Chapter.17 section 1

1. Chapter.17 section 1 Money Creation, the Federal Reserve System, and Monetary Policy

2. Ch. 17 How Banks Works (please read) • Operating a Bank: banks provide savers and borrowers with important services, but they do not do this for free. There is a relationship between risk and rate of return. In general, the greater the return offered by an investment, the greater the risk associated with the investment. Banks manage their assets and liabilities to reduce their risks. A bank would be wrong to make nothing but automobile loans. If something happened that caused many of these loans to go bad, the bank could be in deep trouble. It would be equally wrong to offer only certificates of deposits to savers. By diversifying, banks are able to control their risk and improve the probability that they will earn a profit.

3. Getting a Charter • Charter is the right to operate. • Apply to state banking or to U.S. Comptroller of the Currency to start up a national bank. • Considering the application, the chartering agency would review the quality of management, the need for another bank in the community

4. Getting a Charter • The founders plan to invest $1,000,000 in the bank, indicate on charter application. • Charter is granted, they incorporate, issuing themselves shares of stock, or certificates of ownership. Stock shares net worth $1,000,000. • Net worth: Assets minus liabilities; also called owners’ equity

5. continue • The owners invest this $1,000,00 buying, furnishing, and building the bank. • Asset: is any physical property or financial claim owned by the bank.

6. Bank Balance Sheet • Liability: is an amount the banks owes. • Balance sheet: A financial statement showing assets, liabilities, and net worth at a given time; assets must equal liabilities plus net worth, so the statement is in balance. • Two sides of the ledger must always be equal, or be in balance, which is why it’s called a balance sheet • Assets must equal liabilities plus net worth. • Assets= Liabilities + Net Worth

7. Reserve Accounts • The Fed requires Home Banks to set aside, or to hold in reserve, a percentage of checkable deposits. • Required reserve ratio: dictates the minimum proportion of deposits the bank must keep in reserve. • The dollar amount that must be held in reserve is called required reserves- checkable deposits multiplied by the required reserve ratio.

8. continued • The bank is required to hold a % of the reserve requirement of a checkable deposits. • Excess reserves- Bank reserves in excess of required reserves.

9. The Fed Makes a Move • New Funds deposited in a bank can be multiplied into much larger increases in the total deposits over time. • When the fed buys a bond from a bank, the money paid is new to the economy. • The bank will have increased reserves that it will loan or spend some other way.

10. continued • When the money is spent, it is received as income by someone else, who will deposit it back into a bank. • The banks then, after holding back its required reserve, will make additional loans or invest these funds in some other way.

11. continued • This cycle of deposits, reserves, loans, spending, and more deposits is repeated many times, causing the amount of money in the economy to grow by much more than the amount of the original bond purchase.

12. Money Multiplier • Is limited by the required reserve ratio. • When banks are required to keep more deposits on reserve, they are able to make few loans and the process will be slowed.

13. Chapter 17 section 2 Monetary Policy In the Short Run • People demand money so they can complete financial transactions and to hold as a store of value. • The amount they wish to hold at any time depends on many factors, including the interest rate. • When interest rates are high, people are willing to hold less money.

14. Money supply • Is determined by the amount of money that the Federal Reserve System has placed in the economy. • It can be viewed as a vertical line graph. • The intersection of a demand for money with the supply of money determines the market interest rate in the economy.

15. continued • An increase in the money supply will lead to a lower interest rate while a decrease in the money supply will cause a higher market interest rate. • Lower interest rates stimulate the economy while higher rates slow its growth.

16. Federal Funds • The Fed sets targets for the federal funds rate, which is the rate banks charge each other for borrowing bank reserves. • The Fed targets this rate because it has tighter control over it than other in than other interest rates. • When the Fed changes its target for the federal funs rate, most other interest rates change, too.

17. Chapter 17 section 3 Monetary Policy in the Long Run • Production in the long run cannot be sustained above the economy’s potential. • Efforts to expand aggregate demand and production beyond its potential can succeed in the short run, but will cause prices to rise and production to fall back to its potential in the long run.

18. Monetary authority • All economically developed nations have a monetary authority similar to the Fed. • In some nations, this authority is quite independent of the political process. • In others, it is controlled by political figures in the government. • In these latter nations, rates of inflation have tended to be higher than in other nations where the monetary authorities are more independent.

19. Deflation • Deflation makes it more difficult for those in debt to repay their loans and discourages businesses from investing in new facilities or hiring as many workers. • Some people think there is a danger of deflation in the United States and in other developed nations.

20. Lags in monetary policy • There are lags in the effectiveness of monetary policy. • It takes time for the Fed to recognize that there is a problem, decide what action to take, implement the policy, and for the economy to react to the changed policy.