1. Money Creation
Chapter 32

2. Objectives I. Learning Objectives—In this chapter students will learn:
A. The basics of a bank’s balance sheet and why the U.S. banking system is called a “fractional reserve” system.
B. The distinction between a bank’s actual reserves and its required reserves.
C. How a bank can create money.
D. About the multiple expansion of loans and money by the entire banking system.
E. About the monetary multiplier, how to calculate it, and its relevance.

3. II. The Fractional Reserve System
A. Only a portion (fraction) of checkable deposits is backed up by reserves of currency in bank vaults or deposits at the central bank.
B. Commercial banks and thrifts create checkable deposits by issuing loans.
C. Illustrating the Idea: The Goldsmiths
1. In the 16th century, consumers would deposit their gold in a goldsmith’s vault. The goldsmith then issued receipts for these deposits.
2. Receipts were used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed.
3. Goldsmiths realized they could “loan” gold by issuing receipts to borrowers, who agreed to pay back gold plus interest.
4. Such 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.

4. D. Significant Characteristics of Fractional Reserve Banking
1. Banks can create money by lending more than the original reserves on hand. Although gold is no longer used as reserves, banks are now limited by the reserve requirement set by the Federal Reserve.
2. Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds. Also, the American deposit insurance system prevents panics, because depositors need not fear they will lose their deposits if the bank “runs out” of money.

5. III. A Single Commercial Bank
A. A balance sheet is a statement of assets—things owned by the bank or owed to the bank— and claims on those assets.
B. All balance sheets must balance; the value of assets must equal value of claims against the assets.
1. The bank owners’ claim is called net worth.
2. Non-owners’ claims (what is owed to depositors and others) are called liabilities.
3. Assets = liabilities + net worth.
C. Transaction 1: Creating a Bank
1. The bank is formed with $250,000 worth of owners’ stock shares (Balance Sheet 1).
2. Assets are $250,000 in cash; liabilities are $250,000 in stock shares.

6. D. Transaction 2: Acquiring Property and Equipment
1. The bank obtains $240,000 in property and equipment with some of its capital funds
(Balance Sheet 2).
2. Assets are $10,000 in cash and $240,000 in property; liabilities are $250,000 in stock shares.
E. Transaction 3: Accepting Deposits
1. The bank begins operations by accepting $100,000 in checkable deposits (Balance Sheet 3). Because the bank is holding the cash and also owes it to its depositors, the $100,000 is added to both sides of the T-account.
2. Assets are $110,000 in cash and $240,000 in property; liabilities are $100,000 in checkable deposits and $250,000 in stock shares.
3. The money supply did not change as a result of these transactions, because the money only changed form (from currency to checkable deposits).

7. F. Transaction 4: Depositing Reserves in a Federal Reserve Bank
1. Banks that provide checkable deposits must by law keep required reserves (Table 32.1).
a. Banks can keep reserves at the Fed or in vault cash to meet depositors’ needs (Balance Sheet 4).
b. The required reserve ratio is a fraction of deposits.
Commercial bank’s required reserves
Reserve ratio =
Commercial bank’s checkable deposit liabilities
c. Excess reserves = actual reserves – required reserves
d. Required reserves do not exist to protect against “runs,” because banks must keep their required reserves, and those required reserves are insufficient to pay everyone with a checkable deposit at once.
e. The purpose of the reserve requirement is to give the Federal Reserve control over the lending ability of banks. In other words, required reserves help the Fed control credit and money creation. Banks cannot loan beyond their excess reserves.

8. 2. Reserves are an asset to banks but a liability to the Federal Reserve Bank system, because now they are deposit claims by banks at the Fed.
3. Assets are $110,000 in reserves at the Fed and $240,000 in property; liabilities are $100,000 in checkable deposits and $250,000 in stock shares.
G. Transaction 5: Clearing a Check Drawn against the Bank
1. A $50,000 check drawn against the bank and deposited into another bank is addressed by the Federal Reserve. The Fed takes $50,000 in reserves from the first bank and deposits them in the second bank. Both the reserves and checkable deposits decrease by $50,000 to balance the T-account (Balance Sheet 5).
2. Assets are $60,000 in reserves at the Fed and $240,000 in property; liabilities are $50,000 in checkable deposits and $250,000 in stock shares.

9. 2. Reserves are an asset to banks but a liability to the Federal Reserve Bank system, because now they are deposit claims by banks at the Fed.
3. Assets are $110,000 in reserves at the Fed and $240,000 in property; liabilities are $100,000 in checkable deposits and $250,000 in stock shares.
G. Transaction 5: Clearing a Check Drawn against the Bank
1. A $50,000 check drawn against the bank and deposited into another bank is addressed by the Federal Reserve. The Fed takes $50,000 in reserves from the first bank and deposits them in the second bank. Both the reserves and checkable deposits decrease by $50,000 to balance the T-account (Balance Sheet 5).
2. Assets are $60,000 in reserves at the Fed and $240,000 in property; liabilities are $50,000 in checkable deposits and $250,000 in stock shares.

10. A. Transaction 6: Granting a Loan
IV. Money-Creating Transactions of a Commercial Bank
A. Transaction 6: Granting a Loan
1. The bank grants a loan of $50,000 (Balance Sheet 6a).
a. Money ($50,000) has been created in the form of new checkable (demand) deposit worth $50,000. Assets are $60,000 in reserves, $50,000 in loans, and $240,000 in property; liabilities are $100,000 in checkable deposits and $250,000 in stock shares.
b. By issuing the loan, the bank actually created money that did not previously exist. The money did not simply change form as before, from currency to a checkable deposit; it was literally created!
c. After the borrower has spent the loan money and the check clears, the bank has reached its lending limit; it has no more excess reserves (Balance Sheet 6b). Its $10,000 reserves are 20% of the $50,000 in checkable deposits, and the reserve requirement is 20%.
d. Assets are $10,000 in reserves at the Fed, $50,000 in loans, and $240,000 in property; liabilities are $50,000 in checkable deposits and $250,000 in stock shares.

11. 2. When loans are paid off, money is destroyed, because the bank’s checkable deposits decline by the amount of the loan repayment.
B. Transaction 7: Buying Government Securities
1. When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does.
(Balance Sheet 7)
2. The bank buys $50,000 of bonds from a securities dealer, so the dealer’s checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to a customer.
3. Assets are $60,000 in reserves, $50,000 in securities, and $240,000 in property; liabilities are $100,000 in checkable deposits and $250,000 in stock shares.
4. When banks or the Federal Reserve sell government securities to the public, they decrease supply of money in the same manner as a loan repayment.

12. C. Profits, Liquidity, and the Federal Funds Market
1. Profits: Banks are in business to make a profit like other firms. They earn profits primarily from interest on loans and securities they hold.
2. Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and to meet check clearing transactions.
3. Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from other banks’ available reserves on an overnight basis. The interest rate paid is called the federal funds rate.
V. The Banking System: Multiple-Deposit Expansion
A. The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.

13. B. Three simplifying assumptions:
1. Required reserve ratio is 20 percent.. Profits, Liquidity, and the Federal Funds Market
2. Initially all banks have no excess reserves; they are “loaned up.”
3. When a bank has excess reserves, the bank loans all of the money to one borrower, who writes a check for entire amount to give to someone else, who deposits it at another bank.
The check clears against the original lender.
C. The Bank System’s Lending Potential
1. Suppose a customer finds a $100 bill and deposits it in Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B.
2. Bank B now receives an $80 deposit and must hold 20 percent ($16) in required reserves.
It can now loan a maximum of $64, the excess reserves from that deposit. The entire process is summarized in Table 32.2.
3. An individual bank can safely lend only an amount equal to its excess reserves, but the commercial banking system can lend by a multiple of its collective excess reserves.

14. E. Reversibility: The Multiple Destruction of Money
1. Loan repayment destroys money, and the money multiplier increases that destruction.
2. Because loans are both made and paid off in any period of time, the direction of the loans, checkable deposits, and money supply will depend on the net effect of the two processes.
VI. LAST WORD: The Bank Panics of 1930–1933
A. Bank panics in 1930–1933 led to a multiple contraction of the money supply, which worsened the Great Depression.
B. Many of the failed banks were healthy, but they suffered when worried depositors panicked and withdrew funds all at once. More than 9,000 banks failed in three years.
C. As people withdrew funds, this reduced banks’ reserves and, in turn, their lending power fell significantly. Contraction of excess reserves leads to multiple contraction in the money supply, or the reverse of situation in Table 32.2.

15. D. The money supply was reduced by 25 to 33 percent (depending on how the money supply is counted) in those years. A lower money supply meant less spending for goods and services as well as fewer loans for businesses, exacerbating the Great Depression.
E. President Roosevelt declared a “bank holiday,” closing banks temporarily while government inspectors examined each bank’s accounting records. Only healthy banks were allowed to reopen, and Congress started the Federal Deposit Insurance Corporation (FDIC), which ended bank panics on insured accounts.
F. During the financial crisis of , the FDIC increased deposit insurance from $100,000 to $250,000 per account and guaranteed the safety of all money market mutual fund accounts. The Fed also took immediate action to maintain the banking system’s reserves and the nation’s money supply.