the discount rate have limited effect on the quantity of money because banks rarely borrow from the Fed. C. How an Open Market Operation Works Open market operations are the Fed’s major policy tool. When the Fed buys securities in an open market operation, it pays for them with newly created bank reserves and money. 1. The Fed Buys Securities a. When the Fed buys securities from banks it does so by increasing the banks’ reserves. This action increases the monetary base and increases the reserves of the banking system. b. When the Fed buys securities from the nonbank public, the seller deposits the check received from the Fed in a bank, whose reserves now increase by the amount of the check. 2. The Fed Sells Securities Whether the transaction is with a bank or the nonbank public, the end result is a decrease in reserves, a decrease in the monetary base, and a decrease in the quantity of money. D. The Multiplier Effect of an Open Market Operation 1. An open market purchase increases bank reserves and also increases the monetary base. The increase in the monetary base equals the amount of the open market purchase and equals the increase in banks’ reserves. 2. Excess reserves are created, and banks lend these excess reserves. 3. Bank deposits increase and the quantity of money increases. The multiplier process means that the quantity of money increases more than the initial increase in the monetary base. 4. A currency drain is an increase in currency held outside the banks. A currency drain decreases the amount of money that banks can create from a given increase in the monetary base because currency drains from their reserves and decreases the excess reserves available. E. The Money Multiplier 1. The money multiplier is the number by which a change in the monetary base is multiplied to find the resulting change in the quantity of money. 2. The money multiplier decreases in magnitude when the currency drain increases or when the required reserve ratio increases. 1 a. The money multiplier equals , where L = (1  C)  (1  R) and C is the ( 1  L) currency drain (the percentage of an increase in money held as currency) and R is the required reserve ratio.