How Banks Create Money Please listen to the audio as you work through the slides

How Banks Create Money Learning Objectives: Students will be able to thoroughly and completely explain: 1.How banks create and destroy money, the role of the reserve requirement. 2.How the Money Multiplier works.

How banks create money 1.Through lending 2.Buying bonds from the public How banks destroy money 1.Through the payoff of loans 2.Selling bonds to the public

Fractional Reserve System Balance sheet – Assets = Liabilities + Net Worth – Both sides balance Necessary transactions to understand – Create a bank – Accept deposits – Lend excess reserves

Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock

Cash $250,000Capital Stock $250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH Deposit Added to Vault Cash

Cash $250,000Capital Stock $250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 2 Acquiring Property and Equipment $240,000 Cash

Cash $ 10,000 Property 240,000 Capital Stock $250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH

Cash $ 10,000 Property 240,000 Capital Stock $250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 3 Accepting Deposits into checking accounts $100,000 Cash

Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH

Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH NOTES: Bank deposits are subject to a reserve requirement. Reserve ratio Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities =

Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH Three Important Issues Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $110, ,000 = $90,000 2 – Control of Lending Ability 3 - Asset or Liability to Which Bank?

Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 4 Deposit Into FED account $110,000 Cash

Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH

Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 5 A check is drawn against the bank $50,000

Cash $ 0 Reserves 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH

Cash $ 0 Reserves 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH NOTES: Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money.

Reserves $ 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 6 Make a loan from excess reserves $50,000

Reserves $ 60,000 Loans 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH Making the loan created money!

Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH After a check for the $50,000 is drawn against the bank *

Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 ASSETS LIABILITIES AND NET WORTH TRANSACTION 7 Repaying a loan with cash $50,000 Formation of a Commercial Bank

Reserves $ 10,000 Loans 0 Property 240,000 Checkable Deposits $ 0 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH $50,000 in money supply is destroyed!

Reserves $ 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH Let’s buy bonds from public $50,000

Reserves $ 10,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 8 (Assume previous balance sheet) Bought Government Securities $50,000

Reserves $ 10,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Formation of a Commercial Bank ASSETS LIABILITIES AND NET WORTH Banks conflicting goals: Earn profit Make loans to earn interest Buy securities to earn interest Maintain liquidity Alternative? Overnight bank loans Federal funds rate

The Banking S ystem Multiple-deposit expansion – Assumptions: 20% required reserves All banks “loaned up” no excess reserves Banks lend all of excess reserves when they get them. A $100 bill is found and deposited Multiple deposits can be created 32-26

MULTIPLE DEPOSIT EXPANSION PROCESS Bank Acquired reserves and deposits Required reserves Excess reserves Amount bank can lend - New money created A B C D E F G H I J K L M N Other banks $ $ $ $ $ Total amount of money created by the banking system

MULTIPLE DEPOSIT EXPANSION PROCESS Bank Acquired reserves and deposits Required reserves Excess reserves Amount bank can lend - New money created A B C D E F G H I J K L M N Other banks $ $ $ $ $ Total amount of money created by the banking system Money destruction works in exactly the same multiple way!

The Monetary Multiplier Maximum amount of new money created by a single dollar of excess reserves Higher R, lower m – R = Reserve ratio, m = monetary multiplier Reversibility – Making loans creates money – Loan repayment destroys money

Maximum checkable- deposit creation = Excess reserves x Monetary Multiplier Monetary Multiplier Required reserve ratio 1 = The Monetary Multiplier

Monetary multiplier = 1 required reserve ratio New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example = 1 R