© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 1 How Banks Create Money SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 2 In this chapter you will learn 12.1 How a chartered bank can create (or destroy) money through loans to the public 12.2 About the multiple-deposit expansion of the entire chartered banking system 12.3 What the monetary multiplier is and how to calculate it

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 3 Chapter 12 Topics 12.1 Chartered Banks & the Creation of Money 12.2 The Banking System: Multiple- Deposit Expansion 12.3 The Monetary Multiplier

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 4 Chartered Banks & the Creation of Money the creation of money is done with the help of Canada’s chartered banks

The Balance Sheet of a Chartered Bank ASSETS = LIABILITIES + NET WORTH ASSETS LIABILITIES + NET WORTH BALANCE SHEETS WILL BE USED TO DESCRIBE THE CREATION OF MONEY © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 5

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 6 Prologue: The Goldsmiths Goldsmiths accepted gold deposits and issued paper receipts Paper receipts were used as a medium of exchange 100% reserve system ð eventually led to fractional reserve system

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 7 Prologue: The Goldsmiths Fractional Reserve System Money creation & reserves Bank panics & regulation

Formation of a Chartered Bank ASSETS LIABILITIES AND NET WORTH TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 8

ASSETS LIABILITIES AND NET WORTH Cash $250,000 Capital Stock $250,000 Formation of a Chartered Bank Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 9

ASSETS LIABILITIES AND NET WORTH Cash $250,000 Capital Stock $250,000 TRANSACTION 2 Acquiring Property and Equipment $240,000 Cash Acquiring Property and Equipment Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 10

Acquiring Property and Equipment ASSETS LIABILITIES AND NET WORTH Cash $ 10,000 Property 240,000 Capital Stock $250,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 11

ASSETS LIABILITIES AND NET WORTH Cash $ 10,000 Property 240,000 Capital Stock $250,000 TRANSACTION 3 AcceptingDeposits $100,000 Cash Accepting Deposits Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 12

Accepting Deposits ASSETS LIABILITIES AND NET WORTH Cash $110,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 13

Accepting Deposits ASSETS LIABILITIES AND NET WORTH Cash $110,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Note: demand deposits are LIABILITIES to the bank Note: demand deposits are LIABILITIES to the bank Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 14

ASSETS LIABILITIES AND NET WORTH Reserves $ 110,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Reserves Vancouver Bank Note: cash is part of the bank’s reserves Note: © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 15

ASSETS LIABILITIES AND NET WORTH Reserves $110,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Bank deposits are subject to a desired reserve ratio Reserves Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 16

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Reserves

ASSETS LIABILITIES AND NET WORTH Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Reserves $110,000 Property 240,000 Excess Reserves Excess Reserves Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 20% Desired Reserve Requirement Assume 20% Desired Reserve Requirement FIND THE EXCESS RESERVES FIND THE EXCESS RESERVES Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 20% Desired Reserve Requirement Assume 20% Desired Reserve Requirement FIND THE EXCESS RESERVES FIND THE EXCESS RESERVES desired reserves = 20% X $100,000 =$20,000 desired reserves = 20% X $100,000 =$20,000 actual reserves Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 18

ASSETS LIABILITIES AND NET WORTH Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Reserves $110,000 Property 240,000 Excess Reserves Excess Reserves Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 10% Desired Reserve Requirement Assume 10% Desired Reserve Requirement E = $110, ,000 = $90,000 E = $110, ,000 = $90,000 Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 10% Desired Reserve Requirement Assume 10% Desired Reserve Requirement E = $110, ,000 = $90,000 E = $110, ,000 = $90,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 19

ASSETS LIABILITIES AND NET WORTH Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Reserves $110,000 Property 240,000 Excess Reserves Excess Reserves Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 10% Desired Reserve Requirement Assume 10% Desired Reserve Requirement E = $110, ,000 = $100,000 E = $110, ,000 = $100, Bank of Canada can influence the lending ability of banks through reserves Two Important Points Excess Reserves (E) = Actual Reserves - Desired Reserves Assume 10% Desired Reserve Requirement Assume 10% Desired Reserve Requirement E = $110, ,000 = $100,000 E = $110, ,000 = $100, Bank of Canada can influence the lending ability of banks through reserves Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 20

Clearing a Cheque ASSETS LIABILITIES AND NET WORTH Reserves $110,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 TRANSACTION 4 Clearing a cheque drawn against the bank bank = $50,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 21

ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Property 240,000 Demand Deposits $50,000 Deposits $50,000 Capital Stock 250,000 After Cheque Clearing TRANSACTION 4 This bank loses reserves and deposits to the Bank of Manitoba Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 22

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Money Creation: Single Bank The maximum amount of new money which can be created by a single bank is equal to its excess reserves The bank creates money when it creates new loans Money is destroyed when loans are repaid Banks create money when they buy government bonds from the public

ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Property 240,000 Demand Deposits $ 50,000 Deposits $ 50,000 Capital Stock 250,000 Granting a New Loan Bank has excess reserves of HOW MUCH? Use a 20% reserve ratio Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 24

ASSETS LIABILITIES AND NET WORTH TRANSACTION 5 Reserves $ 60,000 Property 240,000 Demand Deposits $ 50,000 Deposits $ 50,000 Capital Stock 250,000 Granting a New Loan Bank makes a loan to Grisley Company equal to the excess reserves $50,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 25

New Loan Before Cheque Clearing ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Loans 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Vancouver Bank A new loan & a new deposit of $50,000 are created © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 26

New Loan Before Cheque Clearing ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Loans 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Vancouver Bank New money of $50,000 has been created © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 27

New Loan Before Cheque Clearing ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Loans 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Vancouver Bank But did Grisley borrow the money to leave it in the bank? But did Grisley borrow the money to leave it in the bank? © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 28

ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Loans 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 NO!NO! New Loan Before Cheque Clearing Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 29

ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Loans 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 New Loan Before Cheque Clearing Vancouver Bank Grisley Co. writes a cheque worth $50,000 payable to Quickbuck Co. which banks at the Manitoba Bank Grisley Co. writes a cheque worth $50,000 payable to Quickbuck Co. which banks at the Manitoba Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 30

ASSETS LIABILITIES AND NET WORTH Reserves $ 10,000 Loans 50,000 Property 240,000 Demand Deposits $50,000 Deposits $50,000 Capital Stock 250,000 New Loan After Cheque Clearing Vancouver Bank Note that after clearing, the Vancouver Bank has no more excess reserves! Note that after clearing, the Vancouver Bank has no more excess reserves! © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 31

ASSETS LIABILITIES AND NET WORTH Reserves $ 10,000 Loans 50,000 Property 240,000 Demand Deposits $50,000 Deposits $50,000 Capital Stock 250,000 New Loan After Cheque Clearing Vancouver Bank A bank MUST have excess reserves to create loans A bank MUST have excess reserves to create loans © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 32

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Months later... © 2002 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 33

ASSETS LIABILITIES AND NET WORTH Reserves $ 10,000 Loans 50,000 Property 240,000 Demand Deposits $ 50,000 Deposits $ 50,000 Capital Stock 250,000 Repaying a Loan TRANSACTION 6 Repaying a loanworth$50,000 Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 34

ASSETS LIABILITIES AND NET WORTH Reserves $ 10,000 Loans 0 Property 240,000 Demand Deposits $ 0 Deposits $ 0 Capital Stock 250,000 Repaying a Loan Vancouver Bank Note that the amount of money - demand deposits - has declined by $50,000 Note that the amount of money - demand deposits - has declined by $50,000 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 35

ASSETS LIABILITIES AND NET WORTH TRANSACTION 7 Reserves $ 60,000 Property 240,000 Demand Deposits $ 50,000 Deposits $ 50,000 Capital Stock 250,000 Buying Government Securities Bank buys securities from the public for an amount equal to the excess reserves Vancouver Bank © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 36

ASSETS LIABILITIES AND NET WORTH Reserves $ 60,000 Securities 50,000 Property 240,000 Demand Deposits $100,000 Deposits $100,000 Capital Stock 250,000 Vancouver Bank Once again, the money supply has increased by $50,000 Buying Government Securities © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 37

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Government Securities Bond purchases from the public by the chartered banks increases the money supply Bond sales to the public decreases the money supply

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Profits, Liquidity, & the Overnight Loans Rate Bankers have two conflicting goals: ProfitLiquidity Overnight loans rate paid on overnight loans to cover temporary shortages of reserves

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 12 Topics 12.1 Chartered Banks & the Creation of Money 12.2 The Banking System: Multiple- Deposit Expansion 12.3 The Monetary Multiplier

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Banking System: Multiple Deposit Expansion A single bank can lend one dollar for each dollar of excess reserves The banking system can lend (create money) by a multiple of its excess reserves

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Three Assumptions Reserve ratio is 20% Initially, no banks have excess reserves Any bank with excess reserves will lend to ONE borrower who will write a cheque to someone else who will then deposit it in another bank

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ Junkyard owner finds $100 bill in a junked car, & deposits it Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 43

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ Note that at this stage NO new money has been created Note that at this stage NO new money has been created Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 44

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ $ Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 45

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ $ $80.00 Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 46

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ $ $80.00 Money is created once the loan is made Money is created once the loan is made $80.00 Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 47

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created A $ $ $80.00 $80.00 Loan recipient now spends the money. He/she buys something; seller deposits proceeds in his/her bank. Loan recipient now spends the money. He/she buys something; seller deposits proceeds in his/her bank. Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 48

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created AB $ $ $80.00 $80.00 New deposit means excess reserves in seller’s bank; process repeats New deposit means excess reserves in seller’s bank; process repeats Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 49

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created AB $ $ $ $80.00 Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 50

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created ABC $ $ $ $ Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 51

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created ABCDEFGHIJKLMN Other banks $ $ $ $ Total amount of money created by the bank system = $ Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 52

Bank Acquired reserves and deposits DesiredreservesExcessreserves Amount bank can lend. New money created ABCDEFGHIJKLMN Other banks $ $ $ $ Total amount of money created by the bank system = $ Monetary destruction works the same way in reverse Multiple Deposit Expansion Process Table 12-1 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 53

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 12 Topics 12.1 Chartered Banks & the Creation of Money 12.2 The Banking System: Multiple- Deposit Expansion 12.3 The Monetary Multiplier

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Monetarymultiplier R 1 =.20 1 = 5 The Monetary Multiplier =

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Monetary Multiplier Maximumdemand-depositcreation = Excessreserves x Monetarymultiplier Monetarymultiplier R 1 = =.20 1 = 5

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter The Monetary Multiplier Maximumdemand-depositcreation = Excessreserves x Monetarymultiplier Monetarymultiplier R 1 = =.20 1 = 5 = 80 x 5 = 400

$100 New reserves $ 20 Desiredreserves $80Excessreserves $100initialdeposit $400 Bank system lending Money created Outcome of Money Expansion - Fig © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 12 58

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Some Modifications Other Leakages Currency Drains Excess Reserves

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Need for Monetary Control an unregulated banking system can destabilize the economy there is a role for a central bank

© 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter Chapter 12 Topics 12.1 Chartered Banks & the Creation of Money 12.2 The Banking System: Multiple- Deposit Expansion 12.3 The Monetary Multiplier