CHAPTER 32 Creation of Money

Two Definitions of the Money Supply, January 2005 M1 = $1361 billion Currency Outside banks $710 billion Other checkable deposits $321 billions Checking deposits In commercial Banks $330 billion M2 = $6443 billion Money market mutual funds $704 billion M1 $1361 billion Savings deposits $4378 billion

The Banking System Bank Regulation  Deposit insurance (FDIC)  Withdraw funds because of bad news regarding the bank’s finances  Moral hazard Problem  When an individual is insured against risk, he/she puts forth little effort to avoid risk  FDIC could make the banking system less safe

The Banking System Bank Regulation  Bank Supervision  Needed to reduce moral hazard problem  Ensures banks take only sensible, defensible risks  Controls the money supply  Reserve Requirements  Helps control the money supply

The Origins of the Money Supply How Bankers Keep Books  Banks keep balance sheets  Assets = liabilities + net worth  Assets include:  Deposits owned by bank  Reserves/Loans  Liabilities include:  Deposits owed to customers.

The Money Multiplier Banking system is not just a guard of the money supply  It multiplies the amount of money from the Central Bank This multiplying effect is the work of the infamous money multiplier. Each time a bank receives a deposit from a customer, it is required by the reserve requirement ratio set by the Fed (a.k.a. required by law) to keep in its reserves a fraction of the deposit The rest of the deposit can be lent out to potential borrowers. Called “fractional reserve system”  Which means that only a fraction of each deposit has to be kept in the bank’s reserves.

Fractional Reserve Banking The Goldsmiths Principle  Stored gold and gave a receipt  Receipts used as money by public  Made loans by issuing receipts Characteristics  Banks create money through lending  Banks are subject to “panics”

Fractional Reserve System Balance sheet  Assets = Liabilities + Net Worth  Both sides balance Necessary transactions  Create a bank  Accept deposits  Lend excess reserves

Reserve Requirements 9

AssetsLiabilities and Net Worth Lets create a bank… in the town of Vossdonium Transaction #1 Vault cash: cash held by the bank Sold stocks to acquire operating funds Balance Sheet 1: Vossome Bank Cash$250,000Stock Shares $250,000

AssetsLiabilities and Net Worth Transaction 2 Acquiring property and equipment Balance Sheet : Vossome Bank Cash$10,000 Stock Shares $250,000 Property240,000

AssetsLiabilities and Net Worth Transaction 3 Commercial bank functions  Accepting deposits  Making loans Balance Sheet 3: Vossome Bank Cash$110,000Checkable Deposits $100,000 Property 240,000 Stock Shares 250,000

Transaction 4 Depositing reserves in a Federal Reserve bank  Required reserves  Reserve ratio Reserve ratio = Commercial bank’s Required reserves Commercial bank’s Checkable-deposit liabilities Fed establishes and varies rr within limits set by Congress rr helps Fed control lending abilities of commercial banks

AssetsLiabilities and Net Worth Transaction 4 Assume the bank deposits all cash on reserve at the Fed Balance Sheet 4: Vossome Bank Cash$0Checkable Deposits $100,000 Property240,000Stock Shares250,000 Reserves110,000

Reserve Requirements Excess reserves  Actual reserves - required reserves Required reserves  Checkable deposits x reserve ratio Example:  Checkable deposits $100,000  Reserve ratio 10%

AssetsLiabilities and Net Worth Transaction 5a Granting a loan Balance Sheet 6: Vossome Bank Checkable Deposits $100,000 Property240,000 Stock Shares 250,000 Reserves Loans50,000 $60,000

AssetsLiabilities and Net Worth Transaction 6a Using the loan  $50,000 loan cashed Balance Sheet 6b: Vossome Bank Checkable Deposits $50,000 Property240,000 Stock Shares250,000 Required Reserves$10,000 Excess Reserves0 Banks can lend money in their vault that is above the minimum required reserve ratio. Loans50,000

AssetsLiabilities and Net Worth Transaction 6b Bank buys government securities from dealer  Deposits payment into checking Balance Sheet 7: Vossome Bank Checkable Deposits $100,000 Property 240,000 Stock Shares250,000 Reserves$60,000 Securities50,000 New money is created

The Banking System Multiple-deposit expansion Assumptions:  20% required reserves  All banks “loaned up”  Banks lend all of excess reserves A $100 bill is found and deposited Multiple deposits can be created

Bank (1) Acquired Reserves and Deposits (2) Required Reserves (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 The process will continue… The Banking System

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The Monetary Multiplier Monetary multiplier = 1 required reserve ratio New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example = 1 R

The Monetary Multiplier Maximum amount of new money created by single dollar of excess reserves Higher R, lower m Reversibility  Making loans creates money  Loan repayment destroys money

Another Illustration of Money Creation Assume 20% legal reserve requirement Suppose Nina deposits $1,000 in her checking account at Citibank. T-account of Citibank: ______Assets________________Liabilities____________ Reserves $200 Demand deposits $1,000 Loans 800

Kevin borrows $800 from Citibank, and buys a computer at BestBuy BestBuy deposits Kevin’s check at Fleet Bank. Fleet Bank’s T-account: _____Assets________________Liabilities_____________ Required Reserves $160 Demand Deposits $800 Loans (Excess) 640

Vivian borrows $640 from Fleet Bank and buys a new outfit from Macy’s. Macy’s deposits Vivian’s check at Bank of New York. T-account of Bank of New York: ______Assets____________________Liabilities_______ Required Reserves $128 Demand deposits $640 Loans (Excess) 512

Total Demand Deposits After Lending and Re-lending by banks Banks Demand Deposits Citibank $1,000 Fleet 800 Bank of New York 640  + other banks + additional deposits ___________ = $ 5,000 Total

Banks and Money Creation The Process in Reverse: Multiple Contractions of the Money Supply  Deposits (a.k.a money supply) contract when reserves are reduced.  Banks reduce their loan commitments  Contraction in the money supply utilizes the same formula as for money expansion.

The Need for Monetary Policy Left uncontrolled, banks would:  Reduce the money supply in a recession  Increase the money supply during boom periods Changes in the money supply would exacerbate the business cycle One reason for monetary policy:  Prevent this behavior on the part of banks.