15
Money
Creation
McGrawHill/Irwin
Copyright2009byTheMcGrawHillCompanies,Inc.Allrightsreserved.
Chapter Chapter Objectives
Fractional Reserve system
Actual reserves vs. required
reserves
How banks create money through
granting loans
Multiple expansion of loans and
money by the banking system
The monetary multiplier
15-2
Fractional Reserve Banking
The Goldsmiths
Stored gold and gave a receipt
Receipts used as money by public
Made loans by issuing receipts
Characteristics
Banks create money through
lending
Banks are subject to panics
15-3
Fractional Reserve System
Balance sheet
Assets = Liabilities + Net Worth
Both sides balance
Necessary transactions
Create a bank
Accept deposits
Lend excess reserves
15-4
Creating a Bank
Transaction #1
Vault cash: cash held by the
bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets
Cash
Liabilities and Net Worth
$250,000 Stock Shares
$250,000
15-5
Creating a Bank
Transaction #2
Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$10,000 Stock Shares
240,000
$250,000
15-6
Creating a Bank
Transaction #3
Commercial bank functions
Accepting deposits
Making loans
Accepting Deposits
Assets
Cash
Property
Balance Sheet 3: Wahoo Bank
Liabilities and Net Worth
$110,000
240,000
Checkable
Deposits
Stock Shares
$100,000
250,000
15-7
Creating a Bank
Transaction #4
Depositing reserves in a Federal
Reserve bank
Required reserves
Reserve ratio
Reserve
ratio
=
Commercial banks
Required reserves
Commercial banks
Checkable-deposit liabilities
15-8
Reserve Requirements
Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$9.8 Million
$9.3-$43.9 Million
Over $43.9 Million
Noncheckable nonpersonal
savings and time deposits
0%
3
10
3%
3
8-14
0
0-9
Fed can establish and vary reserve
ratio within limits set by Congress
Required reserves help Fed control
lending abilities of commercial banks
15-9
Creating a Bank
Transaction #4
Assume the bank deposits all
cash on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
110,000
Deposits
Property
240,000 Stock Shares
$100,000
250,000
15-10
Reserve Requirements
Excess reserves
Actual reserves - required reserves
Required reserves
Checkable deposits x reserve ratio
Example:
Checkable deposits $100,000
Reserve ratio 20%
15-11
Creating a Bank
Transaction #5
Clearing a check
$50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets
Reserves
Property
Liabilities and Net Worth
Checkable
$60,000
Deposits
240,000 Stock Shares
$50,000
250,000
15-12
Money Creating Transactions
Transaction #6a
Granting a loan
$50,000 loan deposited to checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
$100,000
250,000
15-13
Money Transactions
Creating Transaction #6b
Using the loan
$50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$10,000 Checkable
Deposits
50,000
$50,000
240,000 Stock Shares
250,000
A single bank can only lend an amount
equal to their preloan excess reserves
15-14
Money Creating Transactions
Transaction #7
Bank buys government securities
from dealer
Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Assets
Reserves
Securities
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
New money is created
$100,000
250,000
15-15
Commercial Banks
Conflicting goals
Earn profit
Make loans to earn interest
Buy securities to earn interest
Maintain liquidity
Alternative?
Overnight bank loans
Federal funds rate
15-16
The Banking System
Multiple-deposit expansion
Assumptions:
20% required reserves
All banks loaned up
Banks lend all of excess reserves
A $100 bill is found and deposited
Multiple deposits can be created
15-17
The Banking System
(3)
(4)
(2)
Excess Amount Bank Can
Required Reserves Lend; New Money
Reserves
(1)-(2)
Created = (3)
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100
$20
$80
$80
Bank B
$80
$16
$64
$64
Bank C
$64
$12.80
$51.20
$51.20
Bank D
$51.20
$10.24
$40.96
$40.96
The process will continue
15-18
The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$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
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$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
15-19
The Monetary Multiplier
Monetary
multiplier
=
Graphic
Example
1
required reserve ratio
=
1
R
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
$20
Required
Reserves
$100
Initial
Deposit
15-20
The Monetary Multiplier
Maximum amount of new money
created by single dollar of excess
reserves
Higher R, lower m
Reversibility
Making loans creates money
Loan repayment destroys money
15-21
Bank Panics of 1930-1933
Before deposit insurance
Bank failure led to mass withdrawals
Forced loan reduction
25-33% decline in money supply
1933 national bank holiday to
evaluate all banks
Contributed to the Great Depression
Regulation protects the system today
15-22
Key Terms
fractional reserve banking system
balance sheet
vault cash
required reserves
reserve ratio
excess reserves
actual reserves
Federal funds rate
monetary multiplier
15-23
Next Chapter Preview
Interest Rates
and Monetary
Policy
15-24