Slide 1Slide 2FOMC Press Release, September 21, 2010Questions of the Day1. Banks and money creationSlide 6BANKINGFDI’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 18Effect on Money Supply (M1)2. Tools of the fed and how they workTOOLS OF THE FEDERAL RESERVEFederal Reserve System and PoliciesTools of the Fed: Reserve RequirementTools of the Fed: Reserve RequirementTools of the Fed: Reserve RequirementTools of the Fed: Discount RateDiscount Rate: Banks Borrow from FedTools of the Fed: Discount RateTools 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: Open Market OperationsLimitations to Monetary PolicyTools of the Fed: Summary TableKey Terms and ConceptsPractice: Money Creation“Big Banks Go to Discount Window”MONEYWHAT IS IT, WHO CONTROLS IT, AND WHAT IT DOESMoney I: What is money and who is the Fed?Money II: Money Creation and the Fed (again)Money III: The Financial System and Personal Finance1MONEY II:MONEY CREATION AND THE FED II2FOMC 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?1. BANKS AND MONEY CREATIONFINANCIAL INSTITUTIONSDepository InstitutionsCommercial BanksThriftsSavings & LoansCredit unionsNon-depository InstitutionsFinance co’sSecurities firmsInsurance co’sInvestment co’sFinancial conglomeratesBANKINGFederal Depository Institutions (FDI’s) – any institution that:1. Accepts and 2. Makes •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 associations7FDI’s and the EconomyQ: What do banks do? Why do we have them? What is their economic purpose?A: Banks exist to •In addition, they play a role in the supply of money by •Through checkable (demand) deposits, which are part of M1 and M2 8Balance Sheet of a BankBanks use a T-account as a balance sheet •assets go on the •liabilities and equity go on the •the two sides must 9Balance Sheet (cont)The assets, liabilities and equity are from the bank’s point of view!Assets• •cash on hand (physically in bank vaults)•deposits with the •Loans Liabilities•Deposits (such as checking and savings)•money 10Banks and Money Creation: Example How do banks “create” money?Fractional Reserve Banking – banks hold only a portion of Required Reserve Ratio (rr or R) •The % of •Set by•If rr = 10%, for every $100 deposited:•banks must hold at least •They can loan out at most11Bank Balance Sheet (cont)Q. When you deposit $200 into your checking account, what does the bank do with your money?A. Bank A Balance SheetAssets LiabilitiesReserves: Deposits: $200Loans: govt. bonds mortgages businesses$200 $200Banks 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)?13Banks and Money Creation: Step 1Bank A Balance SheetAssets Liabilitiesreserves: deposits: $1,000loans:M1$1,00014Bank A keeps $100 of the $1,000 as reserves, and loans out the rest, $900, to Beyonce$100Effect on M1 Money SupplyThe money supply hasBanks and Money Creation: Step 2Bank B Balance SheetAssets Liabilitiesreserves: deposits: $900loans:M1$1,000 started with+ $900 “created” by Bank A15Bank B keeps $90 of the $900 as reserves, and loans out the rest, $810, to Cher$90Effect on M1 Money SupplyThe money supply hasBanks and Money Creation: Step 3Bank C Balance SheetAssets Liabilitiesreserves: deposits: $810loans:M1$1,000 started with+ $900 “created” by Bank A+ $810 “created” by Bank B16Bank C keeps $81 of the $810 as reserves, and loans out the rest, $729, to Dido$81Effect on M1 Money SupplyThe money supply has increased by another $729!!Bank C has “created” $729!!Money Multiplier FormulaMoney multiplier (or deposit multiplier) = •Used to determine the final amount of the money supply after the entire process is completedFinal money supply (checkable deposits) = New Money Supply = $1,000 x110%+ …+ $729+ $810+ $900started with$1,000M1We started with Adele and $1,000 in cashWe ended with $10,000 in checking accountsThe money supply changed by Effect on Money Supply (M1)18“created” by Banks$1,000Total M10Other Checking0Traveler’s Checks0Commercial Checking$1,000CurrencyM1 AfterM1 BeforeBecause of bank loans, there is a $9,000 change in the final