© 2005 Thomson C hapter 26 Money Creation and the Banking System

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The fractional reserve system The legal reserve requirement A bank’s balance sheet, its assets and liabilities Demand deposits and bank loans

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The potential money multiplier Bank failure The Federal Deposit Insurance Corporation (FDIC)

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e How Banks Create Money Fractional reserve system A banking system that provides people immediate access to their deposits but allows banks to hold only a fraction of those deposits in reserve.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e How Banks Create Money The fractional reserve system serves as the basis of all modern banking.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e How Banks Create Money If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e How Banks Create Money Balance sheet The bank’s statement of liabilities (what it owes) and assets (what it owns).

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e How Banks Create Money Banks make a profit on the loans they provide, not on their deposits.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e How Banks Create Money Legal reserve requirement The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Cyberspace Banking What is a cyberspace banking? Cyberspace is banking conducted over the Internet.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e How Banks Create Money $100,000 + $80,000 = $180, Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts?

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e How Banks Create Money 1. Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts? Thus fractional reserve banking creates money through loans.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e How Banks Create Money Financial intermediaries Firms that accept deposits from savers and use those deposits to make loans to borrowers.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e How Banks Create Money A fractional reserve system operating within financial intermediaries. 2. What three factors are needed for a banking system to create money?

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e How Banks Create Money A fractional reserve system operating within financial intermediaries. People willing to make demand deposits. 2. What three factors are needed for a banking system to create money?

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e How Banks Create Money 2. What three factors are needed for a banking system to create money? A fractional reserve system operating within financial intermediaries. People willing to make demand deposits. Borrows prepared to take out loans.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e How Banks Create Money Potential money multiplier The increase in the money supply that is potentially generated by a change in demand deposits.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e How Banks Create Money 3. If the legal reserve requirement is 10 percent, what is the potential money multiplier? The potential money multiplier “m” = 1/(legal reserve requirement) = 1/0.1 = 10.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e How Banks Create Money M = ID/LRR. 4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)?

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e How Banks Create Money 4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)? M = $100,000/.25 = $400,000.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e How Banks Create Money 5. Why might the actual increase in the money supply be less than the maximum potential increase in the money supply? Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system.

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e How Banks Create Money Excess reserves The quantity of reserves held by a bank in excess of the legally required amount.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e How Banks Create Money If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves.

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e How Banks Create Money Required reserves are 0.2 × ($100,000) = $20, Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e How Banks Create Money Excess reserves = (total reserves) - (required reserves). 6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e How Banks Create Money 6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? Excess reserves = $35,000 - $20,000 = $15,000.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e How Banks Create Money 7. How are required reserves recorded on a bank’s balance sheet? Required reserves are an asset.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e How Banks Create Money 8. How are excess reserves recorded on a bank’s balance sheet? Excess reserves are an asset.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e How Banks Create Money 9. How are loans recorded on a bank’s balance sheet? Loans are an asset.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e How Banks Create Money 10. How are demand deposits recorded on a bank’s balance sheet? Demand deposits are a liability.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e How Banks Create Money Yes. 11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits?

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e How Banks Create Money 11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits? With required reserves of $10,000 and a legal reserve requirement is 10 percent, then demand deposits equal $100,000.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves. 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made. 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Required reserves will increase.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Excess reserves will decrease.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Loans will decrease.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail 1. What will happen if too many borrowers are unable to repay their loans? A bank may fail.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail 2. If a bank fails, what will happen to the depositors? If deposits are insured by the federal government, then the government will step in and pay depositors up to the maximum insurable amount.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail 2. If a bank fails, what will happen to the depositors? If deposits are not insured by the federal government, then depositors may lose their money.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits. 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail Too many depositors withdrawing their money from their demand deposit accounts will overwhelm the fractional reserve system, and may cause it to fail. 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result. 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? Prior to modern banking regulation and practices, many recessions were caused by financial panics and banking system failures.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Safeguarding the System Federal Deposit Insurance Corporation (FDIC) A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $100,000 of deposits.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Safeguarding the System Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Safeguarding the System The FDIC was created in 1933, too late for the tens of thousands of people who had been financially wiped out by bank failures in the Great Depression.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Federal Deposit Insurance and Moral Hazard Fully insuring deposits leads to a costly side effect known as moral hazard.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Federal Deposit Insurance and Moral Hazard Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Federal Deposit Insurance and Moral Hazard Proposed solutions for the moral hazard problem with deposit insurance include: Privatize the deposit insurance system Reduce the scope of deposit insurance Yet any change in the deposit insurance system may itself destabilize the banking system.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e Safeguarding the System In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Safeguarding the System Despite these safeguards, approximately 10 banks fail each year.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e Safeguarding the System During the 1970s, high farm commodity prices inflated the price of farmland, and high oil prices inflated the value of property in Texas and Oklahoma.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e Safeguarding the System Banks made loans with inflated property values as collateral.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Safeguarding The System When farm commodity prices and oil prices collapsed in the recession of the early 1980s, many farms and businesses failed, and were unable to repay their loans.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Safeguarding the System Banks were left holding collateral —land, buildings, and other capital—that was worth less than the amount of the loan.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Safeguarding the System Consequently, many banks failed, particularly in farm states and in Texas and Oklahoma.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e Safeguarding the System Due to the moral hazard problem, there were questions regarding proper lending practices at some of the failed banks.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e EXHIBIT 1BANK FAILURES: 1930–2000

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Exhibit 1: Bank Failures Which of the two time periods experienced the largest number of bank failures: a. The mid- to late-1930s b. The mid- to late-1980s

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Exhibit 1: Bank Failures Which of the two time periods experienced the largest number of bank failures: a. The mid- to late-1930s b. The mid- to late-1980s

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e EXHIBIT 2BANK FAILURES, SELECTED STATES: 1987–89 Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Exhibit 2: Bank Failures, Selected States: Which of the following states had the largest number of bank failures between ? a. Alabama b. Texas c. California

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Exhibit 2: Bank Failures, Selected States: Which of the following states had the largest number of bank failures between ? a. Alabama b. Texas c. California

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e EXHIBIT 3THRIFT FAILURES: 1980–91

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e Exhibit 3: Thrift Failures: In which of the following years were there the most thrift failures? a b c. 1989

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e Exhibit 3: Thrift Failures: In which of the following years were there the most thrift failures? a b c. 1989

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e Safeguarding the System Many “thrifts” (savings and loans) in the early 1980s were locked in to long-term mortgage loans that paid the thrifts less than the interest they paid on deposits, causing thrifts to lose money.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Safeguarding the System This motivated some thrifts to move in to new, more speculative and risky loan markets. Another factor contributing to the failure of so many thrifts was fraudulent lending practices.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Safeguarding the System The large number of thrift failures in the 1980s put the Federal Savings and Loan Insurance Corporation (FSLIC) in crisis. Legislation was passed that created the Resolution Trust Corporation, which handled the disposal of all failed thrifts. The FDIC has assumed the insurance function of the now-defunct FSLIC.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Controlling the Financial Institutions that Control the Money Supply Financial institutions cannot create the proper money flows to foster economic activity with minimal inflation and unemployment. Control of the money supply is needed. That’s where the Federal Reserve System comes in.