1. Module 25 Banking & Money Creation

2. Module 25 Essential Questions
What is the role of banks in the economy?
What are the reasons for and types of banking regulation?
How do banks create money?

3. The Monetary Role of Banks
More than half of the M1 is currency
The rest is demand deposits
Recall the definition of M1 = currency + coin + traveler’s checks + checking deposits
The role of Banks: because about half of the money supply is accounted for by checking deposits, the banks are crucial in the supply of money in the economy

4. Banks: Can’t Live With ‘Em, Can’t Live Without ‘Em
Financial Intermediaries
T-Accounts, Assets & Liabilities
Reserve & Lend
Reserve Ratio & Required Reserve Ratio

5. What DO Banks DO Anyway? Earn a Profit!
Do banks manufacture money?
Banks are __________ _________________in business to earn _______, but in the process they do make more money.
Banks offer a ______________ for depositors to put money and they offer ____________ services to borrowers who need money.
Savers are paid ___________ on savings, and borrowers are _________ __________interest on borrowing.
Banks take __________assets (savings) to finance the investment of __________ assets (homes and capital equipment).

6. What Do Banks DO Anyway? Earn a Profit!
Do banks manufacture money? No.
Banks are financial intermediaries in business to earn profit, but in the process they do make more money.
Banks offer a safe place for depositors to put money and they offer lending services to borrowers who need money.
Savers are paid interest on savings, and borrowers are charged interest on borrowing.
Banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment).

7. What Do Banks DO Anyway?: Reserve & Lend
Why do banks only hold a fraction of their deposits in reserve?
What does the bank do with the rest of the deposited money?
How does this increase the money supply?

8. What Do Banks DO Anyway?: Reserve & Lend
Why do banks only hold a fraction of their deposits in reserve? B/c customers will withdraw money from their checking and saving accounts
What does the bank do with the rest of the deposited money? Only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans.
How does this increase the money supply? Once loans are made, there is now more money in circulation, and the money supply increases.

9. What Do Banks DO Anyway?: Create Money
How does a bank create money?
What are T-accounts?
What does a bank’s T-account summarize?
What is the ratio of reserves to deposits called?
Who determines how low this ratio may go?
Why do banks hold some deposits in reserve?

10. What Do Banks DO Anyway?: Create Money
How does a bank create money? By lending deposits
What are T-accounts? Simple tools for analyzing a bank’s financial position.
What does a bank T-account summarize? its financial position;
(business’s assets and liabilities), with assets on the left and liabilities on the right.
What is the ratio of reserves to deposits called? the reserve ratio.
Who determines how low this ratio may go? The Federal Reserve
Why do banks hold some deposits in reserve? because there is always the small risk of a bank run. 

11. The Problem of Bank Runs
What is a Bank Run?
2. What leads to these bank runs?
3. What happens if everyone goes to the bank to withdraw their deposits at the same time?  
4. Why can’t the bank give back all the money being demanded?
5. How did banks runs lead the US Gov’t to act?

12. The Problem of Bank Runs
1. What is a Bank Run?
Depositors: money in the bank = safe & earning $  but when everyone withdraws their money at the SAME time…you have a bank run
2. What leads to these bank runs? Fear and panic about the stability of banks lead to bank runs
3. What happens if everyone goes to the bank to withdraw their deposits at the same time? it creates a bank run, and the bank runs out of money
 4. Why can’t the bank give back all the money being demanded? The bank keeps only a small % of the total deposits on reserve, so a bank run can lead to a self-fulfilling prophesy of the bank’s failure.
5. How did banks runs lead the US Gov’t to act? because BRs are very damaging to communities, states & a nation,
the US gov’t passed regulatory measures/laws on banks.

13. Deposit Insurance/FDIC
Bank Regulations
Deposit Insurance/FDIC
Capital Requirements
Reserve Requirements
The Discount Window

14. Bank Regulations 1. Deposit Insurance/FDIC
 The US government created the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Currently, the FDIC guarantees the first $250,000 of each account.
2. Capital Requirements
 To reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits.
Bank’s capital = assets - liabilities
3. Reserve Requirements
 The Federal Reserve establishes the required reserve ratio for banks. This policy insures that the banks will have a certain fraction of all deposits on hand in the event that customers with to withdraw money.
In the United States, the required reserve ratio for checkable bank deposits is 10%.
4. The Discount Window
 The Federal Reserve stands ready to lend money to banks via an arrangement known as the discount  window.
This helps a bank that finds itself in a short-term pinch because many depositors might be withdrawing their cash in a short period of time.

15. Determining the Money Supply
Money supply (M1) is currency in circulation plus checking deposits.
When you make a deposit into your checking account, the bank can make a loan to a borrower and he/she has part of your money in his/her checking account.
So by making a loan, the checking deposits have increased, thus increasing M1; the money supply.

16. How Banks Create Money
Does this process sounds familiar? It should sound a lot like the spending multiplier and the impact that an increase in spending has on the growth of even more spending.

17. Reserves, Bank Deposits, and the Money Multiplier
What happens to some of the loaned funds (referred to as “leaks”)
What are excess reserves?
What is the formula for excess reserves?
What is the monetary base?
What is the money multiplier?
What is the formula for the money multiplier?

18. Reserves, Bank Deposits, and the Money Multiplier
What happens to some of the loaned funds? (referred to as “leaks”) some loaned funds are kept by borrowers in their wallets & not deposited into another bank so it “leaks” out of the banking system (doesn’t get multiplied)
What are excess reserves? A bank’s money reserves over and above what is it required to keep as reserves
What is the formula for Excess Reserves? Excess reserves = total reserves – required reserves)
What is the monetary base? Currency in circulation + bank reserves
What is the money multiplier? Ratio of the money supply to the monetary base; shows the total number of dollars created by the banking system for each dollar added to the monetary base
What is the formula for the money multiplier? (MM = 1/rr)

19. Summary Excess Reserves = total reserves – required reserves
rr = reserve ratio
MM = 1/rr, where rr is the reserve ratio
Loan Expansion = Excess Reserves / rr
For the multiplication of money: the bank holds 10% of cash in reserve and lend the remaining 90%.
90% refers to excess reserves.
MM tells us how much money will be created if a bank has $1 of excess reserves.

20. The Money Multiplier in Reality
Monetary Base
Money Multiplier

21. FRQ #10 p.291
Tracy Williams deposits $500 that was in her sock drawer into a checking account at the local bank. A. How does the deposit initially change the t-account at the local bank? How does it change the money supply? B. If the bank maintains a reserve ratio of 10%, how will it respond to the new deposit? C. If every time the bank makes a loan, the loan results in a new check able bank deposit in a different bank equal to the amount of the loan, by how much could the total money supply in the economy expand in response to Tracy’s initial cash deposit of $500? D. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan, and the bank maintains a reserve ratio of 5%, by how much could the money supply expand in response to an initial cash deposit of $500?

22. Module Review Questions p. 251- 252
Read Module 26 p