Please listen to the audio as you work through the slides How Banks Create Money Please listen to the audio as you work through the slides

How Banks Create Money Learning Objectives: Students will be able to thoroughly and completely explain: How banks create and destroy money, the role of the reserve requirement. How the Money Multiplier works.

How banks destroy money How banks create money Through lending Buying bonds from the public How banks destroy money Through the payoff of loans Selling bonds to the public

Fractional Reserve System Balance sheet Assets = Liabilities + Net Worth Both sides balance Necessary transactions to understand Create a bank Accept deposits Lend excess reserves

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000 Deposit Added to Vault Cash

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

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property 240,000 Capital Stock $250,000

Deposits into checking accounts Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property 240,000 Capital Stock $250,000 TRANSACTION 3 Accepting Deposits into checking accounts $100,000 Cash

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000

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 240,000 Checkable Deposits $100,000 Capital Stock 250,000

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Three Important Issues... 1 - Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $110,000 - 20,000 = $90,000 2 – Control of Lending Ability 3 - Asset or Liability to Which Bank?

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 4 Deposit Into FED account $110,000 Cash

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000

A check is drawn against the bank Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 5 A check is drawn against the bank $50,000

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

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 $ 0 Reserves 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

Make a loan from excess reserves Formation of a Commercial Bank Promisary note LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 TRANSACTION 6 Make a loan from excess reserves $50,000

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Loans 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Making the loan created money!

Formation of a Commercial Bank * LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 After a check for the $50,000 is drawn against the bank

Repaying a loan with cash Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 TRANSACTION 7 Repaying a loan with cash $50,000

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 0 Property 240,000 Checkable Deposits $ 0 Capital Stock 250,000 $50,000 in money supply is destroyed!

Let’s buy bonds from public Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 Let’s buy bonds from public $50,000

(Assume previous balance sheet) Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 TRANSACTION 8 (Assume previous balance sheet) Bought Government Securities $50,000

Formation of a Commercial Bank LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Securities 50,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 Banks conflicting goals: Earn profit Make loans to earn interest Buy securities to earn interest Maintain liquidity Alternative? Overnight bank loans Federal funds rate

The Banking System Multiple-deposit expansion Assumptions: 20% required reserves All banks “loaned up” no excess reserves Banks lend all of excess reserves when they get them. A $100 bill is found and deposited Multiple deposits can be created 32-26

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 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $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 17.59 Total amount of money created by the banking system $400.00

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 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 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $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 17.59 Money destruction works in exactly the same multiple way! Total amount of money created by the banking system $400.00

The Monetary Multiplier Maximum amount of new money created by a single dollar of excess reserves Higher R, lower m R = Reserve ratio, m = monetary multiplier Reversibility Making loans creates money Loan repayment destroys money

The Monetary Multiplier Required reserve ratio 1 = Maximum checkable- deposit creation = Excess reserves x Monetary Multiplier

The Monetary Multiplier = 1 required reserve ratio 1 = R Graphic Example New Reserves $100 $80 Excess Reserves $20 Required Reserves $100 Initial Deposit $400 Bank System Lending Money Created