Financial Sector: Banking and Money Creation

Financial Sector: Banking and Money Creation AP Economics Mr. Bordelon

Monetary Role of Banks • M1 = currency in circulation + traveler’s checks + checking deposits • Checking deposits are ultimately where banks come in. Much of the money supply is accounted for by checking deposits into banks.

Monetary Role of Banks • Banks are financial intermediaries that are in business to earn profit. However, they do actually in fact create money. • Banks provide a place to put money and offer services to borrowers who need money. • Savers are paid interest on savings. • Borrowers are charged interest on borrowing.

Monetary Role of Banks • Banks only hold a fraction of their deposits in reserve. The reserves are there for customers to withdraw money from checking and savings. Only a small fraction of reserves will be withdrawn, so the bank can lend out the rest and profit from the loans. • Once the loans are made, there is now MORE money in circulation, and the money supply increases…but how?

Monetary Role of Banks Assume that this is a Libby’s T-Shirt Company. Libby owns $50,000 in equipment and $10,000 in cloth. These are her assets because she owns them. Libby also has borrowed $25,000 from the bank and this is a liability because she owes it to someone else, in this case, the bank.

Monetary Role of Banks This is the T-account of the First National Bank of Bordelon. Bordelon has $2,000,000 in deposits. These are liabilities to the bank because this money belongs to the customers who could withdraw the money at any time. Think of it as debts owed to creditors—the depositors are loaning money to the bank, if you will. The bank has $200,000 in cash reserves. This is a specific amount of cash on hand that the bank is required to keep by the Federal Reserve. In this case, the reserve ratio is 10%. The bank also has $300,000 in excess reserves, money it could lend out, but didn’t. The remaining $1.5 million has been loaned out.

Monetary Role of Banks • The ratio of reserves to deposits is the reserve ratio. The reserve ratio is set by the Federal Reserve. Currently, the reserve ratio is 10%. • Banks must hold deposits in reserve because of the risk of a bank run.

Bank Runs • Depositors put money in banks to earn interest and to keep it safe. When the public begins to fear that the bank itself might fail, or if they fear for the stability of the entire financial system, they may want to withdraw their money. If everyone goes to the bank to withdraw their deposits, it creates a bank run. • The bank keeps only a small percentage of the total deposits on reserve, so a bank run can lead to a self- fulfilling prophesy of the bank’s failure. This can be very damaging to communities and it can spread across the economy.

Bank Regulation • Deposit insurance. Federal Deposit Insurance Corporation (FDIC) guarantees depositors will be paid even if the bank fails, up to a maximum amount per account, currently $250,000.

Bank Regulation • Capital requirements. To reduce the incentive for risk-taking, regulators require that banks hold substantially more assets than the value of bank deposits. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. • Bank’s capital = assets – liabilities • Bordelon Bank has capital of $200,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets.

Bank Regulation • Reserve requirements. The Federal Reserve establishes the required reserve ratio for banks. This policy insures that banks will have a certain fraction of all deposits on hand in the event that customers wish to withdraw money. In the United States, the required reserve ratio for checkable bank deposits is 10%. • On the AP exam, unless it says otherwise, assume the required reserve ratio is 10%.

Bank Regulation • Discount window. Federal Reserve can lend money to banks through the discount window. The interest rate the Fed charges on these loans, discount rate, is one of the Fed’s tools of monetary policy. • Using the discount window can help a bank that finds itself short of funds in the short-term because many depositors could withdraw their cash in a short period of time.

How Banks Create Money • When you make a deposit into your checking account, the bank can make a loan to a borrower, and the borrower has part of your money in his checking account. • By making the loan, checking deposits have increased, thus increasing M1 (money supply).

How Banks Create Money (Step 1) Libby has $5,000 in cash and decides to open a checking account at First National Bank of Bordelon. This T-account represents the deposit. In this case, money has not been created. Libby just moved her money from cash to checking. M1 is unaffected. First National Bank must keep 10% of Libby’s deposit in cash reserves. Since it’s not made any loans, the remaining $4,500 is in excess reserves. (We’re assuming no capital requirements).

How Banks Create Money (Step 2) First National Bank of Bordelon has made a $4,500 loan to Ashley. Ashley wants to buy some awesome furniture at IKEA, and does so. This T-account reflects these changes.

How Banks Create Money (Step 3) IKEA banks at First National Bank of Hot Swedes. IKEA deposits Ashley’s money at FNBHS. This T-account reflects the deposit and changes. FNBHS must keep 10% in reserves, $450. It holds no excess reserves, loaning everything out to Billy, who wants to buy a car.

Summary • Libby deposits $5,000. • Ashley borrows $4,500 to buy IKEA. • IKEA deposits $4,500 at FNBHS. • FNBHS loans $4,050 to Billy. • The initial deposit of $5,000 created new M1 of $4,500 + $4,050 = $8,550 after only two loans. The process will continue…ad infinitum, buwahahahahaha!

Reserves, Bank Deposits and the Money Multiplier • The question is how much does a deposit actually add (or take away if withdrawn) to M1. • Required reserve ratio is 10%. The remaining 90% (if not loaned) is excess reserves. • Excess reserves = total reserves – required reserves • MM = 1/rr • MM: money multiplier • rr: reserve ratio

Reserves, Bank Deposits and the Money Multiplier • MM = 1/rr • Going back to the example, 1/0.10 = 10. • The initial $4,500 of excess reserves once loaned out would multiply by 10, creating $45,000 newly created M1. • NOTE: The initial $5,000 deposit DOES NOT count as new money.

Money Market in Reality • What if Ashley had not spent the entire $4,500 at IKEA? • What if Bordelon’s Bank decided to keep 20% of Libby’s deposit and lends only $4,100 to Ashley? • This would slow down the money multiplier process and less than $45,000 of M1 would be created.

Question 1 • Bob McBobberson deposits $500 that was in his sock drawer into a checking account at the local bank. • How does the deposit initially change the T-account of the local bank? How does it change the money supply? • If the bank maintains a reserve ratio of 10%, how will it respond to the new deposit?

Question 1 (cont’d) • Bob McBobberson deposits $500 that was in his sock drawer into a checking account at the local bank. • If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan, by how much could the total money supply in the economy expand in response to Bob’s initial cash deposit of $500? • If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan and the bank maintains a reserve ratio of 5%, by how much could the money supply expand in response to an initial cash deposit of $500?

Question 2 • Kyle McRyanster withdraws $400 from his checking account at the local bank and keeps it in his wallet. • How will the withdrawal change the T-account of the local bank and the money supply? • If the bank maintains a reserve ratio of 10%, how will the bank respond to the withdrawal? Assume that the bank responds to insufficient reserves by reducing the amount of deposits it holds until its level of reserves satisfies its required reserve ratio. The bank reduces its deposits by calling in some of its loans, forcing borrowers to pay back these loans by taking cash from their checking deposits (at the same bank) to make repayment.

Question 2 (cont’d) • Kyle McRyanster withdraws $400 from his checking account at the local bank and keeps it in his wallet. • If every time the bank decreases its loans, checkable bank deposits fall by the amount of the loan, by how much will the money supply in the economy contract in response to Kyle’s withdrawal of $400? • If every time the bank decreases its loans, checkable bank deposits fall by the amount of the loan and the bank maintains a reserve ratio of 20%, by how much will the money supply contract in response to a withdrawal of $400?

Question 3 • What will happen to the money supply under the following circumstances in a checkable-deposits-only system? • The required reserve ratio is 25%, and a depositor withdraws $700 from his checkable bank deposit. • The required reserve ratio is 5%, and a depositor withdraws $700 from his checkable bank deposit. • The required reserve ratio is 20%, and a customer deposits $750 to her checkable bank deposit. • The required reserve ratio is 10%, and a customer deposits $600 to her checkable bank deposit.

Questions • Due Thursday.

Financial Sector: Banking and Money Creation