1.  A substantial amount of money in the economy is held by deposit-takers  Someone deposits money into their bank, they pay little interest to them, they lend that money to someone else, while charging a higher interest rate, so they make a profit  This process is done by the roles played by cash reserves and profit motive 12.3 - Money Creation

2.  Desired Reserves are the minimum amount of cash necessary that chartered banks are required to have to satisfy anticipated withdrawal demands  The Reserve Ratio: The deposit taker must hold a certain portion of deposits in the form of cash reserves  EX. If a bank has a reserve ratio of 0.10, and the bank has deposits of $100 million, then it will hold 10% of this dollar value as desired reserves Money Creation

3.  Idle cash reserves no profit, so deposit-takers will try to transform any excess reserves into income-producing assets as soon as possible

4.  Let’s see how lending out excess reserves creates more money  Assume: (1) Public money is in the form of deposits and all payments are made by cheque; (2) All deposits are made to one type of deposit-taker (banks); (3) Reserve ratio is 0.10 (10%)  Note: a bank’s main assets are its cash reserves and loans  A bank’s main liabilities are its customers’ deposits The Money Creation Process

5.  1. At Cabot Bank, cash reserves = desired reserves  2. Saver A makes $1000 and deposits it into Cabot Bank  3. Cabot Bank now has new cash assets and deposit liabilities of $1000 First Transaction Cabot Bank AssetsLiabilities Cash Reserves + $1000Saver A’s Deposit + $1000

6.  Cabot Bank only wants to keep 10% of the $1000 = $100 on hand  Cabot Bank now has an excess of $900  Cabot Bank now lends $900 to Borrower X Second Transaction Cabot Bank AssetsLiabilities Cash Reserves $1000Saver A’s Deposit $1000 Loan to Borrower X + $900Borrower X’s Deposit + $900 The money supply has now risen by $900.

7.  Borrower X withdraws the $900 from his deposit  Cabot Bank’s cash assets and deposit liabilities each fall by $900 Third Transaction Cabot Bank AssetsLiabilities Cash Reserves $100 (=$1000 - $900)Saver A’s Deposit $1000 Loan to Borrower X $900Borrower X’s Deposit $0 (=$900 - $900)

8.  Borrower X bought something for $900 from Saver B  Saver B deposits the $900 in her account at Fraser Bank  Fraser Bank’ cash assets and deposit liabilities increase by $900  Thus, the $900 deposit originally created by Cabot Bank has simply moved to Fraser Bank – no change in money supply Fourth Transaction Fraser Bank AssetsLiabilities Cash Reserves + $900Saver B’s Deposit + $900

9.  Since Saver B deposits money to Fraser Bank, Fraser Bank’s desired reserves should increase by $90 (= $900 x 0.10)  Since the $900 also increases cash reserves, there are now excess reserves of $810 ( = $900 - $900  Fraser Bank lends the $810 to Borrower Y  This created added loans assets and deposit liabilities of $810  Since Borrower Y’s new deposit is money, the money supply increases by $810 Fifth Transaction Fraser Bank AssetsLiabilities Cash Reserves $900Saver B’s Deposit $900 Loan to Borrower Y $810Borrower Y’s Deposit $810

10.  The number of possible transactions are endless  We saw the process of money creation in the few transactions that we saw  Notice how the process of money creation is similar to the process of the spending multiplier (Ch. 11)  In the money creation process, an initial change in money has a magnified effect on the money supply  Money Multiplier is the value by which the amount of excess reserves is multiplied to give the maximum total change in money supply The Money Multiplier

11. The Multiplier Formula

12.  Recall, we assumed that all money is in the form of deposits, and that there is only one form of deposit-taker  These assumptions do not hold true in reality  Public-Held Currency  Rather than all money going to deposit-takers, some money does circulate and is unaffected by the money multiplier  Differences in Deposit  There are a wide range of deposit types, so not all deposits will be reflected as an increase in the money supply Adjustments to the Money Multiplier

13.  The money multiplier represents the maximum possible effect of money creation  If someone deposits $9000, the money multiplier formula allows us to specify the maximum amount of $9000 by which the quantity of money rises as a result of the infusion of $900 in new excess cash reserves Money Multiplier in the Canadian Economic System