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Lecture Principles of money, banking, and financial markets (12th edition): Chapter 18 - Ritter, Silber, Udell

Chapter 18 - Bank reserves and the money supply. In this chapter you will learn to understand the mechanics of check clearing and its impact on the balance sheets of commercial banks and the Federal Reserve, explain how banks create deposits by making loans, define the role of the banking system in deposit creation and destruction. | Chapter 18 Bank Reserves and the Money Supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Understand the mechanics of check clearing and its impact on the balance sheets of commercial banks and the Federal Reserve • Explain how banks create deposits by making loans • Define the role of the banking system in deposit creation and destruction Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18-2 Introduction • Examine the relationship between bank reserves and the money supply • Money supply (M1) is composed mostly of demand deposits in commercial banks and other financial institutions • Bank reserves play a crucial role in creating demand deposits • By regulating bank reserves, Federal reserve gets leverage to control amount of demand deposits and thereby nation’s money supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18-3 1 Check Clearing and Collection • Focus on the relationship between reserves and demand deposits • Demand deposit is an asset for the depositor, but a liability of a bank because it is obligated to pay it on demand • Federal Reserve has little direct contact with the public, mainly deal with the government and financial institutions Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18-4 Check Clearing and Collection (Cont.) • Federal Reserve is primary collection vehicle for checks • Check clearing is accomplished by adding or subtracting reserves held on deposit by the bank at its regional Federal Reserve bank Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18-5 Check Clearing and Collection (Cont.) • Sequence of events when a check, drawn on the other bank (B), is deposited in our bank (A) – Demand deposits in Bank A increase with a corresponding increase in assets (check in process of collection) – When the check clears through the Fed check clearing system, the Fed increases Bank A’s “deposits in Fed” by the amount of the check – .