Class Notes (838,568)
United States (325,481)
Economics (157)
ECON 0110 (84)
Lecture

Section 30 Notes.doc

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Department
Economics
Course
ECON 0110
Professor
K E N K E L
Semester
Spring

Description
SECTION 30: THE COMMERCIAL BANKING SYSTEM GOAL OF A BANK: MAXIMIZE PROFITS Commercial banks are private corporations Owned by individual stockholders Banks earn profits by borrowing money from depositors and lending the money to borrowers at higher interest rates than they pay to depositors Banks also earn profits by charging fees for services Checking account fees, ATM fees, estate and trust planning FUNCTIONS OF BANKS: 1. PROVIDE SAFEKEEPING FOR DEPOSITORS’ MONEY: 2. MAKE LOANS 3. AS A GROUP, BANKS CREATE MONEY FRACTIONAL RESERVE BANKING Banks lend out most of the money that has been deposited. Banks retain some of the deposits in its vault. Some of the deposits might be deposited at the local branch of the Federal Reserve System for safety purposes. RESERVES The cash that a bank has in its vault plus any deposits that a bank has at the Federal Reserve Banks earn no interest on reserves sitting in the vault or at the Fed. Thus, holding money as reserves is unprofitable. To generate profits, banks lend most of the money that has been deposited. REQUIRED RESERVES Every bank is required (by the Federal Reserve System) to keep a certain percentage of deposits as reserves in its vault or at the local Federal Reserve Branch Bank to satisfy any customer withdrawals of deposits. Depositing reserves at the Fed promotes safety of deposits and limits the potential loss during a bank robbery. REQUIRED RESERVE RATIO The minimum percentage of deposits that a bank must keep as reserves This percentage is set by the Federal Reserve Board of Governors. REQUIRED RESERVES The minimum amount of reserves that a bank must hold Required Reserves = Total Deposits x Required Reserve Ratio REQUIRED RESERVE RATIOS 10% on deposits over 45.4 million 3% on deposits of $6.6 million to $45.4 million 0% on deposits less than $6.6 million EXCESS RESERVES = Actual reserves - Required reserves Banks earn no interest on excess reserves Banks increase profits by expanding their lending THE MONEY MULTIPLIER The multiple by which the total supply of money can increase for every $1 increase in reserves. A $1 increase in bank reserves leads to a multiple increase in the money supply The amount of the ultimate increase depends on the required reserve ratio The maximum value of the money multiplier is: Money multiplier = 1 / r Where r is the required reserve ratio EXAMPLE: THE MONEY MULTIPLIER Assume the required reserve ratio is r = .10 STEP 1: Assume the Fed purchases $1,000 of securities from the public ΔM = $1,000 STEP 2: The money is deposited in a bank Required reserves increase by $100 and excess reserves increase by $900 (Assume all excess reserves are loaned out.) The bank lends $900 to borrowers The money supply increases by $900 ΔM = $900 STEP 3: The borrower buys something with the $900, and the seller deposits the $900 in a checking account (We assume all money is deposited in a bank. No cash is held.) Required reserves increase by $90 ($900 x .10 = $90), Excess reserves are $810 ($900 - $90 = $810). The bank lends $810 to borrowers (I.e., all excess reserves are loaned out) The money supply increases by $810 ΔM = $810 STEP 4: The borrower buys something with the $810, and the seller deposits the $810 in a checking account (I.e., all money is re-deposited in a bank.) Required reserves increase by $81 ($810 x .10 = $81) Excess reserves are $729 ($810 - $81 =
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