How banks create money

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

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

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

Formation of a bank Transaction (1): The birth of a bank New owners sell $250 000 worth of shares in the bank

Formation of a bank (cont.) Transaction (2): Becoming a going concern Acquisition of property and equipment

Formation of a bank (cont.) Transaction (3): Accepting deposits Citizens and businesses deposit $100 000 Change in composition not total supply of money

Formation of a bank (cont.) Required reserve ratio The ratio of reserves to deposits to meet official liquidity requirements Transaction (4): Setting aside required reserves Assume reserve ratio is 20% Bank must keep $20 000 (required reserves) banks required reserve banks deposit liabilities Reserve ratio =

Formation of a bank (cont.) Bank decides to keep $110 000 (actual reserves), which is $90 000 more than required (excess reserves) Bank’s required reserves are 20% of $100 000

Formation of a bank (cont.) Transaction (5): Drawing a cheque A citizen who has substantial deposits in the bank draws a cheque for $50 000 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

Formation of a bank (cont.) Transaction (5): Drawing a cheque (cont.)

Creating money Transaction (6): Granting a loan A company borrows $50 000 from the bank Money is created Balance sheet after loan is negotiated:

Creating money (cont.) Now, bank has no excess reserves Balance sheet after cheque drawn on loan has been cancelled: Now, bank has no excess reserves

Creating money (cont.) Transaction (7): Buying government bonds Bank buys $50 000 of government bonds instead of lending $50 000 Money is created

The banking system Multiple banks: multiple-deposit expansion Money is created by a multiple of the banking system’s excess reserves

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

Multiple-deposit expansion (cont.) Balance sheet: Bank A

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

Multiple-deposit expansion (cont.) Bank B Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on …

Multiple deposit expansion process Acquired reserves and deposits Required reserves Excess New money created Bank 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 $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 4.40 17.57 $400.00 Total amount of money created by the banking system

Multiple-deposit expansion (cont.) Total banking system has created $400 How? Via the monetary multiplier Where m is the monetary multiplier 1 reserve ratio monetary multiplier = 1 R m =

Multiple-deposit contraction The multiple credit expansion process is reversible and leads to a multiple reduction in the level of deposits — and hence the supply of money — if reserves are withdrawn

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%)

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

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, during recovery and business cycle peaks