Mr. Bernstein Module 25: Banking and Money Creation February 26, 2015 AP Economics Mr. Bernstein Module 25: Banking and Money Creation February 26, 2015

AP Economics Mr. Bernstein Banking and Money Creation Objectives - Understand each of the following: The role of banks in the economy The reasons for and types of banking regulation How banks create money

AP Economics Mr. Bernstein How Banks Create Money Banks receive deposits Banks make loans Banks hold reserves against those loans If reserves are 10%, loans can be 10x deposits This effectively creates money Demonstrated by T-Account: Fed sets reserve requirements

AP Economics Mr. Bernstein How Banks Create Money: An Example Similar to the Spending Multiplier

AP Economics Mr. Bernstein Problem of Bank Runs If public fears a bank may fold and be unable to pay back depositors, they rush to the bank to make withdrawals before others can Since deposits are several times reserves, a bank with solid loans but the subject of rumours may be unable to meet demand for withdrawals Can become a self-fulfilling prophecy Preventing bank runs is a primary reason for bank regulation

AP Economics Mr. Bernstein Bank Regulation Deposit Insurance Current FDIC insurance is $250,000 per account Capital Requirements (= Assets – Liabilities) Capital Requirements have been rising since 2008 crisis Reserve Requirements Currently 10% in the USA Discount Window Fed stands as short-term lender to banks in need of capital

AP Economics Mr. Bernstein Reserves, Bank Deposits and the Money Multiplier Money Multiplier = 1 / reserve ratio…MM = 1/rr Excess Reserves = Total Reserves - rr MM tells us how much money can be created from each $ of Excess Reserves In reality, MM is not 10 – its now < 1. Why?