Module 25 Banking and Money Creation KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: The role of banks in the economy How banks create money How to create a financial panic… And how to prevent one.

How Banks Work Own Owe $ 10 cash $ 100 checking account $ 90 loans 2. Bank keeps some money in reserve in case depositor withdraws $. Own Owe 1. Joanna deposits money in her bank account $ 10 cash $ 100 checking account $ 90 loans 3. Bank lends remaining money to companies and consumers. Portion held back as a reserve is called a “fractional reserve” because it is a fraction of total deposits. Entire process is called the fractional reserve system. 9/14/2019 Chapter 16-Mods 47-49

How Banks Create Money First person – Banks 2nd person – Firm 3rd– Banks 4th – Firm 5th – Bank 6th – Firm Banks take deposits from firms. Keep 10% in reserve. Lend out the rest. Ask a typical bank teller, “do you make money here?” and you will get a most peculiar look.   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. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing. Another way of thinking about it is that banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment). Banks only hold a fraction of their deposits in reserve. These reserves are there for customers who wish to withdraw money from their checking and saving accounts. Banks know that on any given day, only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. Once loans are made, there is now more money in circulation, and the money supply increases. To see how banks can create money, introduce a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. The ratio of (reserves/deposits) is called the reserve ratio. The Federal Reserve specifies how low this ratio may go. Banks must hold some deposits in reserve because there is always the small risk of a bank run.

How Banks Create Money Note: if the instructor walks through an example like this, it will supplement the example provided in the text and should demonstrate how banks create money. Note: Ask the students if 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.  

Reserves, Bank Deposits, and the Money Multiplier rr = reserve ratio Loan Expansion (new money) = Excess Reserves / rr $ 1 billion excess reserves / 10% reserve requirement = $ 10 billion in new money creation. The key to this multiplication of money is that the bank holds 10% of cash in reserve and lends the remaining 90%. This 90% refers to excess reserves. Excess reserves = total reserves – required reserves   MM = 1/rr Where rr is the reserve ratio. MM tells us how much money will be created if a bank has $1 of excess reserves.

How do you create more excess reserves? Central bank increases the monetary base. Monetary base: bank deposits at central bank + currency. The key to this multiplication of money is that the bank holds 10% of cash in reserve and lends the remaining 90%. This 90% refers to excess reserves. Excess reserves = total reserves – required reserves   MM = 1/rr Where rr is the reserve ratio. MM tells us how much money will be created if a bank has $1 of excess reserves.

Figure 25.4 The Monetary Base and the Money Supply Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Let’s Reverse Money Creation Ask a typical bank teller, “do you make money here?” and you will get a most peculiar look.   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. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing. Another way of thinking about it is that banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment). Banks only hold a fraction of their deposits in reserve. These reserves are there for customers who wish to withdraw money from their checking and saving accounts. Banks know that on any given day, only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. Once loans are made, there is now more money in circulation, and the money supply increases. To see how banks can create money, introduce a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. The ratio of (reserves/deposits) is called the reserve ratio. The Federal Reserve specifies how low this ratio may go. Banks must hold some deposits in reserve because there is always the small risk of a bank run.

How to start a bank run Bank run: is when depositors fear bank failure and demand their money back all at once. Bank failure: when banks cannot payout their depositors. Bank runs force banks to … call in loans and sell assets depressing financial asset prices leading to a financial panic. Depositors put their money in banks to earn interest and to keep it safe. But when the public begins to fear that the bank itself might fold, or if they fear for the stability of the entire financial system, they may want to withdraw their money. If everyone goes to the bank to withdraw their deposits, it creates a bank run.   The bank keeps only a small percentage of the total deposits on reserve, so a bank run can lead to a self-fulfilling prophesy of the bank’s failure. This can be very damaging to communities and it can spread across the economy. This is one of the primary reasons for regulating banks.

Bank Regulation Scavenger Hunt FDIC Deposit Insurance – how much? Capital Requirements - % Tier 1 capital to risk weighted assets under Basel III Reserve Requirements - % of deposits The Discount Window – current rate Learning from the disastrous bank runs of the 1930s, the US has put in place several important regulations to insure the public trust in banks and to lessen the probability of rampant failures.   1. Deposit Insurance 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. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. Bank’s capital = assets - liabilities For example, Main Street Bank has capital of $200,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets. 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.  Should foreshadowing of the discount rate come in here?

Economic Exit Ticket 1. $10 billion of new reserves are injected into the monetary base. Assuming a 10% reserve ratio, how much money will banks create? 2. Rank the four means of preventing bank runs from the strongest to the weakest. Give your rationale. The key to this multiplication of money is that the bank holds 10% of cash in reserve and lends the remaining 90%. This 90% refers to excess reserves. Excess reserves = total reserves – required reserves   MM = 1/rr Where rr is the reserve ratio. MM tells us how much money will be created if a bank has $1 of excess reserves.

Summary Fractional reserve system allows banks to relend a portion of deposits – which in turn create more deposits. Monetary base = currency + bank deposits at central bank. Money multiplier = excess reserves / reserve ratio calculates amount of money created from an increase in the monetary base. A bank run results from the multiplier running in reverse. Reserve requirements, minimum capital ratios, FDIC depositor insurance, and the discount window are designed to prevent bank runs. Ask a typical bank teller, “do you make money here?” and you will get a most peculiar look.   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. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing. Another way of thinking about it is that banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment). Banks only hold a fraction of their deposits in reserve. These reserves are there for customers who wish to withdraw money from their checking and saving accounts. Banks know that on any given day, only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. Once loans are made, there is now more money in circulation, and the money supply increases. To see how banks can create money, introduce a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. The ratio of (reserves/deposits) is called the reserve ratio. The Federal Reserve specifies how low this ratio may go. Banks must hold some deposits in reserve because there is always the small risk of a bank run.