Money Creation

We have seen that the (M1) money supply consists of currency and checkable deposits. The U.S. Mint produces the coins and the U.S. Bureau of Engraving and Printing creates the Federal Reserve Notes.

So who creates the checkable deposits? The answer is banks.

Fractional Reserve System A fractional reserve banking system requires that a portion/fraction of checkable deposits are backed up by reserves of currency in bank vaults or deposits at the central bank.

First, banks create money through lending. Currency serves as bank reserves so that the creation of checkable deposits by banks, via lending, is limited by the amount of currency reserves that the banks feel obligated, or are required by law, to keep.

A second point is that banks operating on the basis of fractional reserves are vulnerable to “panics” or “runs.” A bank would be unable to pay depositors the funds owed to them if they all came to the bank on the same day to withdraw their money.

A Single Commercial Bank To illustrate the workings of the modern fractional reserve banking system, we need to examine a commercial bank’s balance sheet.

Balance sheet- is a statement of assets and claims against those assets summarizing the financial position of a business or bank at a point in time. Every balance sheet must balance. Every asset is claimed by someone.

The claims shown on a balance sheet are divided into 2 groups. Net Worth- represents the claim of the bank’s owners against the assets. Liabilities- represents the claim of non-owners against the assets.

Assets = Liabilities + Net Worth or Owners Equity We will work through a series of bank transactions using balance sheets to illustrate how individual banks create money.

Transaction 1: Creating a Bank We will start by selling $250,000 worth of stock to potential investors. In the balance sheet the bank now has $250,000 cash and $250,000 worth of stock outstanding.

AssetsLiabilities and Net Worth Creating a Bank Balance Sheet 1: Our Bank (A) Cash $250,000Stock Shares$250,000

Transaction 2: Acquiring a Building and Equipment The Board of directors, who are appointed by the owners to run the bank, now have to purchase property and equipment so the bank can have a physical location. This transaction simply changes the composition of the bank’s assets.

AssetsLiabilities and Net Worth Acquiring Property and Equipment Balance Sheet 2: Our Bank (A) Cash$10,000Stock Shares$250,000 Property$240,000

Transaction 3: Accepting Deposits As a bank we will accept deposits of money and make loans. We now take in $100,000 in cash deposits from customers. In doing this the make-up of (M1) has changed.

Currency is down by $100,000 and demand deposits are up by $100,000. There has been no change in the economy’s total supply of money as a result of transaction 3, but a change has occurred in the composition of the money supply.

A withdrawal of cash will reduce the bank’s checkable deposit liabilities and its holdings of cash by the amount of the withdrawal. This, too, changes the composition, but not the total supply of money in the economy.

Accepting Deposits Balance Sheet 3 Assets Liabilities/Net Worth Cash $110,000 Checkable Deposits $100,000 Property $240,000 Stock Shares $250,000

Transaction 4: Depositing Reserves with the Fed. All commercial banks and thrift institutions that provide checkable deposits must by law keep required reserves.

Required reserves are an amount of funds equal to a specified percentage of a bank’s own deposit liabilities which the member bank must keep on deposit with the Fed bank in its district or as vault cash.

Reserve Ratio = required reserves ÷ demand deposit liabilities

EX. If the reserve ratio is 20%, our bank having accepted $100,000 in deposits from the public, would have to keep $20,000 as a required reserve. By depositing $20,000 in the Federal Reserve Bank, our bank will just be meeting the reserve ratio.

But suppose our bank anticipates that its holdings of checkable deposits will grow in the future. Instead of sending just the minimum amount, $20,000, it sends an extra $90,000, for a total of $110,000. In so doing, the bank will avoid the inconvenience of sending additional reserves each time its checkable deposits increase.

AssetsLiabilities and Net Worth Depositing Reserves at the Fed Balance Sheet 4: Our Bank (A) Cash$0 Checkable Deposits $100,000 Property$240,000 Stock Shares $250,000 Reserves$110,000

Notice the amount by which the bank’s actual reserves exceed its required reserves is called excess reserves. Actual reserves − required reserves = excess reserves $110,000 $20,000 $90,000

**** It is very important that you understand this concept. You must be able to compute all of these numbers. It is the excess reserves that allow a bank to create money.

The required reserves are not there for the banks to draw on if a run occurs. Instead the required reserves are there so that the Fed can control the amount of money banks can lend.

Transaction 5: Clearing a Check Assume that Fred has a checkable deposit with our bank (A) and decides to buy $50,000 of farm equipment from the Ajax Company. Fred pays for the equipment by writing a $50,000 check on his account in our bank and gives it to the Ajax Company.

Ajax Company deposits the check in its account with its bank (B). Bank (B) will collect this claim by sending the check to the regional Federal Reserve Bank in its area. The Federal Reserve Bank will adjust the accounts of the 2 banks involved, not the individuals. Finally, the Federal Reserve Bank sends the cleared check back to our bank which then reduces Fred’s account by $50,000.

Our bank (A) has reduced both its assets and its liabilities by $50,000 whereas Bank (B) now has $50,000 more in assets and liabilities. Notice there is no loss of reserves or deposits for the banking system as a whole. What one bank loses, another bank gains.

AssetsLiabilities and Net Worth Clearing a Check Balance Sheet 5: Our Bank (A) Checkable Deposits $50,000 Property $240,000 Stock Shares$250,000 Reserves$60,000

The next 2 transactions are crucial because they explain how a commercial bank can literally create money by making loans and how banks create money by purchasing government bonds from the public.

Transaction 6: Granting a Loan Suppose Gristly Company wants to take out a loan to expand its facilities and that they want to borrow exactly $50,000 which just happens to be the amount of excess reserves that our bank (A) is holding.

Gristly Company hands a promissory note (IOU) to our bank (A) and in exchange receives a checkable deposit in its name on which it can write checks up to $50,000. Our bank has an interest earning asset, called loans, and has created checkable deposits to pay for this asset.

Key Point: At the moment the loan is completed, money has been created. We have swapped a piece of paper, the promissory note, which is not money, for a checkable deposit which is money.

Gristly uses the loan money to expand its facilities and pays Quickbuck Construction Company to do the work. The $50,000 check is transferred from our bank to Quickbuck’s bank (C). The check is collected in the manner described in transaction 5 and our bank (A) loses both reserves and deposits equal to the amount of the check.

Quickbuck’s bank (C) has now acquired $50,000 in reserves and deposits. After the check has been collected, our bank (A) just meets the required reserve ratio of 20%. The bank has no excess reserves.

AssetsLiabilities and Net Worth When a Loan is Negotiated Balance Sheet 6a: Our Bank (A) Checkable Deposits $100,000 Property$240,000 Stock Shares$250,000 Reserves$60,000 Loans $50,000

Transaction 6a shows the balance sheet after Gristly uses the $50,000 loan money and the reserves are transferred to bank (C).

AssetsLiabilities and Net Worth After a Check is Drawn on the Loan Balance Sheet 6b: Our Bank (A) Checkable Deposits $50,000 Property$240,000 Stock Shares$250,000 Reserves$10,000 Loans$50,000 A single bank can only lend an amount equal to its pre-loan excess reserves

Notice back in transaction 6a that our bank (A) could not have loaned any more than $50,000. Any one bank can only loan an amount equal to its excess reserves.

When the loan is repaid Our Bank (A) Assets Liabilities & net Worth Reserves $10,000 Checkable Deposits $0 Property $240,000 Stock Shares $250,000

Transaction 7: Buying Government Securities When a commercial bank buys government bonds from the public, the effect is substantially the same as lending. New money is created. Assume that our bank’s balance sheet stands as it did at the end of transaction 5.

Suppose that instead of extending the loan, our bank (A) buys $50,000 of government securities from a securities dealer. Our bank receives the interest bearing bonds, which appear on its balance sheet as an asset, and gives the dealer an increase in its checkable deposits account.

The bank accepts government bonds, which are not money, in exchange for checkable deposits, which are money.

AssetsLiabilities and Net Worth Buying Government Securities Balance Sheet 7: Our Bank (A) Checkable Deposits $ 100,000 Property$240,000 Stock Shares$250,000 Reserves$60,000 Securities $50,000

Profits, Liquidity and the Federal Funds Market The asset items on a commercial bank’s balance sheet reflect the banker’s pursuit of two conflicting goals.

o Profits- One goal is profit. Banks, like any other business, seek profits, which is why the bank makes loans and buys securities. o Liquidity- The other goal is liquidity. For a bank, safety lies in liquidity, specifically assets such as cash and excess reserves. An interesting way in which banks can partly reconcile the goals of profit and liquidity is to lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks.

Banks lend these excess reserves to other banks on an overnight basis in order to earn additional interest without sacrificing long- term liquidity. The interest paid on these overnight loans is called the Federal funds rate.

The Banking System This far we have seen that a single bank in a banking system can lend one dollar for each dollar of its excess reserves. The situation is different for all commercial banks as a group.

3 Simplifying Assumptions  The reserve ratio is 20%  Initially all banks are meeting this 20% reserve requirement exactly. No excess reserves exist.

 An amount equal to the excess reserves will be lent to one borrower, who will write a check for the entire amount of the loan and give it to someone else, who will deposit the check in another bank.

Suppose a junkyard owner finds $100 while dismantling a car. He then deposits the $100 in bank A, which adds the $100 to its reserves. Reserves and checkable deposits both increase by $100 on the bank’s balance sheet.

Of the newly acquired reserves, 20%, or $20 must be set aside as a required reserve. The remaining $80 becomes excess reserves which will be loaned to one customer.

Bank Acquired Required Excess New money A $100 $20 $80 $80 B $80 $16 $64 $64 C $64 $12.80 $ $51.20 D $51.20 $10.24 $40.96 $40.96 E - …… $400.00

Monetary Multiplier The monetary multiplier, or checkable deposit multiplier, exists because the reserves and deposits lost by one bank become reserves of another bank.

Monetary multiplier = 1 ÷ required reserve ratio ( 1∕.2 = 5) Maximum checkable deposit creation = excess reserves × monetary multiplier $80 5

Higher reserve ratios mean lower monetary multipliers and therefore less creation of new checkable deposit money via loans; smaller reserve ratios mean higher multipliers and more creation of new checkable deposit money via loans.

Maximum vs. Actual Money Expansion Notice in the above equation it says “maximum” checkable deposit creation. However, we need to cite two possible reasons why the money supply may not expand by the full amount possible.

 Currency drains- Suppose in the original example the junkyard owner had kept $50 in his pocket and deposited the other $50. The money supply would only have expanded by $200, not $400.

 Excess reserves- Remember the Fed sets the minimum reserve requirement that banks must abide by. But is there anything that would prevent banks from setting more aside as a required reserve, over and above what the Fed requires?

In the above example the reserve requirement was 20%. But what if the bank chooses to hold 25% aside? How much will the money supply expand now? The answer is $300, not $400.