Money Creation

1. 13 Money Creation

2. Chapter Objectives • Why the U.S. Banking System is Called a “Fractional Reserve” System • Distinction Between a Bank’s Actual Reserves and Its Required Reserves • How a Bank Can Create Money Through Granting Loans • The Multiple Expansion of Loans and Money by the Entire Banking System • The Monetary Multiplier and How to Calculate it

3. The Fractional Reserve System • Only a portion(fraction) of checkable deposits are backed up by cash in bank vaults or deposits at the central bank • Used in U.S. and most other nations today • Can show us how banks can create checkable deposits by issuing loans

4. Fractional Reserve System • The Goldsmiths • Characteristics • Banks Create Money Through Lending • Fractional Reserve Banks are Subject to “Panics” or “Runs”

5. History of Fractional Reserve Banking: Goldsmiths • Early traders used gold to make transactions, but it was unsafe and inconvenient to carry gold • 16th century – people began depositing gold with goldsmiths, the goldsmith would give them a receipt, served as first type of paper money • At first, paper receipts were fully (100%) backed by gold, eventually goldsmiths began issuing receipts in excess of the amount of gold held • Thus the beginning of fractional reserve banking

6. Characteristics of Fractional Reserve Banking • 1. banks can create money through lending • 2. banks operating on the basis of fractional reserves are vulnerable to “panics” or “runs” (Ex. Great Depression in U.S.). This explains why bank industry is highly regulated and why U.S. has deposit insurance (FDIC)

7. Fractional Reserve System • Balance Sheet Assets = Liabilities + Net Worth • Transactions Needed to Enable Banks to Create Money Through Lending As Follows…

8. A Single Commercial Bank • In order to understand modern fractional reserve banking.. We must examine a commercial bank’s balance sheet • Balance sheet – statement of assets and claims on assets that summarizes the financial position of the bank at a certain time • Every balance sheet must balance; value of assets must equal amount of claims against those assets

9. Balance Sheet • Claims on balance sheet divided into two groups: liabilities (claims of nonowners against the firm’s assets) and net worth (the claims of owners against the firm’s assets) • Assets = liabilities + net worth • This can be used to establish how individual banks create money

10. Transaction 1: Creating a Bank • Once a charter is secured to open a bank, must sell stock to buyers to open bank • Founders of bank sell shares of stock in bank—some to themselves and some to other people • This cash (vault cash) is an asset to bank, shares of stock are net worth

11. Assets Liabilities and Net Worth Creating a Bank Transaction 1: • Creating a Bank • Vault Cash Creating a Bank Balance Sheet 1: Wahoo Bank Cash $250,000 Stock Shares $250,000

12. Transaction 2: Acquiring Property and Equipment • Cash is then used by board of directors (bank’s owners) to acquire property and equipment

13. Assets Liabilities and Net Worth Creating a Bank Transaction 2: • Acquiring Property and Equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash $10,000 Stock Shares $250,000 Property $240,000

14. Transaction 3: Accepting Deposits • Banks have 2 functions: accept deposits and make loans • Citizens deposit $ into bank as checkable deposits, these are claims that depositors have against the assets of the bank and are a new liability account • This does not result in money supply change, but composition of money supply has changed • Currency held by a bank is not part of economy’s money supply

15. Assets Liabilities and Net Worth Creating a Bank Transaction 3: • Accepting Deposits • Receive $100,000 as a Checkable Deposit Accepting Deposits Balance Sheet 3: Wahoo Bank Cash $110,000 Checkable Deposits $100,000 Property $240,000 Stock Shares $250,000

16. Transaction 4: Depositing Reserves into Fed Reserve Bank • By law, all banks and thrifts must keep required reserves • Required reserves – amount of funds equal to a specified % of the bank’s own deposit liabilities • This percentage is known as the reserve ratio – ratio of required reserves the bank must keep on the bank’s own outstanding checkable-deposit liabilities • See formula next slide • Ratio established by Fed

17. Commercial Bank’s Required Reserves Reserve Ratio = Commercial Bank’s Checkable-Deposit Liabilities Creating a Bank Transaction 4: • Depositing Reserves in a Federal Reserve Bank • Required Reserves • Reserve Ratio

18. Example • Let’s say reserve ratio is 20% (1/5) • If a bank anticipates it will grow in future, may send additional reserves to Fed Reserve Bank • See balance sheet p.247

19. Current Requirement Statutory Limits Type of Deposit Checkable Deposits: $0-$7.8 Million $6-$48.3 Million Over $48.3 Million 0% 3 10 3% 3 8-14 Noncheckable Nonpersonal Savings and Time Deposits 0 0-9 Assets Liabilities and Net Worth Creating a Bank Transaction 4: Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash $0 Checkable Deposits Reserves $110,000 $100,000 Property $240,000 Stock Shares $250,000

20. Excess Reserves • Found by subtracting its required reserves from its actual reserves • The ability of a bank to make loans depends of the existence of excess reserves • This allows us to understand how the banking system creates money

21. Control • A bank’s required reserves are not enough to meet sudden, massive cash withdrawals • Required reserves help the Fed control the lending ability of commercial banks • Control the ability of banks to grant credit

22. Asset and Liability • When depositing money into the Fed, this is an asset to the commercial bank and a liability to the Fed Reserve Bank

23. Excess Reserves Actual Reserves Required Reserves - = Creating a Bank Transaction 4: • Control • Banking Regulators • Asset and Liability • Transactions are Both Excess Reserves

24. Transaction 5: Clearing a Check Drawn against the Bank • Whenever a check is drawn against one bank and deposited in another bank, collection of that check will reduce both the reserves and checkable deposits of the bank on which the check was drawn • If a bank receives a check, their reserves and checkable deposits will increase by amt of check • What one bank loses, another gains • No loss incurred for the banking system as a whole

25. Assets Liabilities and Net Worth Creating a Bank Transaction 5: • Clearing a Check • $50,000 Check Presented for Payment Clearing a Check Balance Sheet 5: Wahoo Bank Reserves $60,000 Checkable Deposits $50,000 Property $240,000 Stock Shares $250,000

26. Money Creating Transactions of a Commercial Bank • Transactions 6 and 7

27. Transaction 6: Granting a Loan • How does lending affect the balance sheet? • Assets and liabilities increase by size of the loan • When the bank makes loans, it creates money • By extending credit, bank has “monetized” the IOU • Single bank can only loan out amount equal to its initial excess reserves b/c it faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it

28. Assets Liabilities and Net Worth Money Creating Transactions Transaction 6a: • Granting a Loan • $50,000 Loan Deposited to Checking Account When a Loan is Negotiated Balance Sheet 6a: Wahoo Bank Reserves $60,000 Checkable Deposits $100,000 Loans $50,000 Property $240,000 Stock Shares $250,000

29. W 13.1 Assets Liabilities and Net Worth Money Creating Transactions Transaction 6b: • Using the Loan • $50,000 Loan Cashed From Checking Account After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Reserves $10,000 Checkable Deposits $50,000 Loans $50,000 Property $240,000 Stock Shares $250,000 A Single Bank Can Only Lend An Amount Equal to their Preloan Excess Reserves

30. Transaction 7 : Buying Gov. Securities • When a commercial bank buys securities from the gov, the effect is basically the same as lending (new money created) • The selling of government bonds to the public by a commercial bank reduces the money supply • The securities buyer pays by check, reducing assets and liabilities

31. Assets Liabilities and Net Worth Money Creating Transactions Transaction 7: • Buying Government Securities From Dealer • Deposits Payment Into Checking Account Buying Government Securities Balance Sheet 7: Wahoo Bank Reserves $60,000 Checkable Deposits $100,000 Securities $50,000 Property $240,000 Stock Shares $250,000

32. Money Creating Transactions Profits, Liquidity, and the Federal Funds Market • Profit • Loans • Securities • Liquidity • Impact Upon Reserves • Overnight Bank Loans • Federal Funds Market • Federal Funds Rate

33. Profits, Liquidity, and the Federal Funds Market • 2 conflicting goals of a bank: profit and safety • Profit – commercial banks seek to profit through lending and buying securities • Liquidity – bank must be on guard for depositors who want to transform checkable deposits into cash and more checks clearing against it than in its favor

34. Federal Funds Rate • Day-to-day flow of funds rarely leave all banks w/exact levels of required reserves • Funds held at Fed Reserve Banks highly liquid • Banks lend these excess reserves on an overnight basis as a way of earning interest without sacrificing liquidity • Interest rate paid on these overnight loans is Federal Funds Rate

35. The Banking System • Multiple-Deposit Expansion • The Banking System’s Lending Potential • Assumptions: • 20% Required Reserves • All Banks “Loaned Up” • Banks Lend All of Excess Reserves

36. The Banking System: Multiple-Deposit Expansion • A single bank can lend one dollar for each dollar of excess reserves • Banking system as a whole can in reality lend by a multiple of its excess reserves • Read pages 252-253

37. (2) Required Reserves (Reserve Ratio = .2) (1) Acquired Reserves and Deposits (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank The Banking System Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00

38. The Monetary Multiplier • Exists b/c the reserves and deposits lost by one bank become the reserves of another bank • It magnifies excess reserves into a larger creation of checkable-deposit money • Monetary multiplier = 1/required reserve ratio • Max. Checkable deposit creation = excess reserves x money multiplier

39. 1 Monetary Multiplier = Required Reserve Ratio 1 m = R The Monetary Multiplier Monetary Multiplier or Checkable-Deposit Multiplier or in Symbols… Graphic Example New Reserves $100 $80 Excess Reserves $20 Required Reserves $100 Initial Deposit $400 Bank System Lending Money Created

40. W 13.2 The Monetary Multiplier • Reversibility • Making Loans Creates Money • Loan Repayment Destroys Money • Multiple Step Money Expansion • Multiple Step Destruction of Money

41. Reversibility: The Multiple Destruction of Money • This process is reversible • Checkable-deposit money is destroyed when loans are paid off • Loan repayment sets off a process of multiple destruction of money

42. Bank Panics of 1930-1933 Last Word • Series of Bank Panics • Before Deposit Insurance • Mass Withdrawals From Fear • Move to Cash Reduced Money Supply Through Reduction in Loans • Multiple Contraction Slowed Lending and the Economy • 1933 National Bank Holiday for One Week • Resulted in FDIC and 25% Drop in Money Supply • Contributed to the Great Depression • Regulation Protects the System Today

43. fractional reserve banking system balance sheet vault cash required reserves reserve ratio excess reserves actual reserves Federal funds rate monetary multiplier Key Terms

44. Next Chapter Preview… Interest Rates and Monetary Policy Chapter 14!