Money, Banking,

and the Federal

Reserve
SLIDES CREATED BY ERIC CHIANG

CHAPTER

Copyright 2023 Macmillan Learning | Chiang | All rights reserved

12
MONEY IS
CREATED
WHEN
FINANCIAL
INSTITUTIO
NS ACCEPT
DEPOSITS
AND MAKE
LOANS.
  BANKS (FINANCIAL
INSTITUTIONS) ACT AS A
BRIDGE BETWEEN SAVERS
AND BORROWERS.

CREATIN  A BANK’S ABILITY TO MAKE

LOANS (CREATE MONEY) IS

G MONEY LIMITED TO ITS TOTAL

CUSTOMER DEPOSITS.
 BANKS MUST HOLD A
PERCENTAGE OF THEIR
TOTAL DEPOSITS AS
RESERVES.
 RESERVE
RESERVE
REQUIREME
RATIO
BANK NT

RESERVE A BANK’S REQUIRED

S RESERVES
AS A
MINIMUM
PORTION OF
PERCENTAGE DEPOSITS A
OF ITS TOTAL BANK MUST
DEPOSITS HOLD AS
RESERVES
FRACTIONAL
$1,000 DEPOSIT IS
RESERVE DIVIDED BETWEEN
BANKING
SYSTEM
WHEN A BANK
RECEIVES A
DEPOSIT, A CASH LOANS TO
PORTION OF IT IS RESERVES CONSUMER
HELD IN RESERVE. AND S AND
THE REST IS DEPOSITS BUSINESSE
LOANED OUT, AT THE S
WHICH BEGINS FED
MONEY CREATION.
 BANKS CREATE MONEY BY
LENDING EXCESS RESERVES.
SUPPOSE $1,000 IS DEPOSITED IN
BANK A, AND EVERY BANK HOLDS
MONEY EXACTLY 20% OF DEPOSITS IN
RESERVES. BANK A’S BALANCE
CREATIO SHEET (T-ACCOUNT) FOLLOWS:

N Bank A
Assets
Bank A
Liabilities
Reserves +$200 Deposits +$1,000
Loans +$800
 ASSUME THE $800 THAT IS LENT
OUT IS SPENT AT ANOTHER
COMPANY, WHICH THEN DEPOSITS
THE $800 INTO ITS BANK (BANK B).
MONEY BANK B THEN LENDS 80% OF THAT
DEPOSIT TO ANOTHER BORROWER.
CREATIO BANK B’S T-ACCOUNT:

N Bank B
Assets
Bank B
Liabilities
Reserves +$160 Deposits +$800
Loans +$640
 IF THIS PROCESS CONTINUES
WITH EVERY BANK LENDING
80% OF ITS DEPOSITS, THE
TOTAL AMOUNT OF
DEPOSITS GENERATED FROM
MONEY THE ORIGINAL $1,000
DEPOSIT IS:
CREATI $1,000 ÷ 0.20 (THE
ON PERCENTAGE HELD IN
RESERVES) = $5,000.
SINCE $1,000 IN NEW
DEPOSITS LEADS TO $5,000
IN TOTAL DEPOSITS, THE
MONEY MULTIPLIER IS 5.
 THE SUM OF TOTAL
CURRENCY IN CIRCULATION
MONETA AND RESERVES HELD BY
BANKS EITHER IN THEIR
RY BASE VAULTS OR ON DEPOSIT AT
THE FED.
 THE MONEY MULTIPLIER IS
THE FACTOR BY WHICH
INITIAL NEW DEPOSITS CAN
INCREASE THE MONEY
BANK SUPPLY.
RESERVES AND MULTIPLIER = CHANGE IN
THE MONEY MONEY SUPPLY ÷ CHANGE IN
MONETARY BASE
MULTIPLIER
(IF THERE IS NO CASH IN
CIRCULATION, THE POTENTIAL
MONEY MULTIPLIER IS 1 ÷ MINIMUM
RESERVE RATIO, THOUGH THIS LEVEL
OF MONEY MULTIPLIER IS
UNREALISTIC.)
11 | CHAPTER 12

WHEN THE RESERVE

RATIO IS 10% FOR
ALL BANKS, A NEW
$100 DEPOSIT CAN
GENERATE UP TO
$1,000 IN DEPOSITS,
A $900 INCREASE IN
THE MONEY SUPPLY.
  THE ACTUAL MONEY
MULTIPLIER IN THE UNITED
STATES IS NOT MUCH
ACTUAL GREATER THAN 1.

MONEY  THIS IS DUE TO THE

TREMENDOUS AMOUNT
MULTIPLIER OF CURRENCY IN
CIRCULATION AND
RESERVES HELD BY
BANKS.
STASHING
MONEY
AWAY AS
CASH
REDUCES
THE MONEY
MULTIPLIER
BECAUSE
THE CASH
CANNOT BE
LOANED TO
SOMEONE
ELSE.
 1. BANKS HOLD CASH IN
THEIR VAULTS AND ATM
MACHINES.
2. INDIVIDUALS AND
REASONS FOR BUSINESSES HOLD
CURRENCY IN CASH FOR DAILY
TRANSACTIONS.
CIRCULATION
3. CASH IS HELD BY
FOREIGN CONSUMERS,
BUSINESSES, AND
GOVERNMENTS.
 BANKS CAN DEPOSIT
RESERVES RESERVES AT A FEDERAL
RESERVE BANK AND EARN
ON INTEREST. A HIGHER LEVEL
DEPOSIT OF RESERVES INCREASES
THE MONETARY BASE AND
AT THE FED REDUCES THE MONEY
MULTIPLIER.
 SUPPOSE THE AVERAGE
MONEY PERCENTAGE OF DEPOSITS
HELD IN RESERVES IS 25%
MULTIPLIER AND ANOTHER 15% OF THE
MONEY SUPPLY IS HELD AS
CALCULATI CURRENCY IN CIRCULATION.
THE MONEY MULTIPLIER IS:
ON
1 ÷ (0.25 + 0.15) = 2.5
RESERVE
SYSTEM
(THE FED) IS
THE
CENTRAL
BANK OF
THE UNITED
STATES. IT
WAS
ESTABLISHE
D BY THE
FEDERAL
 THE FEDERAL RESERVE IS
AN INDEPENDENT CENTRAL
BANK.
CHARACTERIST  ITS ACTIONS ARE NOT
ICS OF THE SUBJECT TO CONTROL BY
FEDERAL THE EXECUTIVE BRANCH.
RESERVE (FED)  THE ENTIRE FEDERAL
RESERVE SYSTEM IS
SUBJECT TO OVERSIGHT
BY CONGRESS.
 FEDERAL RESERVE BOARD OF
GOVERNORS
 BASED IN WASHINGTON, D.C.
 HAS SEVEN MEMBERS
APPOINTED BY THE PRESIDENT
AND CONFIRMED BY THE
THE SENATE FOR A SINGLE 14-YEAR
TERM

STRUCTURE 12 REGIONAL FEDERAL RESERVE

BANKS
OF THE FED FEDERAL OPEN MARKET
COMMITTEE
 INCLUDES THE BOARD OF
GOVERNORS AND FIVE OF THE
12 REGIONAL BANK
PRESIDENTS (THE NEW YORK
FED PRESIDENT IS A
20 | CHAPTER 12

REGIONAL FEDERAL RESERVE DISTRICTS

21 | CHAPTER 12

REGIONAL
FEDERAL
RESERVE
DISTRICTS

EACH FEDERAL RESERVE BANK ISSUES

CURRENCY, MARKED BY A LETTER (A TO L)
CORRESPONDING TO ITS LOCATION.
 1. PROVIDE A
NATIONWIDE
PAYMENTS SYSTEM
FUNCTIONS 2. DISTRIBUTE COINS
OF AND CURRENCY
3. REGULATE AND
REGIONAL SUPERVISE MEMBER
FED BANKS BANKS
4. SERVE AS THE BANKER
FOR THE U.S.
TREASURY
THE
FEDERAL
OPEN
MARKET
COMMITTEE
DETERMINE
S THE
DIRECTION
OF
MONETARY
POLICY BY
TARGETING
INTEREST
 THE FEDERAL FUNDS RATE
IS THE INTEREST RATE THAT
FINANCIAL INSTITUTIONS
CHARGE EACH OTHER FOR
THE OVERNIGHT LOANS USED
AS RESERVES.
FEDERAL  THIS IS A CLOSELY-
FUNDS WATCHED INTEREST RATE
THAT AFFECTS MANY
RATE OTHER INTEREST RATES.
 THE FED SETS THE
TARGET FEDERAL FUNDS
RATE, THEN TAKES
ACTION TO ACHIEVE ITS
TARGET.
  DURING AN ECONOMIC
CRISIS, THE FED CAN
PROVIDE LOANS WHEN NO
ONE ELSE CAN (OR WILL).
THE FED  THE 2007-2009 AND 2020
AS LENDER RECESSIONS WOULD LIKELY
HAVE BEEN WORSE WITHOUT
OF LAST THE FED’S INTERVENTION.
 THE FED LENT TRILLIONS OF
RESORT DOLLARS TO BANKS AND
OTHER FINANCIAL
INSTITUTIONS SINCE 2008,
DRAMATICALLY ALTERING THE
FED’S BALANCE SHEET.
 THE FED USES FOUR MAIN TOOLS
TO CONDUCT MONETARY POLICY:
1. INTEREST ON RESERVE
BALANCES (IORB): INTEREST
TOOLS OF PAID ON BANK RESERVES
HELD AT THE FED
THE 2. DISCOUNT RATE: INTEREST
RATE CHARGED BY THE FED
FEDERAL TO BANKS

RESERVE 3. OPEN MARKET OPERATIONS:

THE BUYING AND SELLING OF
BONDS IN THE OPEN MARKET
4. RESERVE REQUIREMENT:
REQUIRED RATIO OF BANK
DEPOSITS HELD AS RESERVES
  IN 2008, THE FED BEGAN
PAYING INTEREST ON
RESERVES, WHICH
DRAMATICALLY INCREASED
THE AMOUNT OF RESERVES
INTEREST HELD AT THE FED.
ON RESERVE  FROM 2008 TO 2014, TOTAL
RESERVES HELD AT THE
BALANCES FED INCREASED FROM $10
(IORB) BILLION TO $2.8 TRILLION,
A 280-FOLD INCREASE.
 WHEN THE FED WISHES TO
CHANGE THE FEDERAL
FUNDS RATE, IT DOES SO BY
CHANGING THE IORB RATE.
  SINCE MONEY DEPOSITED
AT THE FED IS
GUARANTEED (CARRIES NO
RISK), THE IORB RATE
IORB RATE CREATES A FLOOR FOR THE
FEDERAL FUNDS RATE.
AND THE  ARBITRAGE, THE BUYING
FEDERAL AND SELLING OF ASSETS IN
DIFFERENT MARKETS TO
FUNDS RATE PROFIT FROM DIFFERENCES
IN PRICE OF THE SAME
ASSET, HELPS TO KEEP THE
FEDERAL FUNDS RATE VERY
CLOSE TO THE IORB RATE.
29 | CHAPTER 12

THE IORB
RATE AND
FEDERAL
FUNDS
RATE

THE FED SETS THE INTEREST RATE ON RESERVE BALANCES,

WHICH THE FEDERAL FUNDS RATE FOLLOWS CLOSELY.
  LIKE FISCAL POLICY,
MONETARY POLICY IS
SUBJECT TO FOUR MAJOR
LAGS:
MONETARY  INFORMATION LAGS
 RECOGNITION LAGS
POLICY  DECISION LAGS
LAGS  IMPLEMENTATION LAGS
 THE AVERAGE TIME FOR
MONETARY POLICY TO
AFFECT THE ECONOMY IS
12 TO 18 MONTHS.
 JANET YELLEN (1946– )
• The first person to have held
the three most prestigious
economic posts in government:
chair of the Council of
Economic Advisers, chair of the
Federal Reserve Board of
Governors, and secretary of
the U.S. Treasury.
• She is married to Nobel Prize
winner George Akerlof. Both
32 | CHAPTER 12

KEY
CONCEPTS
• reserve ratio • Federal Reserve System
• reserve requirement • Federal Open Market
• fractional reserve banking Committee (FOMC)
system • federal funds rate
• excess reserves • open market operations
• money multiplier • arbitrage
• monetary base • discount rate
• insolvent
33 | CHAPTER 12

QUESTION: A. WITHDRAWING CASH FROM A SAVINGS

ACCOUNT
WHICH OF THE
FOLLOWING B. A BANK INCREASING ITS RESERVE RATIO

ACTIONS
WOULD C. A STORE CHOOSING TO ACCEPT ONLY
CASH
INCREASE
MONEY D. A GOVERNMENT INCREASING ITS CASH
CREATION? RESERVES

E. A BANK REDUCING ITS EXCESS

RESERVES
PRACTICE
QUESTION
:
COINSTAR
MACHINES
CONVERT JARS
OF COINS TO
GIFT CARDS
WITHOUT ANY
FEES. HOW
MIGHT THIS
AFFECT MONEY
CREATION?
35 | CHAPTER 12

A. 0.4
QUESTION:
SUPPOSE THE MONEY
B. 1.25
SUPPLY INCREASED BY
$125 MILLION WHILE
C. 1.75
THE MONETARY BASE
INCREASED BY $50
D. 2.5
MILLION. WHAT IS THE
MONEY MULTIPLIER?
E. 7.5
PRACTICE
QUESTION
:
MEMBERS OF
THE FED BOARD
OF GOVERNORS
SERVE A SINGLE
14-YEAR TERM.
WHY IS THE
TERM SO LONG?
WOULDN’T
SHORTER TERMS
BE BETTER?
37 | CHAPTER 12

QUESTION: A. ADJUSTING THE RESERVE

REQUIREMENT
WHICH OF THE
FOLLOWING B. CHANGING THE DISCOUNT RATE
TOOLS IS THE
FED MOST
C. TARGETING THE FEDERAL FUNDS
LIKELY TO USE RATE
TO DEAL WITH A
MACROECONOM D. INCREASING THE LIMIT THAT BANK
DEPOSITS ARE INSURED BY THE FDIC
IC PROBLEM?
E. ISSUING NEW TREASURY BONDS
 End of
Chapter
SLIDES CREATED BY ERIC CHIANG

Copyright 2023 Macmillan Learning | Chiang | All rights reserved