Monetary policy:


The Federal Reserve System

Components of the Federal Reserve System

Instruments of Monetary Policy

Definition of Money - Money is anything which is generally accepted to serve the following functions of money:

Functions of Money

Definitions of the Money Supply

commodity money

fiat money

A History of Money from Ancient Times to the Present Day - by Glyn and Roy Davies


How Monetary Policy Affects the Economy

Expansionary Monetary Policy (Increasing the Money Supply):

Contractionary Monetary Policy (Decreasing the Money Supply):


Fractional Reserve Banking

Banks are businesses which make a profit by accepting deposits (and paying little or no interest to depositors) and lending the money to businesses and households (and charging moderate to high interest rates on the loans).

When you deposit your money in a bank, the bank does not write your name on it and place it in the vault until you withdraw it. Only a small fraction of all the money deposited in banks is kept in the bank's vault or on account with the Fed. The majority of the money deposited in banks is loaned out to businesses or households or otherwise invested by the bank.

To illustrate how fractional reserve banking works, it helps to examine a simplified bank balance sheet.
ASSETS LIABILITIES & NET WORTH
Required Reserves $1,000,000 Deposits $10,000,000
Excess Reserves $ 400,000
Loans $7,500,000 Net Worth $ 400,000
Government Securities $ 900,000
Property & other assets $600,000
TOTAL ASSETS $10,400,000 TOTAL LIABILITIES & NET WORTH $10,400,000




Example of Fractional Reserve Banking (10% Required Reserves)

Current Reserve Requirements

What would be the total effect on the money supply from a $100 increase in the monetary base? Assume the required reserve ratio is 10% (i.e., .10).



NATIONS BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $10 Deposits + $100
Excess Reserves
Loans + $90 Net Worth
Government Securities
Property & other assets



Suppose Nations Bank loaned $90 (of the $100 you deposited there) to Barbie. Barbie takes the $90 and buys something from Charles. Charles now has $90, which he deposits in his bank (First Union). Suppose the bank loans out the maximum amount of the new deposit. First Union's balance sheet would change as follows:

FIRST UNION BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $9 Deposits + $90
Excess Reserves
Loans + $81 Net Worth
Government Securities
Property & other assets



Suppose First Union loaned $81 (of the $90 Charles deposited there) to Debbie. Debbie takes the $81 and buys something from Ellen. Ellen now has $81, which she deposits in her bank (Sun Trust). Suppose the bank loans out the maximum amount of the new deposit. Sun Trust's balance sheet would change as follows:

SUN TRUST BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $8.10 Deposits + $81
Excess Reserves
Loans + $72.90 Net Worth
Government Securities
Property & other assets



Suppose Sun Trust loaned $72.90 (of the $81 Ellen deposited there) to Francisco. Francisco takes the $72.90 and buys something from Gabriel. Gabriel now has $72.90, which she deposits in her bank (Community Bank). Suppose the bank loans out the maximum amount of the new deposit. Community bank's balance sheet would change as follows:



COMMUNITY BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $7.29 Deposits + $72.90
Excess Reserves
Loans + $65.61 Net Worth
Government Securities
Property & other assets

If we continued this example, new loans would be created and deposited, creating new loans to be deposited, creating new loans, etc.

So what is the total effect on the money supply?

The increase in the money supply from a $100 increase in the monetary base when the required reserve ratio is 10% and banks loan out all excess reserves is:

Change in money supply = 100 + $90 + $81 + $72.90 + $65.61 + . . . + . . . + . . . = $1000

The formula for making this calculation is:

Increase in the monetary base / required reserve ratio = total increase in the money supply

or

$100 / .10 = $1000


Example of Fractional Reserve Banking (20% Required Reserves)

What would be the total effect on the money supply from a $100 increase in the monetary base if the required reserve ratio is 20% (i.e., .20)?



NATIONS BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $20 Deposits + $100
Excess Reserves
Loans + $80 Net Worth
Government Securities
Property & other assets



Suppose Nations Bank loaned $80 (of the $100 you deposited there) to Barbie. Barbie takes the $80 and buys something from Charles. Charles now has $80, which he deposits in his bank (First Union). Suppose the bank loans out the maximum amount of the new deposit. First Union's balance sheet would change as follows:

FIRST UNION BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $16 Deposits + $80
Excess Reserves
Loans + $64 Net Worth
Government Securities
Property & other assets



Suppose First Union loaned $64 (of the $80 Charles deposited there) to Debbie. Debbie takes the $64 and buys something from Ellen. Ellen now has $64, which she deposits in her bank (Sun Trust). Suppose the bank loans out the maximum amount of the new deposit. Sun Trust's balance sheet would change as follows:

SUN TRUST BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $12.80 Deposits + $64
Excess Reserves
Loans + $51.20 Net Worth
Government Securities
Property & other assets



Suppose Sun Trust loaned $51.20 (of the $64 Ellen deposited there) to Francisco. Francisco takes the $51.20 and buys something from Gabriel. Gabriel now has $51.20, which she deposits in her bank (Community Bank). Suppose the bank loans out the maximum amount of the new deposit. Community bank's balance sheet would change as follows:



COMMUNITY BANK

ASSETS LIABILITIES & NET WORTH
Required Reserves + $10.24 Deposits + $51.20
Excess Reserves
Loans + $40.96 Net Worth
Government Securities
Property & other assets

If we continued this example, new loans would be created and deposited, creating new loans to be deposited, creating new loans, etc.

So what is the total effect on the money supply?

The increase in the money supply from a $100 increase in the monetary base when the required reserve ratio is 20% and banks loan out all excess reserves is:

Change in money supply = 100 + $80 + $64 + $51.20 + $40.96 + . . . + . . . + . . . = $500

The formula for making this calculation is:

Increase in the monetary base / required reserve ratio = total increase in the money supply

or

$100 / .20 = $500



Notice that with a higher required reserve ratio, the money supply is smaller.

Lowering the required reserve ratio increases the money supply (expansionary monetary policy).

Raising the required reserve ratio reduces the money supply (contractionary monetary policy).

Current Reserve Requirements - from the Federal Reserve Bank of Minneapolis


How the Fed can use the discount rate to affect the economy.

The discount rate:

The current & historical discount rates -- from the Federal Reserve Bank of Minneapolis

Lowering the discount rate increases the money supply (expansionary monetary policy).

Raising the discount rate reduces the money supply (contractionary monetary policy).


How the Fed can use open market operations to affect the economy.

Open Market Operations

Open market purchases of government securities from banks increase the money supply (expansionary monetary policy).

Open market sales of government securities to banks decrease the money supply (contractionary monetary policy).


RELATED LINKS:

U.S. Monetary Policy - from the Federal Reserve Bank of Minneapolis

A History of Money from Ancient Times to the Present Day - by Glyn and Roy Davies

The current & historical discount rates -- from the Federal Reserve Bank of Minneapolis

The Federal Reserve & Monetary Policy -- a series of slides from Dr. Gisela Meyer Escoe at the University of Cincinnati

The Federal Reserve & Monetary Policy - from Dr. Robert Schenk at St. Joseph's College

Cyber-Economics - from Dr. Robert Schenk at St. Joseph's College


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