Page 522 - Introduction to Business

496 PART 5 Finance

discount rate The interest rate at which operating targets, the Fed can change the discount rate, which is the rate at which
banks can borrow from the central banks can borrow from its discount window. A lower discount rate will increase
bank’s discount window
bank borrowing from the Fed. As banks borrow funds, there is an increase in the
supply of bank reserves, which lowers the federal funds rate. The discount window
also enables the Fed to act as lender of last resort to institutions in times of financial
crisis. Banks experiencing depositor runs can turn to the discount window for cash.
reserve requirements The percentage Another monetary policy tool is reserve requirements. While infrequently used
of transactions deposits that must be to change the level of bank reserves, they can have a large effect when needed. For
held by banks in cash form and not
loaned out example, referring to Exhibit 14.5, suppose that the Federal Reserve buys $100 mil-
lion of securities from Bank 1. If the bank has a reserve requirement of 10 percent,
it must retain $10 million in cash reserves (10 percent) but can lend the remaining
$90 million out to its customers. Now assume that borrowers who receive this $90
million make purchases of goods and services and that these funds end up in Bank
2. As shown in Exhibit 14.5, Bank 2 must carry reserves of $9 million (or 10 percent)
but can lend $81 million. This process continues until the original $100 million of
hot money expands as follows:

D R/rr
where D transactions deposits (or checking accounts), R bank reserves (or cash
balances in the bank), and rr bank reserve requirements. Notice that, due to
banks lending money to customers, the money supply eventually expands by $1
billion $100 million/0.10. The creation of money through bank credit means that
small changes in reserve requirements can have a large effect on the money supply.
If the Fed reduced rr to 0.08, the money supply as measured by D would expand to
$1.25 billion, for an increase of $250 million!
The link between bank reserves, credit, and deposits is important because it
means that changes in the federal funds rate will also affect short-term bank loans.
Lower federal funds rates allow banks to make lower rate loans, and vice versa as
federal funds rates increase. As already mentioned, the federal funds rate is consid-

EXHIBIT 14.5
How Central Banks and Commercial Banks Create Money
The Fed can increase the money supply (as measured by bank deposits) by buying securities from banks. Here we see
that $100 million of new or hot money in Bank 1 expands to $90 million in Bank 2. This process will continue with
Bank 2 lending $81 million, which would end up as deposits at Bank 3, and so on. Due to the 10 percent reserve
requirement, the final increase in the money supply would be $100 million/0.10 = $1 billion. A lower reserve require-
ment would result in an even greater increase in the money supply than $1 billion.

Fed pays Loans of $90 million from
$100 million bank 1 to a customer are
to bank 1 eventually deposited in Bank 2

Federal Reserve Bank 1 Bank 2
Uses open market operations Deposits: $100 million Deposits: $90 million
to increase deposits
Loans: $90 million Loans: $81 million
in banks by $100 billion
*Cash reserves: $10 million *Cash reserves: $9 million

Bank 1 sells
securities

*Reserve requirement is 10 percent.

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