Module 25 Banking and Money Creation KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: What roles do banks play in the economy? What types of bank regulations does the US use? How do banks create money?

The Monetary Role of Banks More than half of the M1 is currency The rest is demand deposits Recall the definition of M1 = currency + coin + traveler’s checks + checking deposits   This last component of M1 is where the role of banks comes into focus. If a large part (about half) of the money supply is accounted for by checking deposits into banks, the banks must play a crucial role in the supply of money in the economy

What Banks Do Financial Intermediary Bank Reserves T - Account Assets & Liabilities Reserve Ratio Required Reserve Ratio Ask a typical bank teller, “do you make money here?” and you will get a most peculiar look.   Banks are financial intermediaries in business to earn profit, but in the process they do make more money. Banks offer a safe place for depositors to put money and they offer lending services to borrowers who need money. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing. Another way of thinking about it is that banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment). Banks only hold a fraction of their deposits in reserve. These reserves are there for customers who wish to withdraw money from their checking and saving accounts. Banks know that on any given day, only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. Once loans are made, there is now more money in circulation, and the money supply increases. To see how banks can create money, introduce a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. The ratio of (reserves/deposits) is called the reserve ratio. The Federal Reserve specifies how low this ratio may go. Banks must hold some deposits in reserve because there is always the small risk of a bank run.

The Problem of Bank Runs Customer Deposits > Bank Reserves Why does this usually work? Bank Run – self-fulfilling prophecy Why? Bank Failure Depositors put their money in banks to earn interest and to keep it safe. But when the public begins to fear that the bank itself might fold, or if they fear for the stability of the entire financial system, they may want to withdraw their money. If everyone goes to the bank to withdraw their deposits, it creates a bank run.   The bank keeps only a small percentage of the total deposits on reserve, so a bank run can lead to a self-fulfilling prophesy of the bank’s failure. This can be very damaging to communities and it can spread across the economy. This is one of the primary reasons for regulating banks.

Bank Regulation Deposit Insurance FDIC Capital Requirements  Bank Capital = assets - liabilities Reserve Requirements The Discount Window Learning from the disastrous bank runs of the 1930s, the US has put in place several important regulations to insure the public trust in banks and to lessen the probability of rampant failures.   1. Deposit Insurance The US government created the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Currently, the FDIC guarantees the first $250,000 of each account. 2. Capital Requirements To reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. Bank’s capital = assets - liabilities For example, Main Street Bank has capital of $200,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets. 3. Reserve Requirements The Federal Reserve establishes the required reserve ratio for banks. This policy insures that the banks will have a certain fraction of all deposits on hand in the event that customers with to withdraw money. In the United States, the required reserve ratio for checkable bank deposits is 10%. 4. The Discount Window The Federal Reserve stands ready to lend money to banks via an arrangement known as the discount  window. This helps a bank that finds itself in a short-term pinch because many depositors might be withdrawing their cash in a short period of time.  Should foreshadowing of the discount rate come in here?

Determining the Money Supply Note: remind the students that the most basic definition of money supply (M1) is currency in circulation plus checking deposits.   When you make a deposit into your checking account, the bank can make a loan to a borrower and he/she has part of your money in his/her checking account. So by making a loan, the checking deposits have increased, thus increasing M1; the money supply.

How Banks Create Money Note: if the instructor walks through an example like this, it will supplement the example provided in the text and should demonstrate how banks create money. Note: Ask the students if this process sounds familiar. It should sound a lot like the spending multiplier and the impact that an increase in spending has on the growth of even more spending.  

Reserves, Bank Deposits, and the Money Multiplier “Leaks” Excess Reserves rr = reserve ratio Loan Expansion = Excess Reserves / rr The key to this multiplication of money is that the bank holds 10% of cash in reserve and lends the remaining 90%. This 90% refers to excess reserves. Excess reserves = total reserves – required reserves   MM = 1/rr Where rr is the reserve ratio. MM tells us how much money will be created if a bank has $1 of excess reserves.

The Money Multiplier in Reality Monetary Base Money Multiplier Book FIGURE 25.4 Note: The text notes that the actual money multiplier is closer to 1.9 than it is to 10.