w8 Flashcards
Three groups affect the money supply
- The central bank is responsible for monetary policy
- Depository institutions (banks) accept deposits and make loans
- The public (people and firms) holds money as currency and coin or as bank deposits
monetary base or high-powered money
The sum of reserve deposits and currency (held by the nonbank public and by banks).
This is because each unit of the base that is issued leads to the creation of more money
i. Largest asset in the BS
ii. Two major liabilities of the Fed
iii. banks’ total reserves (RES)
i. holdings of Treasury securities
ii. currency outstanding & deposits by banks and other depository institutions
iii. Vault cash plus banks’ deposits
100% reserve banking and fractional reserve banking
→When bank reserves are equal to deposits, the system is called 100% reserve banking.
→But banks lend out some of their deposits, as only a fraction of reserves are needed to meet the need for outflows.
→If the bank needs to keep only 25% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 75%.
→The reserve-deposit ratio would be 25%.
→When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking.
The most direct and frequently used way of changing the money supply
by raising or lowering the monetary base through open-market operations.
To increase the monetary base
the central bank prints money and uses it to buy assets in the market; this is an open-market purchase.
→Banks then find that their reserve-deposit ratio is higher than desired; this leads to a multiple expansion of loans and deposits.
→Banks then increase their loans until the reserve-deposit ratio returns to the desired level.
If the central bank wants to decrease the monetary base,
it uses an open-market sale
Taking the ratio of money supply and monetary base
M/BASE=(CU+DEP)/(CU+RES)
the currency–deposit ratio (CU/DEP, or cu) is determined by the _____
The reserve–deposit ratio (RES/DEP, or res) is determined by ______.
money multiplier EQ
public ; banks
M=[(cu+1)/(cu+res)]∙BASE
i. fractional reserve banking and money multiplier
ii. 100% reserve banking
i. The money multiplier is greater than 1 for res less than 1
ii. If cu = 0, the multiplier is 1/res, as when all money is held as deposits.
bank run
§If people think a bank will not be able to give them their money, they may panic and rush to withdraw their money, causing a bank run.
§To prevent bank runs, the FDIC insures bank deposits, so that depositors know their funds are safe, and there will be no need to withdraw their money.
The money multiplier during severe financial crises (i.e., the Great Depression).
→The money multiplier is usually fairly stable, but it fell sharply in the Great Depression.
→The decline in the multiplier was due to bank panics.
→People became mistrustful of banks and increased the currency-deposit ratio (Fig. 14.1).
→Banks held more reserves, in anticipation of bank runs, which raised the reserve-deposit ratio.
→Even though the monetary base grew 20% from March 1930 to March 1933, the money supply fell 35% (Figure 14.2a).
→As a result, the price level fell sharply (nearly one-third) and there was a decline in output.
§Tools for Monetary control to meet policy objectives
→Open-market operations (primary)
→Reserve requirements
→Discount window lending
→Interest rate on reserves
§Reserve requirements:
→The Fed forces banks to hold reserves of about 10% of the value of their transactions deposits (less for small banks)
→The Fed could change the money supply by changing reserve requirements but seldom does so because reserve requirements have a large impact on both the money supply and bank profits
Discount window lending:
→Discount window lending is lending reserves to banks so they can meet depositors’ demands or reserve requirements
→The interest rate on such borrowing is called the discount rate
→The Fed was set up to halt financial panics by acting as a lender of last resort through the discount window
→A discount loan increases the monetary base