hello my name is Clark Ross from Davidson College and today for AP macroeconomics I will be lecturing about money and deposit [Music] creation our basic money supply is referred to as M1 and in the summer of 2020 it was approxim $5.3 trillion M1 is comprised of currency which circulates circulating currency 1.8 trillion plus demand deposits checking accounts or checkable deposits 3.5 trillion the sum of which was roughly 5.3 trillion this summer 2020 here is a graph of M1 which includes um both the um circulating currency and the checkable deposits the total you can see is the top one in blue and below it is the checkable deposits in green and the circulating um cash in red you can see from this graph that currency is today well below 50% of M1 in fact it cover corresponds to roughly 35% of M1 you can see at other times it was higher and in fact in the recession of 2010 currency was above 50% of M1 M2 is a broader measure of the money supply and in the summer of 2020 it was approximately 18.3 trillion the reason M2 is so much larger is that it includes M1 which we just described plus savings deposits small denomination time deposits and money market mutual funds it is much broader but it of course is much less liquid which is why we principally in macroeconomics work with M1 now you know from macroeconomics a very important component of our study of monetary policy is the velocity of money the velocity of money or V links money to nominal GDP and always true by definition is money supply M1 time V velocity will equal the price level P times real GDP Q remember price level times real GDP or P times Q is nominal GDP so you should be aware and be able to use this equation M times velocity equals nominal GDP the current figures if we use them have an M which we just described as 5.3 trillion nominal GDP is approximately 19 trillion as of the summer of 2020 if you divide the nominal GDP by the money supply you get the velocity of money and do you see how it is only 3.64 in this uh reading for the summer of 2020 that is very very low at different times it's been closer to 10 what it shows is that in 2020 our money supply has been very high which is in the denominator GDP nominal GDP has not grown so much in the numerator so numerator not growing so much denominator growing very much money means that the velocity has fallen to a very low level historically that's one of the lowest levels 3.64 now this is your basic money market graph it has the nominal interest rate on the vertical axis and the quantity of money on the horizontal axis the central bank or in our case the Federal Reserve sets the money supply and that's why it's vertical money demand you may recall is downward sloping the intersection of money demand and money supply gives us the equilibrium nominal interest rate this is also the target rate for the federal funds the federal funds rate is that rate on overnight loans that the Federal Reserve tries to influence because influencing that interest rate will influence other interest rates so increasing the money supply as we'll see will lower this nominal federal funds rate and lower all interest rates why would the Central Bank wish to lower nominal interest rates because lowering nominal interest rates in the short run will lower real interest rates which is on the vertical axis of this graph lowering real interest rates will increase de desired expenditures that are sensitive to the interest rate these are principally investments but they also are some consumption related uh expenditures like Autos which are purchased on time at an interest rate by a loan so lowering the real interest rate will increase interest sensitive expenditures both investment and consumption ones this increases aggregate demand and expands the economy this is the heart of monetary policy and you can see it here with monetary policy if the Central Bank buys bonds they increase the reserves of Banks and we're going to see that this increases the money supply by a multiplied amount that's a main part of this lectric and that will lower interest rates and that will increase investment in contrast if the Central Bank sells bonds as an open market operation that will reduce reserves reduce the money supply it will increase interest rates and reduce the investment expenditures that is contractionary aim typically at reducing inflation now to look at the multiplied increase in the money supply we have to go to the commercial Banks and their behavior and we start with the balance sheet of a Commercial Bank we're going to see that on that balance sheet are reserves cash reserves against checking account deposits these are related to the fact that the Central Bank requires Banks to maintain a certain level of cash reserves against their demand deposits those cash reserves can either be kept at the bank which is referred to as Vault cash or they may be held at a Regional Federal Reserve Bank you know that we have 12 regional federal reserve banks and each geographic area is tied to a particular bank here in Charlotte North Carolina we're tied to the one in Richmond Virginia that is our regional Reserve Bank uh banks in our area May maintain some of their Reserves at the Federal Reserve Bank now this is the typical balance sheet of a bank on the left side you have assets on the right side you have the liabilities and what's called owners equity we also need to know the required Reserve ratio set by the Central Bank in this case it's 10% now what are the assets that a bank has well first and foremost are the loans that they extend because those loans are earning them interest they are an asset those are mortgages home mortgages business loans loans to uh consumers to buy cars this bank has $800 effectively of loans Banks may also hold government bonds the um same government bonds that the Federal Reserve holds this Bank happens to hold 200 they pay a small amount of interest but they are of course an asset next we have the cash reserves of our particular um bank and they happen to equal $100 if you add up the three assets we get $1,100 in assets for Bank a now the let's go to the right side the principal liability of a bank is the deposits these are the demand deposits the checking accounts that are held by the bank on behalf of owners like you as a individual or me as an individual this bank has a total of $1,000 of value of demand deposits or checking accounts it's against these deposits that they must hold a 10% cash Reserve 10% of a th000 is 100 so go back and look to your to the left side under assets this bank has exactly 10% of the deposits as cash reserves so this bank is perfectly legal but has no excess Reserve deposits are called a liability because the bank doesn't own them you own your deposit and the bank must pay that back now if we take from the assets of $1,100 the $1,000 of deposits this bank has a positive residual value called owner Equity of $100 when you add up the liabilities a th000 the owner's equity of 100 it will equal 1,00 and that is part of why we call a balance sheet because always the assets on the left side will equal the sum of liabilities and owner equity on the right side 1100 equals 1100 this bank has no excess reserves look at bank B Bank B has deposits of a thousand and so they need to have how much in um reserves well 10% of a thousand would be a hundred again but look how they have 150 of reserves this bank has $50 of excess reserves they are holding cash reserves $50 more than they are required based on their deposits what this bank can do with the $50 of excess reserves is lend them out make more loans or put them in government bonds but a bank would like to do something with excess reserves to generate earnings or interest whether it be through loans or government bonds and that is where we're going to make a transition to looking at how a bank in making loans new loans from excess reserves generates a multiplied increase in the money supply it's called a model of deposit creation when a Commercial Bank receives a cash Deo deposit the bank's ability to increase loans begins a chain of new new loans that can lead to a multiplied increase in demand deposits and in the money supply we'll see that the extent of the maximum multiplied increase in demand deposits is directly tied to the required Reserve ratio let's turn to an example all right try to follow with these people they are people by letters person a person a walks into bank one and deposits ,000 of cash that she previously held in her home so that's a new deposit of $1,000 bank one must maintain $100 of cash reserves against that deposit but do you see how bank one will now have $900 of excess reserves they received $1,000 of cash they're holding a 100 as reserves that leaves 99,900 that leaves 9 $900 of new reserves that they can loan out so new loans are going to be $900 and bank one is going to loan $900 to person B why did person B borrow the money well it turns out that person B took a loan to employ a contractor to build a deck on person B's house person B is going to pay that contractor who is person C $900 for the um deck when person C has finished the deck and receives the payment of $900 we're going to assume that he the contractor deposits that $900 into his bank which is a different bank bank number two there so now bank number two has new deposits of $900 they must keep $90 of cash reserves new reserves for Bank two $90 but that gives them excess reserves of $810 that they can loan out and we assume that they loan out $810 to person D so have a new loan of $810 now person D borrows the money but to do something with it and it turns out that person D decides to have a medical procedure and person D pays $800 $810 to The Physician person e who does the medical procedure The Physician person e takes that money and puts it in her bank which is bank number three a different bank and she deposits $810 into her checking account now all of a sudden Bank three is confronted with having extra reserves how many well they must keep $81 of new reserves 10% against that deposit of 810 but that gives them $729 to loan to person F and I'm going to leave it to you to figure out what person F does with the money because we're going to stop here and review what we've done all right let's review what we've done remember all this is premised on a required Reserve ratio of 10% so let's look at the results remember with bank one person a brought $1,000 in from her house that was the new cash deposit that started the whole process Bank One kept $100 of reserves against a thousand but they loaned out $900 remember remember to person B who was able to build a deck person B paid the contractor who was person C $900 the contractor deposited that $900 into his bank bank two that bank then kept $90 of new reserves against the 900 and loaned out 8 0 to person D who had a medical procedure person D then paid the physician $810 and she deposited in her bank bank three Bank three kept $81 of reserves against that 810 10% but they could then loan out $729 to person F this process will continue through other iterations and other Banks and other people in the end if we add up all the new deposits it's going to be $10,000 under new deposits you see how at the bottom it says $10,000 the new reserves are the $11,000 of cash that person a brought in but they are going to be spread across many banks now bank one is going to have a $100 of that original Deposit Bank two 90 Bank three 881 all the banks together will have 1,000 and that represents remember the $1,000 of cash brought in by person a the total of new loans will be 9,000 Now remind yourself that on the asset side you have reserves and new loans 1,000 plus 9,000 equals 10,000 that is going to be the change on the liability side new deposits 10,000 see how they balance and equal the way they should with a balance sheet so as a final summary we see new deposits of 10,000 new reserves of a th000 new loans of 9,000 the multiplication of the new reserves is by 10 and it is equal to one divided by the required Reserve ratio so in this example since the required Reserve ratio is 10% I have 1 divided by10 and that equals 10 the maximum final increase in demand deposits is 10 times the increase in cash reserves so the new reserves is a th000 multiply that by 10 and that's how I get my $10,000 of new deposit if the required Reserve ratio were more like 20% you can figure out I would have 1 over 0.2 which equals only five and the deposit creation multiplier would be five it would be much less if the required Reserve ratio were higher so the lower the required Reserve ratio the greater the expansion in deposits what about the actual change in the money supply well you should remember that from the first graph we from the excuse me you should remember from the first chart we did today that the money supply is the sum of circulating cash and demand deposits so in this case the actual increase in the money supply is only $9,000 this takes a little bit of subtle reasoning and challenges you as a macroeconomic student to realize that cash circulating cash will fall by $1,000 in this example because person a took that money remember from her home and brought it to bank one so we actually have cash decreasing by a thousand but remember the demand deposits went up by 10,000 so if I add a minus 1,000 to a positive 10,000 I get a net increase in the money supply of $9,000 it still is a very large multiplied increase in the money supply but you have to be careful and assess in your calculation does something happen to circulating cash if so what and what happens to demand deposits and in this case when you do the two you get a net change of $99,000 now you're not always going to get the maximum increase why well you may not get a $10,000 increase in demand deposits Banks may keep excess reserves remember when we uh had a bank with excess reserves and I said the bank could increase its loans but it hadn't so Bank One need not increase loans by a full $900 that was the maximum legal increase that they could and that's what we assume they did with the con to the uh person person B who hired a contractor but let's say bank one doesn't find enough good creditworthy customers or for some other reason doesn't lend out all the money let's say they only made a loan of $700 in kept 200 of excess reserves do you see how our process would all be at a lower level in that case and we would not get a $10,000 increase in demand deposits another reason is that we might have what's called leakage to coining currency remember the contractor was paid $900 for building that debt and we assume that the contractor person C brought the full $900 to his bank too and deposited it what if instead the contractor deposited only $800 and kept a $100 in cash to use for spending in that case Bank two would only have been able to increase its loans by $720 or 90% of 800 instead of the $810 that we used which was 90% of the full 900 so leakage to coin and currency is going to reduce the effectiveness of this uh process and lower the final increase in demand deposits a third thing is to recognize the process takes many iterations we only did what four of them and after even a few months we have not had a full multiplied increase a full multiplied increase we did have of course some multiplication and increase even after four iterations but the process does take time but you now understand how expansionary monetary policy can in fact lead to a multiplied increase in the money supply and look here an open market operation increase the money supply Supply this is a multiplied increase in the money supply based on the fact that with an expansionary monetary policy Banks got excess extra reserves from the Federal Reserve and they were able to start a chain of new lending that increased the money supply in a multiplied way that multiplication of the money supply will lower the nominal interest rate and incre and and and lead to other interest rates falling and an increase in investment and other interest sensitive expenditures how did the uh Federal Reserve pursue an expansionary monetary policy well they bought bonds do you remember that an open market operation of buying bonds is going to increase the demand for existing bonds and that increases the price of bonds do you see that and what does the Federal Reserve or the Central Bank do well they turn over those proceeds from buying bonds to Banks and Banks effectively then can start their process of new loans and um lowering interest rates and you see how the the real interest rate Falls in this process increasing our investments now remember the goals of expansionary monetary policy GDP is going to increase employment will increase and unemployment will decrease so expansionary monetary policy an open market operation the Central Bank Buy bonds the price of bonds goes up Banks get more reserves the money supply increases interest rates go down remember that scenario the inverse relationship of bond prices going up interest rates going down and remember what this will achieve GDP real GDP will increase employment will increase and unemployment will decrease again expansionary monetary policy leads to an increased money supply decreased interest rates increased investment increased agregate demand increased GDP increased employment and decreased unemployment you will hear that many times which is why I've repeated it now that we've concluded the um lecture part of today's program I would like to show you how we have five AP macroeconomic questions for you to use these have been used in Prior exams and it shows you the importance of this topic in our testing process but it also gives you an opportunity to apply your knowledge so here's question one with the Matia Bank in the United States and you're presented with a balance sheet and some questions go to the next slide and you have answers to the question of the Matia Bank our second question deals with the Su bank again a balance sheet presented to you and correct answers on the next Slide the third question is actually uh without a graph it asks you to draw a correctly labeled graph as you see and it introduces Itself by credit card fees changing and how this can affect the monetary situation of the country next slide gives you the correct graph and the rest of the answers associated with that third question the fourth question deals with country Z and um again it's in essay form but you have to um make uh calculations as well as a graph is required in Part B here go to the next slide and you see the answer to um question four or dealing with country Z finally the last question the last question here deals with Kim and Kim is depositing money into a bank just the way we started our program today and instead of $1,000 of deposit we have Kim depositing a 100 and correct answer for the behavior associated with Kim's deposit thank you we have concluded our program we have had a lecture on the basics of monetary policy with specific attention to deposit creation how the banking system when they receive a change in reserves can lead to a multiplied increase in demand deposits and the money supply an increase in reserves will increase in a multiplied way demand deposits in contrast a reduction in reserves can lead to a multiplied decrease in the money supply contractionary monetary policy as you may recall that's aimed at reducing inflation thank you very much for your attention and the time with you and special thanks to the College Board for sponsoring the program