Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-1 Chapter 11 How Banks Create Money

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-2 Learning Objectives Describe the simplified balance sheets of a single bank and the banking system. Explain the money-creating abilities of a single bank that is part of a multibank system. Explain the money-creating abilities of the banking system as a whole through multiple-deposit expansion, and compare this with the money-creating abilities of the single bank.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-3 Learning Objectives (cont.) Define the monetary (or credit) multiplier. Discuss some of the limitations on the banking system’s ability to create deposits and expand the money supply. Describe how the banks’ lending activities may contribute to financial instability and to increased fluctuations in the level of economic activity.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-4 Balance Sheet A statement of assets and claims that summarises the financial position of a firm at a point in time Each side balances: – Assets are items of economic and financial value – Assets = Liabilities + Net Worth

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-5 Formation of a Bank Transaction (1): The birth of a bank – new owners sell $ worth of shares in the bank

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-6 Formation of a Bank (cont.) Transaction (2): Becoming a going concern – Acquisition of property and equipment

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-7 Formation of a Bank (cont.) Transaction (3): Accepting deposits – Citizens and businesses deposit $100,000 – Change in composition not total supply of money

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-8 Formation of a Bank (cont.) Transaction (4): Setting aside required reserves – Assume reserve ratio is 20% – Bank must keep $ (required reserves) Reserve ratio = bank’s required reserve bank’s deposit liabilities

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 11-9 Formation of a Bank (cont.) – Bank decides to keep $ (actual reserves), which is $ more than required (excess reserves) – Bank’s required reserves are 20% of $

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Formation of a Bank (cont.) Transaction (5): Drawing a cheque – A citizen who has substantial deposits in the bank draws a cheque for $ to buy goods – The seller of the goods deposits the cheque in another bank – The banking system as a whole has not lost or gained

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Formation of a Bank (cont.) Transaction (5): Drawing a cheque (cont.)

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Creating Money Transaction (6): Granting a loan – A company borrows $ from the bank – Money is created – Balance sheet after loan is negotiated:

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Creating Money (cont.) Balance sheet after cheque drawn on loan has been cancelled: Now, bank has no excess reserves

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Creating Money (cont.) Transaction (7): Buying government bonds – Bank buys $ of government bonds instead of lending $ – Money is created

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia The Banking System Multiple banks: multiple-deposit expansion Money is created by a multiple of the banking system’s excess reserves

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Multiple-Deposit Expansion Assume initially: 20% reserve requirement Bank A – Accepts a deposit for $100  Does not alter money supply  Excess reserves of $80 – A loan of $80 is negotiated

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Multiple-Deposit Expansion (cont.) Balance Sheet: Bank A

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Multiple-Deposit Expansion (cont.) Loan cheque of $80 is drawn on Bank A and deposited in Bank B Bank B – Gains $80 in reserves and deposits – Excess reserves of $64 – Loans $64

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Multiple-Deposit Expansion (cont.) Bank B Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on…

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Multiple Deposit Expansion Process Bank Acquired reserves and deposits Required reserves Excess reserves A B C D E F G H I J K L M N Other banks $ $ $ $ $ Total amount of money created by the banking system New money created

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Total banking system has created $400 How? – Via the monetary multiplier where m is the monetary multiplier 1R1R 1 reserve ratio Multiple-Deposit Expansion (cont.) monetary multiplier = m =

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Possible Leakages Currency drains – Loan may be paid in cash and remain in circulation Transfer of deposits to non-bank financial institutions Excess reserves – Individual banks may choose to have larger reserves than required (say 25% instead of 20%)

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Willingness to Borrow For the full multiplier effect to take place: – Borrowers must be willing and able to utilise the loans – Borrowing is likely to be low during a recession

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Banks and Financial Instability Banks may contribute to business fluctuations Can exacerbate recession, by holding back on credit expansion May amplify inflationary pressures, by increasing lending and credit creation

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia Next Chapter: Monetary Policy