ECON131 Chapter 12: Money Creation and the Federal Reserve
The Fed announced in September 2013 that it would postpone winding down its monetary stimulus until the economic recovery was stronger. When the Fed does finally begin to reduce bond purchases . . .
interest rates will rise.
Banks create money by . . .
lending their excess reserves, or reserves above the reserve requirement.
The Federal Reserve's Board of Governors consists of . . .
seven members who are appointed by the president and confirmed by the Senate. Board members serve terms of 14 years and cannot be reappointed.
Much of the money creation that occurs in the economy begins with deposits made by . . .
the government.
When the Fed sells bonds and adds to . . .
the market supply of bonds for sale, it lowers prices and raising the nominal interest rate.
Banks hold two types of reserves:
required reserves and excess reserves above what they are required to hold.
The ability of the Fed to make loans and inject the banking system with new money allows . . .
the fractional banking process to work and prevents the economy from facing a much worse financial crisis.
The Twelve Federal Reserve Banks and their branches perform a variety of functions like . . .
providing a nationwide payments system, distributing coins and currency, regulating and supervising member banks, serving as the banker for the U.S. Treasury, and providing the Federal Reserve System and the Board of Governors with information on economic conditions in its home region (Beige Book).
When the Fed buys bonds, its demand . . .
raises the price of bonds, lowering nominal interest rates in the market.
After looking over the past 6 months' worth of data, the Federal Reserve finally realizes that the economy is trending toward a recession. This is an example of . . .
recognition lag.
Used by the Federal Reserve, the three primary tools for conducting monetary policy are . . .
reserve requirements, the discount rate, and open market operations.
Unlike fiscal policy, the Fed's decision lags tend to be . . .
shorter because Fed policies are not subjected to lengthy legislative processes.
The deposits and lending that occur in a bank . . .
starts the money creation process.
The essence of banking is that banks . . .
take in short-term deposits (liabilities) and make long-term, often illiquid, loans (assets).
A lower reserve requirement . . .
increases the ability of banks to make loans.
Economists at the Federal Reserve bank are collecting data that will indicate whether or not expansionary policy has altered the overall price level. The time the Fed must wait for economic data to be collected, processed, and reported is the . . .
information lag.
When an economic event takes place, changes may ripple throughout the economy for up to three months before monetary authorities begin to see changes in the data. This is . . .
information lag.
The principal reason for the existence of central banks is . . .
lending to banks during financial panics or being a lender of last resort.
Because all banks are required to hold a certain percentage of their deposits as reserves in their vault or at their regional Fed bank, the maximum amount of money that can be created is . . .
limited by the reserve requirement.
In the United States, the Federal Deposit Insurance Corporation (FDIC) . . .
protects bank deposits (up to $250,000 per account) from bank failure. It typically arranges for another (healthy) bank to take over the failing bank, resulting in virtually no interruption of services to the bank's customers.
Which of the following lists represents monetary policy actions that are consistent with one another?
sell government bonds, raise reserve requirements, raise the discount rate
If the reserve requirement is 2.5% and a bank initially receives $30,000 in deposits from the Fed, then the maximum amount of money that the banking system can create is . . .
$1.2 million
How much money can be created (plus the initial deposit) if the money multiplier is 4 and the initial deposit is $4,000?
$16,000 New Money = 4 (Multipler) x $4,000 (Initial Deposit) = $16,000.
Sumit deposits $1,500 cash into his checking account. The reserve requirement is 25%. What is the change in his bank's required reserves?
$375
If the reserve requirement is 10%, a withdrawal of $500 leads to a potential decrease in the money supply of . . .
$5,000.
Money can be initially deposited into the banking system in two ways:
1) Cash deposit made by a bank customer. 2) Government injection of new money into the banking system through the power of printing money
How many regional Federal Reserve banks are there?
12
Leakages
A reduction in the amount of money that is used for lending that reduces the money multiplier. It is caused by banks choosing to hold excess reserves and from individuals, businesses, and foreigners choosing to hold more cash.
Solvency Crisis
A situation when a bank's liabilities exceed its assets
Federal Open Market Committee (FOMC)
A twelve-member committee that is composed of members of the Board of Governors of the Fed and selected presidents of the regional Federal Reserve Banks. It oversees open market operations (the buying and selling of government securities), the main tool of monetary policy
Fractional Reserve Banking System
Describes a banking system in which a portion of bank deposits are held as vault cash or in an account with the regional Federal Reserve Bank, while the rest of the deposits are loaned out to generate the money creation process
The main policymaking arm of the Fed is the . . .
Federal Open Market Committee.
If the money multiplier increases from 4 to 5, what must have happened to the reserve requirement?
It decreased from 25 to 20.
What happens to the money multiplier when the reserve requirement increases from 20% to 25%?
It decreases from 5 to 4.
If the money multiplier decreases from 12 to 10, what must have happened to the reserve requirement?
It increased from 8.3 to 10.
In May 2011, China ordered many of its banks to increase the amount they hold in reserves. It was the fifth increase that year. What would you expect to be TRUE about the money multiplier as a result?
It was decreasing.
Money Multiplier
Measures the potential or maximum amount the money supply can increase (or decrease) when new deposits enter (exit) the system and is defined as 1 divided by the reserve requirement. The actual money multiplier will be less, because some banks hold excess reserves
What happens when the Federal Reserve buys a $10,000 bond?
New reserves of $10,000 are put into the banking system.
Excess Reserves
Reserves held by banks above the legally required amount
What happens when the Federal Reserve sells a $10,000 bond?
Reserves of $10,000 are taken out of the banking system.
Leakage-Adjusted Money Multiplier
Takes into account the required reserve requirement along with excess reserves held by banks and cash held by individuals, businesses, and foreigners. It provides a more realistic estimate of the money multiplier in the economy.
Open Market Operations
The buying and selling on the open market of U.S. government securities, such as Treasury bills and bonds, to adjust reserves in the banking system
Federal Reserve System
The central bank of the United States
Which of the following statements concerning the structure of the Federal Reserve System is CORRECT?
The chairman and vice-chairman of the Board of Governors are appointed by the president and confirmed by the Senate for terms of 4 years.
Federal Funds Rate
The interest rate financial institutions charge each other for overnight loans used as reserves
Reserve Ratio
The percentage of a bank's total deposits that are held in reserves, either as cash in the vault or as deposits at the regional Federal Reserve Bank
Reserve Requirement
The required ratio of funds that commercial banks and other depository institutions must hold in reserve against deposits
Reserve Requirements
The required ratio of funds that commercial banks and other depository institutions must hold in reserve against deposits
Equity
The value that is shared by the bank's stockholders. It is the difference between a bank's assets and liabilities.
The Federal Reserve is composed of . . .
a central governing agency, the Board of Governors, located in Washington, D.C., and twelve regional Federal Reserve Banks in major cities around the nation.
If the reserve requirement is less than the reserve ratio, excess reserves . . .
are greater than zero.
Cash and demand deposits (checking accounts) are . . .
both components of the money supply measured as M1.
The Federal Reserve Board meets roughly once a month to determine broad economic policy. It does not have to deal with the political process, as those in Congress must, which is a major reason _____ lag is shorter for monetary policy than it is for fiscal policy.
decision
If Abigail withdraws $300 cash from her checking account, then her bank's assets . . .
fall by $300, and its liabilities fall by $300.
Open market operations involve the purchase and sale of . . .
government securities.
The _____ lag is associated with the response of banks and financial markets to monetary policy decisions.
implementation
Like fiscal policy, monetary policy is subject to four major lags:
information, recognition, decision, and implementation.
Early in U.S. history, banks were . . .
private and chartered by the states.
What are the basic goals of the Federal Reserve System?
promote full employment, economic growth, and a safer, more flexible, and more stable monetary and financial system
The Fed decides to decrease the proportion of deposits that banks must hold from 3% to 1%. Which monetary policy tool is it using?
reserve requirements
If banks increase excess reserves to increase their ability to absorb a higher rate of defaults . . .
the actual multiplier will fall.
If the Federal Reserve decides to increase the money supply . . .
the federal funds rate will fall.
The Federal Reserve is considered to be . . .
an independent central bank, in that its actions are not subject to executive branch control; however, it subject to oversight from Congress due to the government's power to coin money and set its value.
Discount Rate
The interest rate the Federal Reserve charges commercial banks and other depository institutions to borrow reserves from a regional Federal Reserve Bank
In which of the following scenarios would government action to increase the money supply be LEAST effective?
The money multiplier is zero.
Suppose that the Federal Reserve analyzed some data showing that the economy was heading toward a recession. Which policy move would be the most likely to be considered?
buying bonds in open market operations
The Fed generally uses open market operations as its primary monetary policy tool, and a recession would raise the possibility of . . .
buying bonds. Such purchases should lead to lower interest rates and stimulate the economy.
A change in the federal funds rate reflects . . .
changes in the market demand and supply of excess reserves.
Monetary policy involves all of the following EXCEPT . . .
increases in personal taxes.
