Chapter.17 section 1
Money Creation, the Federal
Reserve System, and Monetary
Ch. 17 How Banks Works
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.
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
Considering the application, the chartering
agency would review the quality of
management, the need for another bank in
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
Net worth: Assets minus liabilities; also
called owners’ equity
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.
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
Assets must equal liabilities plus net worth.
Assets= Liabilities + Net Worth
The Fed requires Home Banks to set aside, or to
hold in reserve, a percentage of checkable
Required reserve ratio: dictates the minimum
proportion of deposits the bank must keep in
The dollar amount that must be held in reserve
is called required reserves- checkable deposits
multiplied by the required reserve ratio.
The bank is required to hold a % of the
reserve requirement of a checkable
Excess reserves- Bank reserves in excess
of required reserves.
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.
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
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
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.
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
When interest rates are high, people are
willing to hold less money.
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.
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
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
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.
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
In these latter nations, rates of inflation have
tended to be higher than in other nations where
the monetary authorities are more independent.
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
Lags in monetary policy
There are lags in the effectiveness of
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.