Banking and Money Creation

What Banks Do Banks use liquid assets to finance illiquid investments Liquid assets must be available to meet depositors’ withdrawals (vault or Fed account) Bank reserves are not considered currency in circulation

T-Account A T-account is a table of a business’s assets and liabilities For banks, a simplified version of the T-account would look something like this: AssetsLiabilities Loans Deposits Reserves Bank assets must be more than liabilities, as a fraction of deposits must be held as reserves (reserve ratio), with the minimum required reserve ratio set by the Fed

The Problem of Bank Runs A significant share of depositors demand money at the same time. There is not enough money on hand due to lending. To generate currency quickly, loans have to be sold at a discount. Significant reduction in bank’s assets leads to bank failure. Depositors at other banks worry about the safety of their money. Bank Run: a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure.

Bank Regulation 1. Deposit insurance removes the reason for bank runs 2. Capital requirements lessens the desire to make risky investments 3. Reserve requirements force banks to keep money on hand 4. Discount window provides backup funds to cover unexpected demand, preventing discount sales

Banks’ Role in Determining Money Supply 1. Banks remove currency from circulation, as reserves are non-checkable. 2. Banks create money.

How Banks Create Money Silas deposits $1,000. What does this mean for money in circulation? What about checkable deposits? What is the net effect on M1? From Silas’s deposit, the bank holds 10% in reserves and lends the rest to Mary. What happens to checkable deposits? What about money in circulation? And this keeps going…

The Money Multiplier Formula The result is a multiplier effect Assumptions: 1. All loaned funds are re-deposited 2. 10% reserve ratio 3. Banks are lending all excess reserves Money Multiplier = 1/rr (reserve ratio) This is both the ratio of the money supply: monetary base AND the increase in checkable bank deposits from $1 increase in excess reserves

Monetary Base versus Money Supply Monetary base: the sum of currency in circulation and the reserves held by the banks Monetary base differs from money supply in 2 ways: 1. Bank reserves are part of monetary base, but not money supply 2. Checkable deposits are part of money supply, but not monetary base Money in circulation is common to both, which is why the formula is complicated by the amount of money people hold in currency

Money Multiplier and REALITY In the simplified situation we discussed, money multiplier is 1/rr = 1/.10 = 10 In reality, the actual money multiplier is normally around 1.9 – much lower as a result of large amounts of cash not on deposit Money multiplier even lower when the government offers incentives for banks to hold excess reserves (like in 2008)