Federal Reserve Money Creation

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Federal Reserve Money Creation
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Lets turn to an example of Fed action that
starts the process going. Here again we assume
no currency. In the example that follows we have
a very similar story to the one we just
completed. But in what follows we start with no
bank having excess reserves to lend until the FED
makes an action. Banks have lent all they can.
So, banks have assets and liabilities and they
have just enough reserves. We will start with a
bank and not know the value of its assets and
liabilities. But we do not need to know the
totals here, only the changes need be known.
The FED action is to purchase bonds from a bank.
The bonds the bank can hold are US government
bonds. The FED pays for the bonds by giving the
bank reserves.
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A L NW
Lets assume the bank has no excess reserves and
the reserve requirement r 0.10, or 10. Now
say the Fed buys 10 worth of the banks bonds.
The Fed does this by taking the bonds and
increases the BR of the bank. Since the bank was
already meeting its reserve requirements the new
reserves are all excess and can be lent. The
loan will be spent. The final position on this
bank is the 10 in bonds moved to 10 more in
loans. But we are not done.
B 10 BR 10
L 10 D 10
BR 10 D -10
L 10 B -10
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Round 2 round 3
BR10 D 10 L 9 D
9 BR -9 D -9 BR 1 D 10 L 9
BR 9 D 9 L 8.10 D 8.10 BR 8.10
D -8.10 BR .9 D 9 L 8.100
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When the first bank lent the 10, stuff was bought
and the money ends up in the bank of the seller
of the stuff. That bank now has 10 more in D and
10 more in BR, so with a r .1 it can lend 9 and
keep 1 in BR to meet the new deposit
requirement. The process repeats and the next
bank gets 9 in D and 9 in BR, but only has to
keep .9 in BR and can loan the rest. This goes
on and on with other banks. The change in the
money supply within the banking system from the
Fed action is (10 9 8.1 ) 10 (1 .9
.92 ) 10(1/.1) 100 10(1/r) the initial
excess reserves divided by the required reserve
ratio.
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The Federal Reserve
The Federal Reserve, hereafter called the Fed, is
the central bank in the US. It is often called a
bankers bank or a lender of last resort. The
Fed is the organization in the economy that can
influence the money supply in the US. The three
tools it can use to influence the money supply -
currency and checkable deposits - are 1) open
market operations (buying and selling bonds) 2)
reserve requirement setting policy 3) discount
rate policy.
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reserve requirements
If the Fed changes the reserve requirement then
banks have to adjust the amount of demand
deposits they hold. A decrease in the reserve
requirement would mean that banks have more to
lend and the money supply could expand.
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discount rate
The discount rate is the rate at which the Fed
would lend to banks. Do not confuse this rate
with the Fed Funds rate, the rate banks lend to
each other. The two are related, though. If
the Fed lowered the discount rate it would make
it more attractive for banks to borrow from the
Fed. In reality, what the Fed does when it lends
is to put reserves into the bank. The bank can
then lend out the reserves.