Question

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Securities - US Treasuries - Mortgage Securities - Loans Gold Certificates SDR Certificates Coins Foreign Currency Assets Other Assets Federal Reserve Notes in Circulation Rev Repos Deposits - Member Bank Accts - US Treasury Acct - Foreign Agency Accts - Other Other Liabilities (+ Capital) Assets Liabilities Federal Notes in Circulation = Fed Notes Held by Public + Fed Notes Held by Member Banks Coins Coins Purchased from US Treasury - Coins Held by Public - Coins Held by Member Banks Vault CashFed Notes Held by Member Banks + Coins Held by Member Banks Member Bank Reserves - Member Bank Accts + Vault Cash Use the FED balance sheet above to explain the following: 1) How does paying Federal Government spending increase Member Bank Reserves, and therefore increase money available to spend in the economy? 2) How does paying Federal income taxes destroy Member Bank Reserves and therefore reduce money available to spend in an economy? 3) How does the FED increase the FED Funds rate? Use a T-account ledger to show how banks create money by making loans. What role does Member Bank Reserves play in the money creation process?

Answer 1

1. When Govt spends money in the economy, this money reaches the general population in the form of wages, rents or fees. They will further use it to buy different products and services. Businesses will deposit this surplus in their Checking accounts. This way, the Member bank reserves increase due to increased Govt. spending. The money after setting aside reserves will be used for further credit functions, ie. loans, and mortgages.

2. When Income Tax needed to paid, the individual debit the tax payable from their salary or checking accounts maintained at banks. This lead to reduction of deposits. Due to reduced deposits, there will be less lending which will further destroy the Member bank reserves because loan and mortgages will be reduced.

3. FED increase the FED funds rate by increasing the reserve requirements. As banks are required by law to follow these reserve requirements, the Assets side shows increase in the Gold and SDR certificates and US treasuries. This increase in reserves reduces the amount available for lending to each other. Thus, the Funds rate is increased to make the lending more expensive.