Chapter 16 Money Creation and Deposit Insurance. Slide 16-2 Introduction The operation of the U.S....
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Transcript of Chapter 16 Money Creation and Deposit Insurance. Slide 16-2 Introduction The operation of the U.S....
Chapter 16
Money Creation and Deposit Insurance
Slide 16-2
Introduction
The operation of the U.S. financial system depends on electronically transmitted
information about deposits and payments.
How does the Federal Reserve respond when widespread power outages prevent the information network from operating?
Slide 16-3
Learning Objectives
Describe how the Federal Reserve assesses reserve requirements on banks and other depository institutions
Understand why the money supply is unaffected when someone deposits in a depository institution a check drawn on another depository institution
Slide 16-4
Learning Objectives
Explain why the money supply changes when someone deposits in a depository institution a check drawn on the Federal Reserve System
Determine the maximum potential extent to which the money supply will change following a Federal Reserve purchase or sale of government securities
Slide 16-5
Learning Objectives
Describe the ways in which the Federal Reserve can potentially alter the money supply and explain the manner in which the Fed actually does conduct monetary policy
Explain the essential features of federal deposit insurance
Slide 16-6
Chapter Outline
Links Between Changes in the Money Supply and Other Economic Variables
The Origins of Fractional Reserve Banking
Depository Institution Reserves
The Relationship Between Reserves and Total Deposits
Slide 16-7
Chapter Outline
The Fed’s Direct Effect on the Overall Level of Reserves
Money Expansion by the Banking System
The Money Multiplier
Deposit Insurance
Slide 16-8
Did You Know That…
Most demand deposit accounts are covered by federal deposit insurance?
The banking system as a whole creates money in the process of issuing commercial and personal loans?
Slide 16-9
Links Between Changes in the Money Supply and Other Economic Variables
There are links between changes in the money supply and changes in GDP.
There are links between changes in the money supply and the rate of inflation.
Slide 16-10
The Origins of Fractional Reserve Banking
Fractional Reserve Banking
– A system in which depository institutions hold reserves that are less than the amount of deposits
– Origins in Mesopotamia• Goldsmiths issued notes that exceeded the
value of gold and silver on hand
Slide 16-11
The Origins of Fractional Reserve Banking
What do you think?
– Can banks pay off all of their depositors?
– How is it possible that they can pay them off eventually but not pay them off simultaneously?
Slide 16-12
Money Supply Growth versus the Inflation Rate
Figure 16-1Source: Economic Report of the President; Federal Reserve
Bulletin; Economic Indicators, various issues.
Slide 16-13
Depository Institution Reserves
Question
– Do banks set their own reserve rate?
Answer
– No. The Federal Reserve sets the reserve requirement.• Currently it is 10% on most checkable deposits.
Slide 16-14
Depository Institution Reserves
Legal Reserves
– Anything that the law permits banks to claim as reserves
Slide 16-15
Depository Institution Reserves
Required Reserves
– The value of reserves that a depository institution must hold in the form of vault cash or deposits with the Fed
Slide 16-16
Depository Institution Reserves
Required Reserve Ratio
– The percentage of total deposits that the Fed requires depository institutions to hold in the form of vault cash or deposits with the Fed
– Required reserves equal checkable deposits times the required reserve ratio
Slide 16-17
Depository Institution Reserves
Excess Reserves
– The difference between legal reserves and required reserves
Excess reserves = legal reserves - required reserves
Slide 16-18
The Relationship Between Reserves and Total Deposits
How a single bank reacts to an increase in reserves
– We will examine the balance sheet of a single bank.
Slide 16-19
The Relationship Between Reserves and Total Deposits
Assumptions– Reserve ratio is 10%
– Checkable deposits are the bank’s only liabilities
– An individual bank can lend all it wants
– Loan proceeds are deposited into checkable accounts
– Zero excess reserves
– Banks have zero net worth
Slide 16-20
The Relationship Between Reserves and Total Deposits
Description of a Balance Sheet
Assets Liabilities
What are owned Reserves Loans
What are owed Deposits
*Also assume Net Worth = zero
Net Worth = Assets - Liabilities
Slide 16-21
The Relationship Between Reserves and Total Deposits
Total reserves $100,000Required reserves $100,000Excess reserves 0
Loans $900,000
Total $1,000,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,000,000
Total $1,000,000
Reserve Ratio = 10%
Balance Sheet 16-1
Slide 16-22
The Relationship Between Reserves and Total Deposits
Assets Liabilities
Balance Sheet: Typical Bank
Scenario• A customer of Typical Bank deposits $100,000
in Typical Bank• The deposit is a check drawn on another bank
Slide 16-23
The Relationship Between Reserves and Total Deposits
Total reserves $200,000Required reserves $110,000Excess reserves $90,000
Loans $900,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000Old deposits $1,000,000New deposit $100,000
Total $1,100,000
OutcomeTypical Bank’s deposits and
reserves increase by $100,000
Slide 16-24
The Relationship Between Reserves and Total Deposits
Following the deposit
– What are the required reserves of Typical Bank?
– Does Typical Bank have excess reserves?
Required reserves = .10 x $1,100,000 = $110,000
Excess reserves = $200,000 - $110,000 = $90,000
Slide 16-25
The Relationship Between Reserves and Total Deposits
Total reserves $200,000Required reserves $110,000Excess reserves $90,000
Loans $900,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000Old deposits $1,000,000New deposit $100,000
Total $1,100,000
OutcomeTypical Bank has required reserves of $110,000 and excess reserves of $90,000
Slide 16-26
The Relationship Between Reserves and Total Deposits
Following the deposit
– What will Typical Bank do with its excess reserves?• Loan them out
– Could Typical Bank safely loan out more than its excess reserves?
Slide 16-27
The Relationship Between Reserves and Total Deposits
Total reserves $200,000Required reserves $119,000Excess reserves $81,000
Loans $990,000Old loans $900,000New loans $90,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000Old deposits $1,000,000New deposit $100,000
Total $1,100,000
Typical Bank’s balance sheet following a loan to another customer
Slide 16-28
The Relationship Between Reserves and Total Deposits
What do you think?
– Did this loan expand the money supply?
Hints
– Have the reserves of the banking system changed?
– What happened to the loan balance at the bank where the deposit came from?
Slide 16-29
The Relationship Between Reserves and Total Deposits
Observations
– The amount of reserves in the banking system determines the lending potential of the banks, given the reserve ratio.
– If the reserves increase so does the lending potential of the banks, given the reserve ratio.
Slide 16-30
The Fed’s Direct Effect on the Overall Level of Reserves
Federal open market committee
– Can instruct the New York Federal Reserve Bank trading desk to buy or sell bonds
Slide 16-31
The Fed’s Direct Effect on the Overall Level of Reserves
Open Market Operations
– The purchase and sale of existing U.S. government securities in the open private market by the Federal Reserve System
Slide 16-32
The Fed’s Direct Effect on the Overall Level of Reserves
+$100,000 U.S. government securities
Assets Liabilities
Balance Sheet: The Fed
+$100,000 depository institutions reserves
ScenarioThe Fed buys $100,000
of U.S. government securities
Slide 16-33
The Fed’s Direct Effect on the Overall Level of Reserves
+$100,000 reserves
Assets Liabilities
Balance Sheet: Bank
+$100,000 checkable deposit owned by bond dealer
OutcomeThe reserves and the money supply
increase by $100,000
Slide 16-34
The Fed’s Direct Effect on the Overall Level of Reserves
-$100,000 U.S. government securities
Assets Liabilities
Balance Sheet: The Fed
-$100,000 depository institutions reserves
ScenarioThe Fed sells $100,000
of U.S. government securities
Slide 16-35
The Fed’s Direct Effect on the Overall Level of Reserves
-$100,000 reserves
Assets Liabilities
Balance Sheet: Bank
-$100,000 checkable deposit balances
ScenarioThe reserves and money supply
fall by $100,000
Slide 16-36
Money Expansion by the Banking System
Total reserves $100,000Required reserves $100,000Excess reserves 0
Loans $900,000
Total $1,000,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,000,000
Total $1,000,000
Beginning balances
Slide 16-37
Money Expansion by the Banking System
Total reserves $100,000Required reserves $100,000Excess reserves 0
Loans $900,000
Total $1,000,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,000,000
Total $1,000,000
Scenario• Fed purchases $100,000 of securities
from a Typical Bank customer• The funds are deposited in Typical Bank
Slide 16-38
Money Expansion by the Banking System
Total reserves $200,000Old reserves $100,000New reserves $100,000
Loans $900,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000Old deposits $1,000,000New Deposits $100,000
Total $1,100,000
Slide 16-39
Money Expansion by the Banking System
Total reserves $200,000Required reserves $110,000Excess reserves $90,000
Loans $900,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000Old deposits $1,000,000New Deposits $100,000
Total $1,100,000
OutcomeThe money supply increases by $100,000
Slide 16-40
Money Expansion by the Banking System
Total reserves $200,000Required reserves $110,000Excess reserves $90,000
Loans $900,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000
Total $1,100,000
Scenario• After the Fed’s purchase Typical Bank
has excess reserves of $90,000• Typical Bank loans its excess reserves
to another Typical Bank customer
Slide 16-41
Money Expansion by the Banking System
Total reserves $200,000Required reserves $119,000Excess reserves $81,000
Loans $990,000Old loans $900,000New loans $90,000
Total $1,190,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,190,000Old deposits $1,100,000New deposits $90,000
Total $1,190,000
ScenarioDoes this loan impact the money supply?
Slide 16-42
Money Expansion by the Banking System
Total reserves $200,000Required reserves $119,000Excess reserves $81,000
Loans $990,000
Total $1,190,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,190,000
Total $1,190,000
OutcomeThe money supply increases by $90,000,
the amount of the loan
Slide 16-43
Money Expansion by the Banking System
Total reserves $200,000Required reserves $119,000Excess reserves $81,000
Loans $990,000
Total $1,190,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,190,000
Total $1,190,000
Scenario• The Borrower uses the $90,000
to purchase a Burger King franchise• Burger King banks at Bank 2
Slide 16-44
Money Expansion by the Banking System
Total reserves $200,000Required reserves $119,000Excess reserves $81,000
Reduction -$90,000
New balance $110,000Required reserves $110,000Excess reserves 0
Loans $990,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,190,000Burger King check -$90,000
New balance $1,100,000
Total $1,100,000
Slide 16-45
Money Expansion by the Banking System
Total reserves $110,000Required reserves $110,000Excess reserves 0
Loans $990,000
Total $1,100,000
Assets Liabilities
Balance Sheet: Typical Bank
Checkable deposits $1,100,000
Total $1,100,000
Slide 16-46
Money Expansion by the Banking System
Reserves +$90,000
Total +$90,000
Assets Liabilities
Balance Sheet: Bank 2 (changes)
Burger King deposit +$90,000
Total +$90,000
ScenarioWhat impact will the Burger King
deposit have on Bank 2?
Slide 16-47
Money Expansion by the Banking System
Reserves +$90,000Required reserves +$9,000Excess reserves +$81,000
Total +$90,000
Assets Liabilities
Balance Sheet: Bank 2 (changes)
Burger King deposit +$90,000
Total +$90,000
OutcomeThis deposit creates excess
reserves of $81,000 in Bank 2
Slide 16-48
Money Expansion by the Banking System
Total reserves $90,000Required reserves $17,100Excess reserves $72,900
Loans +$81,000
Total $171,000
Assets Liabilities
Balance Sheet: Bank 2 (changes)
Checkable deposits $171,000Old deposits $90,000New deposits +$81,000
Total $171,000
Scenario• Bank 2 loans out the excess
reserves of $81,000• Does the money supply change?
Slide 16-49
Money Expansion by the Banking System
Reserves $90,000Reduction to cover check -$81,000Total Reserves 9,000
Required reserves $9,000Excess reserves 0
Loans $81,000
Total $90,000
Assets Liabilities
Balance Sheet: Bank 2 (changes)
Checkable deposits $171,000Oil Co. check -$81,000
Total checkable deposits $90,000
Total $90,000
ScenarioAssume the borrower spends the $81,000
with an oil well drilling firm that banks with Bank 3
Slide 16-50
Money Expansion by the Banking System
Reserves +$81,000Required reserves +$8,100Excess reserves +$72,900
Total $90,000
Assets Liabilities
Balance Sheet: Bank 3 (changes)
Checkable deposits +$81,000
Total +$81,000
Scenario• Bank 3’s deposits and reserves
increase by $81,000• Can Bank 3 make a new loan?• If so, will it impact the money supply
Slide 16-51
Money Expansion by the Banking System
Reserves +$8,100Required reserves +$8,100Excess reserves 0
Loans +$72,900
Total +$81,000
Assets Liabilities
Balance Sheet: Bank 3 (changes)
Checkable deposits +$81,000
Total +$81,000
OutcomeBank 3’s balance sheet after it makes the loan and the loan proceeds have cleared to Bank 4
Slide 16-52
Money Expansion by the Banking System
How much has the money supply increased after the Fed’s $100,000 purchase of government securities and the three bank loans?
Slide 16-53
Money Expansion by the Banking System
$100,000 Purchase by the Fed90,000 Loan by Bank 181,000 Loan by Bank 272,900 Loan by Bank 3
What do you think?• Could Banks 4, 5, 6, etc.
create even more money?• How much can be created?
$343,900 Total
Slide 16-54
Maximum Money Creation with 10 Percent Required Reserves
MaximumNew Loans
New Deposits New Required plus InvestmentsBank (new reserves) Reserves (excess reserves)
1 $100,000 $10,000 $90,000
2 90,000 9,000 81,000
3 81,000 8,100 72,900
4 72,900 7,290 65,610
Totals $1,000,000 $100,000 $900,000
. . . .
. . . .
. . . .
All other banks 656,100 65,610 590,490
Table 16-1
Slide 16-55
Money Expansion by the Banking System
What would happen when:
– The Fed sells government securities?
– Borrowers pay back the loans?
Slide 16-56
The Multiple Expansion in the Money Supply Due to $100,000 in New Reserves When the Required Reserve Ratio is 10%
Figure 16-2
Slide 16-57
The Money Multiplier
Money Multiplier
– Gives the maximum potential change in the money supply due to a change in reserves
Slide 16-58
The Money Multiplier
Actual changein the money
supply= Actual money
multiplierChange in
total reservesx
Potential money multiplier = 1
required reserve ratio
Slide 16-59
The Money Multiplier
Example
– Fed buys $100,000 of government securities
– Reserve ratio = 10%
Potential changein the money
supply= $100,000 = $1,000,000x
1
.10
Slide 16-60
The Money Multiplier
Forces that reduce the money multiplier
– Leakages• Currency drains• Excess reserves
Slide 16-61
The Money Multiplier
Real-world money multipliers
– M1 multiplier = 2.5 - 3.0
– M2 multiplier = 6.5 in the 1960s andover 12 in the
2000s
Slide 16-62
Ways in Which the FederalReserve Changes the Money Supply
Open market operations
Borrowed reserves and the Discount Rate
– The interest rate that the Federal Reserve charges for reserves it lends to depository institutions
Slide 16-63
Ways in Which the FederalReserve Changes the Money Supply
Federal Funds Market– A private market in which banks can
borrow reserves from other banks that want to lend them
Federal Funds Rate– The interest rate that depository
institutions pay to borrow reserves in the interbank federal funds market
Slide 16-64
Policy Example:The Discount Window is Open
The Federal Reserve stands willing to loan funds to member banks at the discount rate.
Because the discount rate is one percentage point above the federal funds rate, most banks prefer to go to the federal funds market rather than to the discount window.
Slide 16-65
Sweep Accounts
Many banks offer automatic transfer accounts, in which savings account balances are transferred to demand deposit accounts only when needed.
This feature allows banks to hold fewer reserves. The required reserve ratio is lower for savings account balances.
Slide 16-66
Sweep Accounts
Banks use sweep accounts to shift funds from checking accounts into savings accounts until they are needed to settle check payments.
Consequently, more of money supply growth has been shifted to M2, and M1 is considered a less reliable indicator of total liquidity.
Slide 16-67
Payment-system risks
– Liquidity Risk• The risk of loss from late receipt of payment
– Credit Risk• The risk that the other party to an exchange
may not honor its terms
– Systemic Risk• The risk of settlement system breakdowns
Payment Systems, Their Risks, and Deposit Insurance
Slide 16-68
Deposit Insurance
Federal Deposit Insurance Corporation (FDIC)
– A government agency that insures the deposits held in member banks
– All members of the Fed and qualifying banks can purchase insurance.
Slide 16-69
Bank Failures
Figure 16-4 Source: Federal Deposit Insurance Corporation
Slide 16-70
Deposit Insurance
The rationale for deposit insurance
– Bank Runs• Attempts by many of a bank’s depositors to convert
checkable and time deposits into currency out of fear for the banks solvency
Bank runs are prevented when depositors know they can convert their deposits to currency because of deposit insurance.
Slide 16-71
Deposit Insurance
How deposit insurance causes increased risk taking by bank managers
– Deposit insurance premiums never have reflected all of the risks faced by a bank’s loans
– Managers have an incentive to make higher risk loans
Slide 16-72
Deposit Insurance
Deposit insurance, adverse selection, and moral hazard
– Asymmetric Information• Information possessed by one side of a
transaction but not the other• The side with more information will be at an
advantage
Slide 16-73
Deposit Insurance
Deposit insurance, adverse selection, and moral hazard– Adverse Selection
• A problem created by asymmetric information prior to a transaction
• Individuals who are the most undesirable from the other party’s point of view end up being the ones who are most likely to want to engage in a particular financial transaction, such as borrowing
Slide 16-74
Deposit Insurance
Deposit insurance, adverse selection, and moral hazard
– Moral Hazard• A situation in which, after a transaction has
taken place, one of the parties to the transaction has an incentive to engage in behavior that will be undesirable from the other party’s point of view
Slide 16-75
Deposit Insurance
The results of moral hazard
– The S&L crisis of the mid-1980s• Thrift Bailout Act of 1989 cost taxpayers
$200 billion
Slide 16-76
Policy Example: Some Supervisory Examinations Never End
At offices of some of the largest U.S. banks, FDIC examiners are a permanent presence.
They monitor daily bank activity in an attempt to detect signs of any forthcoming problems with liquidity or soundness.
Slide 16-77
Issues and Applications: Keeping Money Flowing Without Electric Power
The widespread power outage in August of 2003 brought banking operations throughout the Northeast to a standstill.
The Federal Reserve transmitted funds on behalf of banks, who then later repaid these temporary loans.
As the lender of last resort, the Fed provides liquidity for all creditworthy banks.
Slide 16-78
Summary Discussion of Learning Objectives
How the Federal Reserve assesses reserve requirements
Why the money supply does not change when someone deposits in a depository institution a check drawn on another depository institution
Slide 16-79
Summary Discussion of Learning Objectives
Why the money supply does change when someone deposits in a depository institution a check drawn on the Federal Reserve
The maximum potential change in the money supply following a federal resource purchase or sale of U.S. government securities
Slide 16-80
Summary Discussion of Learning Objectives
The Fed influences the money supply through open market operations, the discount rate, and the reserve requirement.
Federal Deposit Insurance was established to prevent bank runs. While it protects individual depositors, it also may encourage more risk-taking by bank managers.
End of Chapter 16Money Creation and Deposit Insurance
