MACRO TEST 4:
Medium of ExchangeCommodity Standard
Fiduciary Standard
M1
M2
Liquidity
Federal Reserve
Reserve Ratio
(Reserve Requirement)
Reserves
Required Reserves
Excess Reserves
Loaned Up (Loaned Out)
Excess Reserve Ratio
Currency Ratio
Currency Drain
Deposit Multiplier
Credit Multiplier
Money Multiplier
Discount Rate
Open Market Operations
Federal Funds Rate
The Federal Reserve System is the Central Bank of the United States.
It sets many of the rules and regulations by which banks and other financial institutions must abide. It holds deposits of banks, acts as a clearinghouse for checks, distributes and retires currency, sets reserve ratios, lends to banks via its discount window, buys and sells government securities in the open market, performs bank inspections, and acts as the fiscal agent of our federal government. In so doing, it controls our money supply and influences the levels of various short term interest rates. In other words, it is the author of our Monetary Policy.
As shown above, there are 12 Federal Reserve District Banks, each of which oversees banking activity within its own region.
1 – Boston 2 – New York 3 – Philadelphia 4 – Cleveland 5 – Richmond 6 – Atlanta 7 – Chicago 8 – St. Louis 9 – Minneapolis 10 – Kansas City 11 – Dallas
Reserves are the liquid assets held by banks. These reserves are mostly in the form of cash.
As the central bank of the U.S., the Federal Reserve has the power to set the reserve ratio for banks.
The reserve ratio tells banks the percentage of their deposits that they can not lend or invest. It ensures a bank’s liquidity and it reassures depositors, who are the principal source of any bank’s funds.
Because the reserve ratio must be obeyed, it is also sometimes called the reserve requirement.
A bank must hold enough liquid assets to meet this requirement. But it may hold more than enough. The amount of reserves they must hold is called the required reserves. Any amount above the required level is called excess reserves.
Banks usually want to have no excess reserves, because lending and investing is the way they make a profit. When a bank has loaned or invested all its excess reserves and has nothing left to lend, the bank is loaned up or loaned out.
Bank Reserves = Required Reserves + Excess Reserves
To test your understanding, fill in the chart below ☺
Suppose the Federal Reserve sets the reserve ratio = 10 %
Bank Deposit
Required Reserves
Excess Reserves
Maximum Loans & Inv.
Actual
Loans & Inv. Loaned Up?
100$ 10$ 90$ 90$ 90$ Yes
800$ 80$ 720$ 720$ 720$ Yes
2000$ 200$ 1800$ 1800$ 1600$ No
500$ 400$
Because each bank has the power to create money by lending or investing, a small injection of reserves into the banking system may lead to a large multiple expansion of the money supply.
To estimate deposit creation based on injected reserves, one needs only to take the reciprocal of the reserve ratio.
Deposit Multiplier = d = 1 / r where r = reserve ratio set by the Federal Reserve
and Deposits = D = d (R) where R = reserves
The same reciprocal can be used to estimate the amount of new money or credit that is created via a series of bank loans or investments.
Credit Multiplier = d = 1 / r where r = reserve ratio set by the Federal Reserve
and Credit = CR = d (ER) where ER = excess reserves; i.e. loanable reserves
Finally, we find a similar relation exists between the entire money supply and the monetary base.
Money Multiplier = m = (1 + c) / (r + e + c) where c = currency ratio = currency/deposits r = reserve ratio = required reserves/deposits e = excess reserve ratio = excess reserves/deposits
Monetary Base = B = Required reserves + Excess Reserves + Currency = RR + ER + C
Money Supply = (Money Multiplier) (Monetary Base) = m (B)
Regarding Interest Rates:
The price of money, the cost of borrowing money, is called the interest rate. Different loans have different characteristics and different risks. Thus, their interest rates will differ. But all rates that are quoted in the market are called nominal rates. And all these nominal rates include a reward, the so-called real rate of interest. Of course, nominal rates also include any expected devaluation of repaid funds in the form of additional interest. This additional interest, which is related to inflationary expectations, is called the inflation premium.
Market Interest Rates = Nominal Interest Rates = Real Interest Rates + Inflation Premium
• If inflation is expected to be high, then the premium will rise and so will the nominal or market rate of interest.
Expansionary Monetary Policy:
(used to stimulate a recessionary economy)The equilibrium interest rate is found where the demand and supply of money intersect.
If the money supply expands (shifts to the right) then the interest rate will fall.
The interest rate most immediately sensitive to an increased money supply is the federal funds rate, the rate that banks charge each other for overnight loans.
But if a consistent and significant increase in the money supply takes place, other rates like the prime and
mortgage rates will also fall.
Lower interest rates make it cheaper to borrow money for investment and the purchase of durable goods, such as cars and homes. This stimulates the demand for goods and creates jobs.
This is why expansionary policy is useful during a recession.
Problem: recession
Solution: expansionary monetary policy
Achieved: when the Federal Reserve: 1) lowers reserve ratio - allowing banks to lend more
2) lowers discount rate – making it inexpensive for banks to borrow more reserves from the Fed
3) buys securities in the open market – providing banks with more reserves
more money…..….lower i-rates……..more investment…...more output, income, & jobs
Contractionary Monetary Policy
involves a reduction in the money supply and has the opposite effect. Thus it is appropriate during inflation.Problem: inflation
Practice for Test # 4:
Multiple Choice:_______Which definition of money is the first to include small time deposits? A) M1 B) M2 C) M3 D) M4
_______Most money is: A) printed or coined B) created when banks lend or invest
C) not very liquid D) backed by gold or silver
_______Which of the following is the Central Bank of the U. S.? A) Federal Reserve
B) Treasury C) Comptroller of the Currency D) FDIC
_______What is the rate that banks charge each other for overnight loans? A) prime B) nominal C) federal funds D) real E) market
_______During a recession, increasing the money supply will: A) lower interest rates
B) raise interest rates C) slow the economy D) none of the above _______Higher interest rates will: A) encourage investment B) boost the economy
C) discourage consumption of durable goods D) none of the above
Fill Ins:
Fiduciary………..is a standard of money based on faith
Liquidity………..is the ease with which an asset can be cashed or used as cash
Prime Rate………is the rate that banks charge their best corporate customers
Discount Rate………...is the rate that the Central Bank charges banks for loans
Federal Funds Rate………..is the rate which is most sensitive to the Central Bank’s buying or selling of government securities
Money Multiplier………….is the rate of change in the money supply due to a change in base money
Federal Funds Rate………...is the rate that banks charge each other for overnight loans
Real Interest Rates………= (nominal interest rates) - (inflation premium)
Federal Reserve System…….is the Central Bank of the United States
Banks………..are the most important financial intermediaries
Excess Reserves……….are the liquid assets that banks hold beyond the required amount
Base Money………= (liquid assets inside banks) + (currency held outside banks)
Required Reserves…………..are the liquid assets that banks must hold
INCREASE, DECREASE or STAYS the SAME:
If the reserve ratio falls, then the money supply will: …..increase
If the discount rate rises, then borrowed reserves will: ….decrease
If the Central Bank sells government securities, the price of securities will: ….decrease
If the Central Bank sells government securities, then interest rates will: ….increase
If the excess reserve ratio falls, then the money multiplier will: …..increase
If a currency drain occurs, then the money supply will: …..decrease
In a fully employed economy, if the money supply rises, the price level will: ….increase
List 3 specific actions of the Central Bank that would expand the money supply and lower interest rates:
a)…….lower reserve requirement
b)…...lower discount rate
c)…….Buy securities on the open market
When are such actions warranted?...during recession
List 3 specific actions of the Central Bank that would shrink the money supply and raise interest rates:
a)…….raise reserve requirement
b)…...raise discount rate
c)…….Sell securities on the open market
When are such actions warranted?...during inflation
