How Banks Create of Money

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Presentation transcript:

How Banks Create of Money AP Macroeconomics How Banks Create of Money

Banks can create money! When you deposit money in a checking account at the bank, does the bank have to keep all your money in the bank vault? The FED requires that banks keep only a certain percentage of your money in the bank vault or on deposit at the FED.

Reserve Ratio (Requirement) The percent that must be kept in the bank vault or on deposit at the FED is the required reserve ratio or reserve requirement. For example, if the RR is 20%, the bank must keep $200 of your $1000 deposit in the bank vault. What can the bank do with the other $800 (excess reserves)?

So – how do banks create $? Deposit RR ER Loan A $1000 $200 $800 B $160 $640 C $128 $512 D $102.4 $409.6 E … F Total Amount of $ created by banking system: $4000

Money Creation Formula A single bank can create $ by the amount of its excess reserves. The banking system as a whole can create $ by a multiple of the excess reserves. MM X ER = Expansion of money Money Multiplier = 1/RR Ex. If RR = 20% MM = 1/.20 = 5 If $1000 is deposited in bank, required reserves are $200; excess reserves are $800. The banking system as a whole can create: 5 X $800 = $4000.

New vs Existing $ If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation (buried treasure), the deposit immediately increases the money supply. The deposit then leads to further expansion of the money supply through the money creation process. Total change in MS if initial deposit is new $ = Deposit + $ created by banking system.

New vs. Existing $ If a deposit in a bank is existing $ (already counted in M1; ex. Currency or checks), depositing the amount does NOT change the MS immediately because it is already counted. Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposits. Total change in the MS if deposit is existing $ = banking system created money only.

Factors that weaken the effectiveness of the deposit multiplier: If bank customers take their loans in cash rather than in new checking account deposits. (cash or currency drains) If banks fail to loan out all their excess reserves.