How Banks and Thrifts Create Money Most transactions are “created” as a result of loans from banks or thrifts. Chapter demonstrates the money- creating abilities of a single bank or thrift and then looks at the system as a whole.

How Banks and Thrifts Create Money  This chapter the term “bank” is used generically and applies to all depository institutions.

Balance Sheet A Balance sheets summarize the financial position of the bank at a certain time. The value of assets must equal the value of claims Claims on a balance sheet are divided into two groups: – The bank owners’ claim is called net worth – Non-owners’ claims are called liabilities – Equation: Assets=Liabilities + Net Worth

Fractional Reserve System Type of system the U.S. has in which only a fraction of the total money supply is held in reserve as currency.

Goldsmiths In the 16 th century goldsmiths had safes for gold and precious metals, where they kept for consumers and merchants Receipts for these deposits were issued. Receipts were used as money in place of gold for convenience. Goldsmiths realized they could “loan” gold by issuing receipts to borrowers

Goldsmiths The loans began “fractional reserve banking,” because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.

Significance of fractional reserve banking: Banks can create money by lending more than the original reserves on hand Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds Federal Deposit Insurance Corporation (FDIC) was created to prevent panics

Money Creation by a Single Bank in Banking System Bank is formed (example - with $250,000 worth of owners’ capital stock)‏ Bank obtains property and equipment with some of the capital funds Bank begins operations by accepting deposits Banks keep reserve deposits in its district Federal Reserve Bank Ex. pg. 254

Required Reserves Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. Banks keep a significant portion of their own reserves in their vaults

Reserve Ratio The “specified percentage” of checkable-deposit liabilities that a commercial bank must keep as reserves. The Fed has the authority to establish and vary the reserve ration within limits legislated by Congress (between 8% and 14%)‏ First 6 million of checkable deposits held by bank exempt from reserve requirements

Reserves Three percent reserve required on checkable deposits between $6 million and $42.1million No reserves are required against non- checkable non-personal (business) savings CDs. (up to 9% can be required)‏

Control: Required reserves do not exist to protect against “runs” because banks must keep their required reserves. Required reserves exists to give the Federal Reserve control over the amount of lending or deposits that banks can create Required reserves help the Fed control credit and money creation. Banks cannot loan beyond their fraction required reserves.

Asset and Liability Reserves are an asset to banks Reserves are a Liability to the Fed

Profits, Liquidity, and the Federal Funds Market Profits: Banks are in business to make a profit They earn profits primarily from interest on loans and securities they hold Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and meet check-clearing transactions

Profits, Liquidity, and the Federal Funds Market Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other’s available reserves on overnight basis The interest rate paid is called the Federal Funds Rate

Need for Monetary Control During prosperity, banks will lend as much as possible and reserve requirements provide a limit to the expansion of loans During recession, banks may cut lending, which can worsen recession. Profit-seeking bankers will be motivated to expand or contract loans that could worsen the business cycle. The Fed uses monetary policy to counteract such results in order to prevent worsening recessions or inflation. (Cpt. 15)‏