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Money, Prices, & the Federal Reserve



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Money Prices the Federal Reserve Chapter 10 1 Chapter 10 Learning Objectives You should be able to Describe the three functions of money List the components of M1 and M2 Explain how banks create money Define a bank panic and discuss the role of the FDIC in preventing bank panics Describe the structure of the Fed List the three tools of monetary policy and explain how they operate Write down the quantity equation and explain its economic significance 2 Functions of Money Medium of exchange Unit of account Store of wealth 3 Components of M2 and M1 Components of M2 Savings deposits 48 Components of M1 Money market mutual funds 16 Currency 50 M1 28 21 M1 Small denomination time deposits 15 Traveler s checks 1 Checking accounts 49 4 McGraw Hill Irwin 2004 The McGraw Hill Companies Inc All Rights Reserved The Money Multiplier Banks lend a portion of their deposits keeping the balance as reserves Reserves are vault cash and the bank s deposits at the Fed 5 The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals 6 The required reserve ratio is the percentage of their deposits banks are required to hold by the Fed If banks choose to hold an additional amount this is called the excess reserve ratio 7 An Example of the Creation of Money The first 7 rounds of the money creation process is illustrated on the following table Assume a deposit of 10 000 and a reserve ratio of 20 percent Assume that all new money remains in the banking system none is held as currency 8 An Example of the Creation of Money 9 Determining How Many Demand Deposits Will Be Created To find the total amount of deposits that will eventually be created multiply the original deposited amount by 1 r where r is the reserve ratio 10 11 12 Determining How Many Demand Deposits Will Be Created If the original deposit is 100 and the reserve ratio is 10 percent then Money multiplier 1 10 10 Multiply original deposit by the multiplier 10 X 100 1 000 13 Equation 10 2



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