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Econ 381 Lecture 17- Microfoundations of Money
Terms in this set (30)
Bank Balance Sheet
An accounting statement of the assets and liabilities that a bank owns
Reserve Requirement (rr(bar)):
The minimum fraction of deposits that banks must (by law) hold as reserves
The use of borrowed money to supplement existing funds for purposes of investment
The ratio of total liabilities (or assets) to capital/equity
Reserve-Deposit Ratio (rr):
The actual fraction of deposits that banks choose to hold as reserves
Currency-Deposit Ratio (cr):
The fraction assets that people choose to hold as cash
What is the difference between M1 and the Monetary Base? Which does the Federal Reserve have more direct control over?
1. Monetary Base: The total # of dollars held by the public as currency, and by the banks as reserves
The Feds have direct control
2. M1: A metric representing the Money Supply, and includes (1) Physical Currency, (2) Checking Accounts, (3) Demand Deposits, and (4) Negotiable Orders of Withdrawal (NOW) accounts
M1 is often used to determine the amount of dollars circulating in an economy
Be able to draw a simple bank balance sheet, highlighting specific assets and liabilities:
- Assets = Liabilities
--> (Gov. & Corp. Bonds)
- Capital/Owner's Equity
In general terms, how does the fractional reserve ranking system effect the money supply?
1. By only keeping enough in reserves to equal the demand for withdrawals, the banks increase the amount of money loaned to the economy.
2. When the money multiplier increases, the amount of currency that an economy starts and finishes with will have different values, because that money that was deposited, was then able to be loaned out (because of fractional reserve banking), after being loaned out, the money is eventually deposited, and then loaned out again, over and over again.
Be able to explain how a simple money multiplier (1/rr(bar)) can expand the money supply from what is printed in currency:
1. When the money multiplier increases, the amount of currency that an economy starts and finishes with will have different values, because that money that was deposited, was then able to be loaned out (because of fractional reserve banking), after being loaned out, the money is eventually deposited, and then loaned out again, over and over again.
2. The money multiplier is the increase in the money supply, resulting from a $1 increase in the monetary base
Be able to calculate the leverage ratio from a slightly more advanced bank balance sheet:
See example from HW
Be able to explain how the leverage ratio tells us how much asset losses a bank can absorb before going bankrupt:
When the value of assets decrease to a point where the bank's value of assets is equal to the bank's capital coming from deposits and debts, then the bank's new equity level is equal to zero. This is because the debt holders and depositors are paid first.
Be able to explain how high amounts of leverage by banks and households wee part of causes of the Great Recession:
1. In 2008-2009, because of the bank leverage levels, the losses to bank capital were proportionately higher than the losses to bank's assets.
2. Sometimes these losses were so large that the assets fell below liabilities.
3. When assets fall below liabilities, we see banks become insolvent, sending bank capital levels to below zero.
Be able to show how the money supply is related to the monetary base, the reserve-deposit ratio, and the currency-deposit ratio.
Be able to derive the new money multiplier that accounts for currency holdings:
#1- Solving relationship btw M^s & ...
1. Ms= C + D, & Mb= C + R
2. M/B= ((C/D) + (D/D)) / ((C/D) + (R/D))
3. Replace C/D w/: cr, and R/D w/: rr
--> M/B= (cr + (1)) / (cr + rr)
4. Solve for M: M= ((cr + 1) / (cr + rr))*B
#2- Deriving new Money Multiplier:
1. Realize that after finding: M= ((cr + 1) / (cr + rr)) * B,
replace (cr + 1) / (cr + rr), with: 'm'
2. This is your new money multiplier
3. Thus, M= (m)*(B)
How are excess reserves different than actual reserves?
Excess reserves refers to the amount of additional reserves that a bank holds above the actual reserves, (also known as the reserve requirement set by the federal reserve).
How do changes in the (1) monetary base, (2) reserve-deposit ratio, and (3) currency-deposit ratio affect the money supply?
1. Increase in Mb = Increase in Ms, by same percentage
2. Decrease in rr = Increase in (m), and also an increase in Ms
3. Decrease in cr = Increase in (m), and also an increase in Ms
Describe why the depositing behavior of consumers and the lending behavior of banks placed limits on monetary policy following the Great Recession:
1. Because of consumers' loss of confidence in the banks, the consumers ended up increase cr, and thus reducing (m). At the same time, banks became more cautious, the banks ended up increasing rr, and thus reducing (m)
2. When the monetary policy, "Quantitative Easing", was implemented, the banks took the opportunity to increase the amount held in reserves. By banks increasing the amount of money held in reserves, this meant that less money was loaned out to the economy. Thus, this decision by the banks prevented the normal process of money creation that occurs in a system of Fractional-Reserve Banking
Money has three purposes:
1. Store of Value
2. Unit of Value
3. Medium of Exchange
If banks hold 100% of deposits in reserve, then the banking system has what type of an affect on Money Supply?
When the banks hold 100% of deposits in reserve, the banking system doesn't have any affect on the Money Supply
The Model of the Money Supply has three exogenous variables:
1. Monetary Base
2. Reserve-Deposit Ratio
3. Currency-Deposit Ratio
Why is the monetary base also known as "High-Powered Money"?
Because the Monetary Base has a multiplying effect on the Money Supply
As the Money Supply model shows, the money multiplier is the link between:
The Money Supply and the Monetary Base
What does the money multiplier depend on?
The Reserve-Deposit Ratio
What does the reserve-deposit ratio depend on?
What does the reserve-deposit ratio influence?
1. The rr depends on what Federal Policy instruments are implemented
2. The rr influences the money multiplier
Why can't the fed precisely control Money Supply (2)?
1. Households can change 'cr', leading to a change in both 'm' and 'M'.
2. Banks often hold excess reserves
Feds control the money supply with (4):
1. Open Market Operations
2. Reserve Requirements
3. Discount Rates
4. Interest on Reserves
Because banks are highly leveraged, a _____ decrease in value of bank's assets can have a ____ impact on bank capital:
1. Small decrease in value of banks assets
2. Huge impact on bank capital
The stock of assets that can be readily used to make transactions
To understand what determines the Money Supply under fractional-reserve banking, we need to take into account the interaction among (3):
1. The Feds decision about how many dollars to create
2. The Banks decision about whether to hold deposits as reserves or to lend them out
3. The households decision about whether to hold their money in currency or demand deposits
M1- Demand deposits, travelers checks, or other checkable assets
M2- M1 + small time deposits, saving deposits, money market mutual funds, money market deposit accounts
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