1. How Banks and Thrifts Create Money14
C H A P T E R
How Banks and Thrifts Create Money
Give Money Quiz (timed)
Ch. 14 lecture in one day.
Main Idea of ch. 14 is the creation and destruction of money.

2. Money Creation?
Creating money may seem like something only the Bureau of Engraving (makes our FED reserve notes/ dollar bills) and The US Mint (makes our coins), but BANKS also make money.
They create checkable deposits.
The prologue to ch. 14 tells a story of goldsmiths… realizing that there were often more receipts in circulation (as currency) than gold on deposit. They then started making interest bearing loans…. And banking was born.

3. BALANCE SHEET OF A COMMERCIAL BANK
ASSETS = LIABILITIES + NET WORTH
They must equal. If they don’t.. fix it!
Balance Sheet – a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time.
A Balance sheet MUST BALANCE!
Net Worth = Assets - Liabilities

4. 2 Characteristics of the Fractional Reserve Banking System
1. Reserves limit money creation
2. Gov’t regulations & the FDIC prevent panics
Fractional Reserve Banking has 2 significant characteristics:
Banks create money through lending
-- they are limited through the reserve requirement set by the gov’t (FED)
2. FDIC insured deposits up to 100,000 dollars, and the gov’t closely monitors the action of banks. It is now unlikely that a bank will suffer a run, a panic, or bankruptcy.

5. 3 Questions to Consider:
How can a commercial bank or thrift create money?
How can they destroy money?
What factors govern how banks create or destroy money?
Students need to thoroughly understand this process. The next several slides go step by step through the process.

6. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
TRANSACTION 1
Creating a bank
$250,000 Cash
for
Capital Stock
The founders of the bank sell shares to raise money for the bank’s creation.
They have raised $250,000 cash (asset), and they owe $250,000 to their shareholders (liability).

7. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $250,000
Capital Stock $250,000
Deposit Added to Vault Cash

8. Acquiring Property and
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $250,000
Capital Stock $250,000
TRANSACTION 2
Acquiring Property and
Equipment
$240,000 Cash
They buy a building for $220,000 & office equipment for $20,000 = $240,000
Property is an asset, so we still balance… it just lowers our amount of cash.

9. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $ 10,000
Property ,000
Capital Stock $250,000

10. (changes in money in circulation…not money creation)
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $ 10,000
Property ,000
Capital Stock $250,000
TRANSACTION 3
Accepting
Deposits
$100,000 Cash
Commercial banks have 2 basic functions (take deposits and make loans)
If the bank receives $100,000 in checkable deposits (people opening checking accounts), then there is an increase of $100,000 cash to assets.
$100,000 will also be added to liabilities, because the bank is liable for the money (it is owned by the depositors) –a checkable deposit is a CLAIM AGAINST AN ASSET.
Main ideas about this transaction:
The money supply in circulation just dropped by $100,000, because money in a bank is not counted in the Sm.
Withdrawals will increase Sm in circulation, and will decrease each column equally.
(changes in money in circulation…not money creation)

11. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000

12. FORMATION OF A COMMERCIAL BANK
NOTES:
Bank deposits are
subject to a reserve
requirement.
Reserve
ratio
Commercial bank’s
required reserves
checkable-deposit
liabilities =
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
All banks are required by law to deposit a %age of their checkable deposits with the FED. This is called a reserve requirement or required reserves.
Banks do this by keeping cash in its vault, and by depositing money into a FED account.
The specific amount of the reserve requirement is the RESERVE RATIO:
Commercial bank’s required reserves/commercial bank’s checkable-deposit liablities
(percentage or a fraction… same thing)
The reserve is much more complex than this, because a certain amount is exempt… then the rate is progressive after that.

13. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 4
Deposits
at the FED
$110,000 Cash
This bank deposited $110,000 in the Fed.

14. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000

15. (assume 20% reserve requirement)
Three Important Issues...
1. Excess Reserves = Actual Reserves - Required Reserves
(assume 20% reserve requirement)
$110, ,000 = $90,000
2 – Control of Sm
3 - Asset and Liability
1. Banks often deposit in excess of the required reserve, b/c they anticipate growth & profit, and they don’t want to have to make additional deposits regularly. Excess (or extra reserves) also help banks lend money.
2. Reserves provide CONTROL (not protection from panic) to the FED… control of Sm!
3. FED deposits become assets for the bank… and they become a liability to the FED

16. A check is drawn against the bank
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 5
A check is drawn against the bank
$50,000
Jim-Bob bought an H2 for $50,000. He writes a check against his deposit at the bank.
The bank pays the $50,000 to the Hummer Dealership’s bank, and the balance sheet reflects the deduction.
Two questions to consider:
How is this check collected or cleared? (used to take days… now is instant)
Jim-Bob hands the check to Hummer.
Hummer deposits check into bank.
H Bank sends check to the FED.
The FED takes $50,000 from the bank’s reserve & deposits it into H Bank’s reserve.
The FED sends the check to the bank.
The bank reduces Jim-Bob’s account by $50,000 & corrects it’s balance sheet.
The check is stored or mailed back to Jim-Bob for his records.
2. What effect does the collection of the check have on the balance sheets of the banks involved?
The bank has $50,000 less reserve (asset) and $50,000 less liability (checkable deposit)
H bank has $50,000 added to its reserve (asset) and +$50,000 liability from the dealerships increased checkable deposit.

17. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000

18. FORMATION OF A COMMERCIAL BANK
NOTES:
Banks create money
by lending excess
reserves and destroy
it by loan repayment.
Purchasing bonds
from the public also
creates money.
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000

19. Make a loan from excess reserves
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
TRANSACTION 6
Make a loan from excess reserves
$50,000
Transactions 6, 7, & 8 explain how banks create money & destroy money.
A business decides it wants to expand its business to a second location, they apply for a loan. The bank gives them $50,000 loan… after finding its credit record satisfactory.
The bank increases the business’s checkable deposit by $50,000.
The business gives an IOU to the bank.
THE IOU IS AN ASSET. (a loan is an asset, b/c it represents money)
THE $50,000 IS LIABILITY. (the checkable deposit is a liability to the bank, because it now belongs to the business)
This is money creation, you walk in with an IOU… and you walk out with $50,000!
This is a change in Sm.

20. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Loans ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
Making the loan
created money!

21. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
After a check for the $50,000
is drawn against the bank

22. Repaying a loan with a check
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
TRANSACTION 7
Repaying a loan with a check
$50,000

23. FORMATION OF A COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans
Property ,000
Checkable
Deposits $
Capital Stock ,000
$50,000 in money supply
is destroyed!

24. (Assume previous balance sheet)
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Securities ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 8
(Assume previous balance sheet)
Buy Government
Securities
$50,000

25. Bankers pursue two conflicting goals:
FORMATION OF A
COMMERCIAL BANK
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Securities ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
Bankers pursue two conflicting goals:
Profits and Liquidity
Note use of Federal Funds Market...
Federal Funds Rate

26. MULTIPLE DEPOSIT EXPANSION PROCESS
Bank
Acquired reserves
and deposits
Required
reserves
Excess
Amount bank
can lend - New
money created A B C D E F G H I J K L M N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
21.97
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
17.57
Total amount of money created by the banking system
$400.00

27. Money destruction works in exactly the same multiple way!
MULTIPLE DEPOSIT EXPANSION PROCESS
Bank
Acquired reserves
and deposits
Required
reserves
Excess
Amount bank
can lend - New
money created
Money
destruction works
in exactly the same
multiple way! A B C D E F G H I J K L M N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
21.97
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
17.57
Total amount of money created by the banking system
$400.00

28. = x = THE MONETARY MULTIPLIER 1 Required reserve ratio Monetary
Maximum
checkable-
deposit
expansion =
Excess
reserves x
Monetary
Multiplier

29. OUTCOME OF MONEY EXPANSION
$100
New reserves
$20
Required
reserves
$80
Excess
reserves
$400
Bank system lending
$100
Initial
Deposit
Money Created

30. Leakages exist... Currency Drains Excess Reserves
OUTCOME OF MONEY EXPANSION
$100
New reserves
$20
Required
reserves
Leakages exist...
Currency Drains
Excess Reserves
$80
Excess
reserves
$400
Bank system lending
$100
Initial
Deposit
Money Created

31. This creates a need for
Monetary Control