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Unit Three: Banking and Monetary Policy

Unit Three: Banking and Monetary Policy. Topic: The Creation of Money in the Banking System. Learning Targets. I will describe what a balance sheet is used for, and be able to fill in a balance sheet based on given scenarios.

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Unit Three: Banking and Monetary Policy

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  1. Unit Three: Banking and Monetary Policy Topic: The Creation of Money in the Banking System

  2. Learning Targets • I will describe what a balance sheet is used for, and be able to fill in a balance sheet based on given scenarios. • I will be able to define a fractional reserve banking system, and I will be able to show how it is used to create money. • I will know how to calculate and use the money multiplier. • I will list and describe the possible leakages from the money system.

  3. Balance Sheet • Def: statement of a assets and claims on a bank at a particular time; also called a T-account. • Assets = liabilities + net worth • Assets: what a bank owns. • Liabilities: claims of non-owners against the firm’s assets (what a bank owes). • Net worth: the difference between assets and liabilities; if it becomes negative, the bank is heading towards bankruptcy.

  4. Fractional Reserve Banking System • Def: banks only hold part of the total deposits in currency. • The Fed determines the rate of holdings. • Characteristics: • Money creation • Reserves • Bank panics • Regulation

  5. Example of Money Creation • We are going through a VERY simplified version of money creation. • We are going to assume that our banks have the ability to have a net worth of zero.

  6. ASSETS $100 (required reserves) $900 (loans) LIABILITIES AND NET WORTH $1000 T-Account: Smith National BankDeposit of $1000; 10% reserve ratio

  7. Ta-da! • What happens to the $900 in loans? • Dave takes out $900 in loans, and buys a used computer from his friend, Katie, for $900. What will Katie do? • Deposit $900 in her bank, Austin National Bank.

  8. ASSETS $90 (required reserves) $810 (loans) LIABILITIES AND NET WORTH $900 T-Account: Austin National BankDeposit of $900; 10% reserve ratio

  9. Ta-da! • What happens to the $810 in loans? • Ava takes out a loan for $810 to buy her mommy a birthday present. What does her mommy do? • Her mommy deposits the money in her bank, Killian National Bank.

  10. ASSETS $81 (required reserves) $729 (loans) LIABILITIES AND NET WORTH $810 T-Account: Killian Nat’l BankDeposit of $810; 10% reserve ratio

  11. Ta-da! (last time, I promise)! • What happens to the $729 in loans? • Batman takes out a loan…blah, blah, blah…more money is created!!!

  12. The Money Multiplier • Def: tells us how much money is created from an initial deposit. • The numerical value of the money multiplier is the reciprocal of the reserve ratio (in our example, the reserve ratio is 10% or 1/10, so the multiplier would be 10). • To find out how much money would be created, multiply the initial deposit by the multiplier (in our example, the initial deposit is $1000, so $10,000 would be created).

  13. Leakages • Money can “leak” out of the system: • if it is not borrowed; • if banks do not lend out all of the deposits (called excess reserves – keeping more money than required); • cash leakages (not deposited, hid under mattress, in the fridge, etc.).

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