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Quick Question on The Fed

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Catskillgreenery posted on Thu, May 21 2009 8:27 PM

I just want to check if my understanding of the reserve requirement is accurate.

When the Fed buys an asset from banks or government debt it creates however much money in the form of reserves. So the money supply should be potentially inflated by 10 times the Fed's purchase because of fractional reserve banking. In March when The Fed announced it was buying 1 trillion in assets and treasuries this ment a potential increase of 10 trillion in the money supply.

Please let me know if I'm understanding this correctly. I'm pretty sure I am but it seems a little insane how much M3 inflation can potentially be created by banks since the Fed has inflated reserves so much lately.

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Robert replied on Thu, May 21 2009 9:58 PM

I could be mistaken but not only are you correct, I believe it could even be greater than 10 times more the original purchase price by the time it filters down through the banking system.

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Answered (Not Verified) DougM replied on Fri, May 22 2009 9:52 AM
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It's many times more. I don't have time to do the calculation right now but I'll do it as soon as I have time if someone else hasn't already.

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Answered (Not Verified) Man replied on Fri, May 22 2009 10:02 AM
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The Money Multiplier is 1/the Required Reserve Ratio. So 1/.10 is 10, meaning for each dollar someone puts in the entire banking system will create 10. So you are correct. 10% really isn't our reserve requirement anymore, its actually much lower. Basic economic textbooks and introductions to banking like to use 10% because it is an even number and is what the RR actually used to be.

There also is the problem of currency "drains", or removal of currency from the banking system. When an individual withdraws money from the banking system, it is the opposite of putting money in. Meaning that since banks will have to maintain RRs, they will contract loans and the amount of money they can make decreases slightly. This is the same for the Federal Reserve. When they buy assets the amount of money banks can create increases, and when they sell assets the amount of money banks can create decreases.

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