Chapter 32 Money Creation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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 32-2

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” 32-3

Fractional Reserve System Balance sheet Assets = Liabilities + Net Worth Both sides balance Necessary transactions Create a bank Accept deposits Lend excess reserves 32-4

Creating a Bank Transaction #1 Vault cash: cash held by the bank Assets Liabilities and Net Worth Creating a Bank Balance Sheet 1: Wahoo Bank Cash $250,000 Stock Shares $250,000 32-5

Creating a Bank Transaction #2 Acquiring property and equipment Assets Liabilities and Net Worth Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash $10,000 Stock Shares $250,000 Property 240,000 32-6

Creating a Bank Transaction #3 Commercial bank functions Accepting deposits ($100,000) Making loans Assets Liabilities and Net Worth Accepting Deposits Balance Sheet 3: Wahoo Bank Cash $110,000 Checkable Deposits $100,000 Property 240,000 Stock Shares 250,000 32-7

Checkable-deposit liabilities Creating a Bank Transaction #4 Depositing reserves in a Federal Reserve bank Required reserves Reserve ratio Reserve ratio = Commercial bank’s Required reserves Checkable-deposit liabilities 32-8

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% 8-14 0-9 Fed can establish and vary reserve ratio within limits set by Congress Required reserves help Fed control lending abilities of commercial banks 32-9

Creating a Bank Transaction #4 Assume the bank deposits all cash on reserve at the Fed Assets Liabilities and Net Worth Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash $0 Checkable Deposits Reserves 110,000 $100,000 Property 240,000 Stock Shares 250,000 32-10

Reserve Requirements Excess reserves Required reserves Example: Actual reserves - required reserves Required reserves Checkable deposits x reserve ratio Example: Checkable deposits $100,000 Reserve ratio 20% 32-11

Creating a Bank Transaction #5 Clearing a check $50,000 check reduces reserves and checkable deposits Clearing a Check Assets Liabilities and Net Worth Balance Sheet 5: Wahoo Bank Checkable Deposits Reserves $60,000 $50,000 Property 240,000 Stock Shares 250,000 32-12

Money Creating Transactions Transaction #6a Granting a loan $50,000 loan deposited to checking Assets Liabilities and Net Worth When a Loan is Negotiated Balance Sheet 6a: Wahoo Bank Reserves $60,000 Checkable Deposits Loans 50,000 $100,000 Property 240,000 Stock Shares 250,000 32-13

Money Creating Transactions Transaction #6b Using the loan $50,000 loan cashed Assets Liabilities and Net Worth After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Reserves $10,000 Checkable Deposits Loans 50,000 $50,000 Property 240,000 Stock Shares 250,000 A single bank can only lend an amount equal to their preloan excess reserves 32-14

Money Creating Transactions Bank buys government securities from dealer Deposits payment into checking Assets Liabilities and Net Worth Buying Government Securities Balance Sheet 7: Wahoo Bank Reserves $60,000 Checkable Deposits Securities 50,000 $100,000 Property 240,000 Stock Shares 250,000 New money is created 32-15

Commercial Banks Conflicting goals Earn profit Maintain liquidity Make loans to earn interest Buy securities to earn interest Maintain liquidity Alternative? Overnight bank loans Federal funds rate 32-16

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 32-17

The Banking System The process will continue… Bank A $100 $20 $80 $80 (1) Acquired Reserves and Deposits (2) Required (3) Excess (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) 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… 32-18

The Banking System Bank A Bank B Bank C Bank D Bank E Bank F Bank G (1) Acquired Reserves and Deposits (2) Required (Reserve Ratio = .2) (3) Excess (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks $100.00 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 21.99 $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 $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 32-19 $400.00

The Monetary Multiplier = 1 required reserve ratio 1 = R Graphic Example New Reserves $100 $80 Excess Reserves $20 Required Reserves $100 Initial Deposit $400 Bank System Lending Money Created 32-20

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 32-21

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 32-22

Key Terms fractional reserve banking system balance sheet vault cash required reserves reserve ratio excess reserves actual reserves Federal funds rate monetary multiplier 32-23

Next Chapter Preview… Interest Rates and Monetary Policy 32-24