Slide 1FOMC Press Release, September 21, 2010Questions of the Day16.1 Banks and money creationSlide 5BANKINGFDI’s and the EconomyBalance Sheet of a BankBalance Sheet (cont)Banks and Money Creation: ExampleBank Balance Sheet (cont)Banks and Money Creation: ExampleBanks and Money Creation: Step 1Banks and Money Creation: Step 2Banks and Money Creation: Step 3Money Multiplier FormulaSlide 17Effect on Money Supply (M1)16.2 Tools of the fed and how they workTOOLS OF THE FEDERAL RESERVEFederal Reserve System and PoliciesTools of the Fed: Open Market OperationsFederal Funds Market: Banks Lend to Each OtherFederal Funds Market: Banks Lend to Each OtherTools of the Fed: Open Market OperationsTools of the Fed: Open Market OperationsTools of the Fed: Open Market OperationsTools of the Fed: Open Market OperationsFederal Funds Market: Banks Lend to Each OtherTools of the Fed: Open Market OperationsTools of the Fed: Discount RateFederal Funds Market: Banks Lend to Each OtherDiscount Rate: Banks Borrow from FedTools of the Fed: Discount RateTools of the Fed: Reserve RequirementTools of the Fed: Reserve RequirementTools of the Fed: Reserve RequirementTools of the Fed: Open Market OperationsLimitations to Monetary PolicyTools of the Fed: Summary TableKey Terms and ConceptsPractice: Money Creation“Big Banks Go to Discount Window”TOPIC XVI:MONEY CREATION AND THE FED II1FOMC Press Release, September 21, 2010•Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending … is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak.•Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the long run, with its mandate to promote maximum employment and price stability. …inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.•The Committee will maintain the target range for the federal funds rate at 0 to ¼ percent and continues to anticipate that economic conditions … are likely to warrant exceptionally low levels for the federal funds rate for an extended period.•The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economy recover and return inflation, over time, to levels consistent with its mandate.Questions of the Day•When you deposit $200 into your bank account, where does your money go?•The Federal Reserve controls the nation’s money supply, but banks can inflate or deflate the amount•How does this work?•What tools does the Federal Reserve have to manipulate (control) the nation’s money supply?•How do they work?16.1 BANKS AND MONEY CREATIONFINANCIAL INSTITUTIONSDepository InstitutionsCommercial BanksThriftsSavings & LoansCredit unionsNon-depository InstitutionsFinance co’sSecurities firmsInsurance co’sInvestment co’sFinancial conglomeratesOur FocusBANKINGFederal Depository Institutions (FDI’s) – any institution that:1. Accepts and maintains deposits and2. Makes loans•Includes commercial banks and thrift institutions•Commercial Banks•Bank of America, First Tennessee, SunTrust, Regions, etc•Thrift Institutions•credit unions (UT Federal Credit Union)•savings banks•savings and loans associations6FDI’s and the EconomyQ: What do banks do? Why do we have them? What is their economic purpose?A: Banks exist to help borrowers (families for new homes, business to start or expand) connect with lenders/savers•In addition, they play a role in the supply of money by “creating” and/or “destroying” money; (by saying creating and destroying we more mean inflating and deflating) •Through checkable (demand) deposits, which are part of M1 and M2 7Balance Sheet of a BankBanks use a T-account as a balance sheet •assets go on the left•liabilities and equity go on the right•the two sides must equal8AssetsLiabilities + Owner’s EquityLeft sideRight side Debit CreditBalance Sheet (cont)The assets, liabilities and equity are from the bank’s point of view!Assets• Reserves •cash on hand (physically in bank vaults)•deposits with the Fed•Loans •To customers (money owed to the bank)•To others (government or other banks)Liabilities•Deposits (such as checking and savings)•Money the bank owes you 9Banks and Money Creation: Example How do banks “create” money?Fractional Reserve Banking – banks hold only a portion of their deposits as reserves and loan the rest out Required Reserve Ratio (rr or R) •The % of deposits banks must hold in the form of reserves•Set by the Federal Reserve•If rr = 10%, for every $100 deposited:•banks must hold at least $10 as reserves (either in vaults or with the Fed)•They can loan out at most $9010Bank Balance Sheet (cont)Q. When you deposit $200 into your checking account, what does the bank do with your money?A. It holds some, and loans the rest out Bank A Balance SheetAssets LiabilitiesReserves: $20Deposits: $200Loans: govt. bonds $50 mortgages businesses$200 $200$130Banks and Money Creation: Example •Suppose Adele deposits $1,000 cash into her checking account in Bank A•Suppose that rr = 10%1. What happens to the balance sheet of Bank A?2. What happens to the money supply (M1)?12Banks and Money Creation: Step 1Bank A Balance SheetAssets Liabilitiesreserves: deposits: $1,000loans: $900 +$1,000+$1,000M1$1,000+ $900$1,90013Bank A keeps $100 of the $1,000 as reserves, and loans out the rest, $900, to Beyonce$100Effect on M1 Money SupplyThe money supply has increased by $900. Bank A has “created” $900Started with “created” by Bank AAmount of M1Banks and Money Creation: Step 2Bank B Balance SheetAssets Liabilitiesreserves: deposits: $900loans: $810 $900 $900M1$1,000 started with+ $900+ $810“created” by Bank A$2,71014Bank B keeps $90 of the $900 as reserves, and loans out the rest, $810, to Cher$90Effect on M1 Money SupplyThe money supply has increased by another $810. Bank B has “created” $810“created” by bank BAmount of M1Banks and Money Creation: Step 3Bank C Balance SheetAssets Liabilitiesreserves: deposits: $810loans: $729$810