CHAPTER 12 (23):

MONEY CREATION AND THE

FEDERAL RESERVE

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COREECONOMICS, 3RD EDITION BY ERIC CHIANG
Slides by Debbie Evercloud
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 CHAPTER OUTLINE
• How Banks Create Money
• The Money Multiplier and Its Leakages
• The Federal Reserve System
• The Federal Reserve at Work

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 LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Explain how banks create money
– Define fractional reserve banking
– Define banking regulations, such as reserve
requirements and deposit insurance
– Explain the money multiplier

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 LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Describe the history and structure of the Federal
Reserve System
– Describe the Federal Reserve’s principal
monetary tools
– Explain open market operations
– Explain why Federal Reserve policies take time
to affect the economy

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 EXAMPLE: MICROLOANS
• Microloans have facilitated the growth of
entrepreneurship in developing countries.
• In both poor and wealthy countries, the
presence of lenders is crucial to the
process of investment.
• This chapter looks at the process of
money creation in which banks accept
deposits from savers and channel these
funds to borrowers.
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 BY THE NUMBERS:
THE MONETARY BASE
St. Louis Adjusted Monetary Base
4500.0

4000.0

3500.0

3000.0

2500.0
Billions of Dollars

2000.0

1500.0

1000.0

500.0

0.0
84 85 8 6 87 8 8 8 9 90 91 92 9 3 94 95 9 7 98 99 0 0 01 0 2 03 04 0 5 06 0 7 08 0 9 1 0 12 1 3 14 15 1 6 17 1 8 1 9
/19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /19 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20
9 7 3 0 5 2 8 4 0 7 3 0 5 1 0 5 2 9 5 1 7 3 0 5 2 9 5 0 9 5 1 7 4 1
2 /2 3/2 4/2 5/2 6/1 7/1 8/0 9/0 9/3 0/2 1/2 2/2 1/1 2/1 3/1 4/0 5/0 5/2 6/2 7/2 8/1 9/1 0/1 1/0 2/0 2/2 1/2 2/2 3/1 4/1 5/1 6/0 7/0 7/3
0 0 0 0 0 0 0 0 0 1 1 1 0 0 0 0 0 0 0 0 0 0 1 1 1 1 0 0 0 0 0 0 0 0
Source: Federal Reserve Bank of St. Louis/FRED

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 MONEY CREATION
• The primary purpose of financial markets
and institutions is to act as conduits for
transferring funds from lenders to
borrowers.
• By accepting deposits and making loans,
however, banks and other financial
institutions are also able to create money.

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 MONEY CREATION
• When you deposit cash in your checking
account, the bank acquires an asset in the
form of cash.
• The bank also acquires a liability in the
form of a checking account balance that
must be honored on demand.

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 MONEY CREATION
• When the bank makes a loan, it does so
by creating a checking account balance for
the loan customer.
• This balance is a liability for the bank,
because it must be honored on demand.
• Alongside the liability, the bank now has
an asset in the form of a loan that the
customer is obligated to pay.

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 MONEY CREATION
• A bank’s reserve ratio is the level of
reserves its holds as a percentage of
total deposits.
• The government requires that banks
maintain a minimum level of reserves
called the reserve requirement.

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 MONEY CREATION
• Financial institutions operate as part of a
fractional reserve banking system.
– When someone deposits money into a bank
account, the bank is required to hold part of
this deposit as cash, or in an account with the
regional Federal Reserve Bank.

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 MONEY CREATION
• Banks create money by loaning out their
excess reserves.
• An initial deposit of cash can be turned
into loans and deposits many times over.
• This demonstrates the power of the
banking system to create money.

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 CHECKPOINT:
HOW BANKS CREATE
MONEY

PAUSE

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 CHECKPOINT:
HOW BANKS CREATE
MONEY
• The fractional reserve system permits
banks to create money through their ability
to accept deposits and make loans.
• The reserve ratio is the fraction of total
customer deposits held as reserves.
• The reserve requirement is the minimum
reserve ratio banks must follow.

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 MONEY CREATION
• The money multiplier measures the
potential or maximum amount the money
supply can increase when new deposits
enter the system.
• The money multiplier is defined as:
Money Multiplier = 1 / Reserve Requirement

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 MONEY CREATION
• When the government expands the money
supply, it does so by adding reserves
electronically to banks in exchange for
bonds and other assets.
• Banks will then make loans against these
excess reserves.
• The expansion process is compounded by
the money multiplier.

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 MONEY CREATION
• The potential money multiplier and the
actual money multiplier are rarely the
same because of money leakages.
– A leakage is money that leaves the money
creation process because of an action taken
by a bank, an individual, or a business.

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 LEAKAGES
• A bank faces a solvency crisis if its
liabilities exceed its assets.
– Banks are exposed to the risk of becoming
insolvent when borrowers default on loans.
– The loan is lost as an asset, but the liabilities to
depositors remain.
– Consequently, banks may hold excess reserves
during tough economic times to increase their
ability to absorb a higher rate of defaults.

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 LEAKAGES
• When banks choose not to loan all of their
excess reserves, the actual money
multiplier is reduced.
– The reduction in loans recirculates less
money back through the banking system.

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 ISSUE: THE MONEY
MULTIPLIER
• The consequences of the housing crisis
led banks to tighten their lending practices.
• As a result, the money multiplier fell
dramatically from 2008 to 2009.
– The Federal Reserve has compensated for
the low money multiplier by injecting even
more money into the banking system,
dramatically increasing the monetary base.

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 LEAKAGES
• When individuals or businesses choose to
keep money in cash rather than in bank
deposits, there is a leakage in the money
supply.
– That money is not available to be loaned to
someone else.
– The actual money multiplier is reduced.

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 LEAKAGES
• The role that the U.S. dollar plays as the
world’s most popular reserve currency
causes the majority of dollars to be held
outside of U.S. borders.
– This has the effect of reducing the actual
money multiplier relative to its potential.

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 LEAKAGES
• What is a leakage-adjusted money
multiplier?
– It takes into account the required reserve
requirement along with excess reserves held
by banks and cash held by individuals and
businesses.

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 LEAKAGES
• During the 2007–2009 recession, the
money multiplier fell precipitously from
1.7 to less than 1.
– A money multiplier of less than 1 means that
fewer loans were being made than the new
money introduced to the economy.

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 CHECKPOINT: THE MONEY
MULTIPLIER AND ITS LEAKAGES

PAUSE

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 CHECKPOINT: THE MONEY
MULTIPLIER AND ITS LEAKAGES
• The potential money multiplier is equal to 1
divided by the reserve requirement.
• Money leakages are caused by banks
holding excess reserves and by individuals
and businesses holding a portion of their
funds in cash.
• The leakage-adjusted money multiplier
provides a more realistic estimate of the
money multiplier in the economy.
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 THE FEDERAL RESERVE
SYSTEM
• The Federal Reserve System is the
central bank of the United States.
• The Federal Reserve Act of 1913 was a
compromise between proposals for a huge
central bank and for no central bank at all.
• The Federal Reserve is an independent
central bank, in that its actions are not
subject to executive branch control.

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 THE FEDERAL RESERVE
SYSTEM
• The Fed is composed of:
– The Board of Governors, located in
Washington, D.C.
– Twelve regional Federal Reserve Banks in
major cities around the nation

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 THE FEDERAL RESERVE
SYSTEM

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 FUNCTIONS OF THE FEDERAL RESERVE

• The Fed’s Board of Governors consists of

seven members who are appointed by the
President and confirmed by the Senate.
• Twelve Federal Reserve Banks perform a
variety of functions, including:
– Providing a nationwide payments system
– Distributing coins and currency
– Regulating and supervising member banks
– Serving as the banker for the U.S. Treasury
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OPEN MARKET OPERATIONS
• The Federal Open Market Committee
(FMOC) consists of:
– Seven members of the Board of Governors
– Five of the 12 regional Federal Reserve Bank
presidents
• The FOMC oversees open market
operations, the main tool of monetary
policy.

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 LENDER OF LAST RESORT
• The value of the Fed’s ability to provide
loans during a financial crisis stood out
during the financial panic in late 2008.
• In just a few months, the Fed extended
more that $2 trillion in loans.
– Had the Fed and its “lender of last resort”
capability not been available, the 2008–2009
recession would have been much deeper.

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CHECKPOINT: THE FEDERAL
RESERVE SYSTEM

PAUSE

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CHECKPOINT: THE FEDERAL
RESERVE SYSTEM
• The Federal Reserve is the central bank of
the United States.
• The Federal Reserve System is structured
around 12 regional banks and the Board of
Governors.
• The Federal Reserve serves as the lender
of last resort, stepping in to loan money to
banks facing emergency cash shortages.

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 TOOLS OF THE FEDERAL
RESERVE
• The Federal Reserve uses three primary
tools in the conduct of monetary policy:
– Reserve requirements
– The discount rate
– Open market operations

These tools are used to increase or

decrease the money supply.

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 RESERVE REQUIREMENTS
 The reserve requirement is the
required ratio of funds that commercial
banks and other depository institutions
must hold in reserve against deposits.
 A bank with excess reserves can loan
these reserves to another bank and
earn a rate of interest known as the
federal funds rate.

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 DISCOUNT RATE
 The discount rate is the rate regional
Federal Reserve Banks charge depository
institutions for short-term loans to shore up
reserves.
−The discount window also serves as a
back-up source of liquidity.

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OPEN MARKET OPERATIONS
• The Fed uses open market operations to
inject reserves or withdraw reserves from
the banking system.
• Open market operations involve the Fed
buying and selling U.S. government
securities.
• Open market operations are the most
important of the Fed’s policy tools.

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 TARGET FEDERAL FUNDS
RATE
• Targeting the federal funds rate through
open market operations gives the Fed an
ability to influence the price level and
output in the economy.
– The Fed uses open market operations to
adjust reserves and thus change nominal
interest rates, nudging the federal funds rate
toward the Fed’s target.

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 POLICY LAGS
• Monetary policy is subject to four major
time lags:
– Information lag
– Recognition lag
– Decision lag
– Implementation lag

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 ISSUE: WHEN
INTEREST RATES ARE ZERO
• By December 2008, the Federal Reserve
had lowered the federal funds rate target
to essentially 0%.
– Yet, the economy was still struggling and
needed additional help to prevent a deeper
recession.
– The Fed developed new ways to expand the
money supply without using its regular open
market operations.

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 ISSUE: WHEN
INTEREST RATES ARE ZERO
• Tools used by the Fed when interest rates
were zero included:
– The purchase of mortgage-backed securities
– Lending through term auction facilities
– Quantitative easing

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CHECKPOINT: THE FEDERAL
RESERVE AT WORK

PAUSE

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CHECKPOINT: THE FEDERAL
RESERVE AT WORK
• The Fed’s tools include altering reserve
requirements, changing the discount rate,
and open market operations.
• The Fed uses open market operations to
keep the federal funds rate at target levels.
• The Fed’s policies are subject to
information, recognition, decision, and
implementation lags.

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 CHAPTER SUMMARY
• Money is created when banks make loans
that eventually get deposited back into the
system, generating checkable deposits.
• In a fractional reserve banking system,
banks hold only a portion of deposits in
reserves, loaning out the rest.
• The money multiplier is the maximum
amount the money supply can increase
when new deposits enter the system.

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 CHAPTER SUMMARY
• The Federal Reserve System is the central
bank of the United States.
– It is composed of a seven-member Board of
Governors and 12 regional Federal Reserve
Banks.
• The Fed uses three major tools to conduct
monetary policy:
– Reserve requirements
– Discount rate
– Open market operations
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 DISCUSSION QUESTIONS
• What limits the amount of money that can
be created through bank loans?
• Why does the level of banks’ excess
reserves change over time?
• Why did the Federal Reserve change
some of its actions following the financial
crisis of 2007–2009?

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