How Banks and Thrifts Create Money 14 C H A P T E R How Banks and Thrifts Create Money Give Money Quiz (timed) Ch. 14 lecture in one day. Main Idea of ch. 14 is the creation and destruction of money.

Money Creation? Creating money may seem like something only the Bureau of Engraving (makes our FED reserve notes/ dollar bills) and The US Mint (makes our coins), but BANKS also make money. They create checkable deposits. The prologue to ch. 14 tells a story of goldsmiths… realizing that there were often more receipts in circulation (as currency) than gold on deposit. They then started making interest bearing loans…. And banking was born.

BALANCE SHEET OF A COMMERCIAL BANK ASSETS = LIABILITIES + NET WORTH They must equal. If they don’t.. fix it! Balance Sheet – a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time. A Balance sheet MUST BALANCE! Net Worth = Assets - Liabilities

2 Characteristics of the Fractional Reserve Banking System 1. Reserves limit money creation 2. Gov’t regulations & the FDIC prevent panics Fractional Reserve Banking has 2 significant characteristics: Banks create money through lending -- they are limited through the reserve requirement set by the gov’t (FED) 2. FDIC insured deposits up to 100,000 dollars, and the gov’t closely monitors the action of banks. It is now unlikely that a bank will suffer a run, a panic, or bankruptcy.

3 Questions to Consider: How can a commercial bank or thrift create money? How can they destroy money? What factors govern how banks create or destroy money? Students need to thoroughly understand this process. The next several slides go step by step through the process.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock The founders of the bank sell shares to raise money for the bank’s creation. They have raised $250,000 cash (asset), and they owe $250,000 to their shareholders (liability).

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000 Deposit Added to Vault Cash

Acquiring Property and FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000 TRANSACTION 2 Acquiring Property and Equipment $240,000 Cash They buy a building for $220,000 & office equipment for $20,000 = $240,000 Property is an asset, so we still balance… it just lowers our amount of cash.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property 240,000 Capital Stock $250,000

(changes in money in circulation…not money creation) FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property 240,000 Capital Stock $250,000 TRANSACTION 3 Accepting Deposits $100,000 Cash Commercial banks have 2 basic functions (take deposits and make loans) If the bank receives $100,000 in checkable deposits (people opening checking accounts), then there is an increase of $100,000 cash to assets. $100,000 will also be added to liabilities, because the bank is liable for the money (it is owned by the depositors) –a checkable deposit is a CLAIM AGAINST AN ASSET. Main ideas about this transaction: The money supply in circulation just dropped by $100,000, because money in a bank is not counted in the Sm. Withdrawals will increase Sm in circulation, and will decrease each column equally. (changes in money in circulation…not money creation)

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000

FORMATION OF A COMMERCIAL BANK NOTES: Bank deposits are subject to a reserve requirement. Reserve ratio Commercial bank’s required reserves checkable-deposit liabilities = LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 All banks are required by law to deposit a %age of their checkable deposits with the FED. This is called a reserve requirement or required reserves. Banks do this by keeping cash in its vault, and by depositing money into a FED account. The specific amount of the reserve requirement is the RESERVE RATIO: Commercial bank’s required reserves/commercial bank’s checkable-deposit liablities (percentage or a fraction… same thing) The reserve is much more complex than this, because a certain amount is exempt… then the rate is progressive after that.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 4 Deposits at the FED $110,000 Cash This bank deposited $110,000 in the Fed.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000

(assume 20% reserve requirement) Three Important Issues... 1. Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $110,000 - 20,000 = $90,000 2 – Control of Sm 3 - Asset and Liability 1. Banks often deposit in excess of the required reserve, b/c they anticipate growth & profit, and they don’t want to have to make additional deposits regularly. Excess (or extra reserves) also help banks lend money. 2. Reserves provide CONTROL (not protection from panic) to the FED… control of Sm! 3. FED deposits become assets for the bank… and they become a liability to the FED

A check is drawn against the bank FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 5 A check is drawn against the bank $50,000 Jim-Bob bought an H2 for $50,000. He writes a check against his deposit at the bank. The bank pays the $50,000 to the Hummer Dealership’s bank, and the balance sheet reflects the deduction. Two questions to consider: How is this check collected or cleared? (used to take days… now is instant) Jim-Bob hands the check to Hummer. Hummer deposits check into bank. H Bank sends check to the FED. The FED takes $50,000 from the bank’s reserve & deposits it into H Bank’s reserve. The FED sends the check to the bank. The bank reduces Jim-Bob’s account by $50,000 & corrects it’s balance sheet. The check is stored or mailed back to Jim-Bob for his records. 2. What effect does the collection of the check have on the balance sheets of the banks involved? The bank has $50,000 less reserve (asset) and $50,000 less liability (checkable deposit) H bank has $50,000 added to its reserve (asset) and +$50,000 liability from the dealerships increased checkable deposit.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

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

Make a loan from excess reserves FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 TRANSACTION 6 Make a loan from excess reserves $50,000 Transactions 6, 7, & 8 explain how banks create money & destroy money. A business decides it wants to expand its business to a second location, they apply for a loan. The bank gives them $50,000 loan… after finding its credit record satisfactory. The bank increases the business’s checkable deposit by $50,000. The business gives an IOU to the bank. THE IOU IS AN ASSET. (a loan is an asset, b/c it represents money) THE $50,000 IS LIABILITY. (the checkable deposit is a liability to the bank, because it now belongs to the business) This is money creation, you walk in with an IOU… and you walk out with $50,000! This is a change in Sm.

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Loans 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Making the loan created money!

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 After a check for the $50,000 is drawn against the bank

Repaying a loan with a check FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 TRANSACTION 7 Repaying a loan with a check $50,000

FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 0 Property 240,000 Checkable Deposits $ 0 Capital Stock 250,000 $50,000 in money supply is destroyed!

(Assume previous balance sheet) FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 8 (Assume previous balance sheet) Buy Government Securities $50,000

Bankers pursue two conflicting goals: FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Bankers pursue two conflicting goals: Profits and Liquidity Note use of Federal Funds Market... Federal Funds Rate

MULTIPLE DEPOSIT EXPANSION PROCESS Bank Acquired reserves and deposits Required reserves Excess Amount bank can lend - New money created A B C D E F G H I J K L M N Other banks $100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $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 17.57 Total amount of money created by the banking system $400.00

Money destruction works in exactly the same multiple way! MULTIPLE DEPOSIT EXPANSION PROCESS Bank Acquired reserves and deposits Required reserves Excess Amount bank can lend - New money created Money destruction works in exactly the same multiple way! A B C D E F G H I J K L M N Other banks $100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $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 17.57 Total amount of money created by the banking system $400.00

= x = THE MONETARY MULTIPLIER 1 Required reserve ratio Monetary Maximum checkable- deposit expansion = Excess reserves x Monetary Multiplier

OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created

Leakages exist... Currency Drains Excess Reserves OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves Leakages exist... Currency Drains Excess Reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created

This creates a need for Monetary Control