Money Creation Chapter 32 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Fractional Reserve system Actual reserves vs. required reserves How banks create money through granting loans Multiple expansion of loans and money by the banking system The monetary multiplier 32-2

Fractional Reserve Banking The Goldsmiths –Stored gold and gave a receipt –Receipts used as money by public –Made loans by issuing receipts Characteristics –Banks create money through lending –Banks are subject to panics 32-3

Fractional Reserve System Balance sheet –Assets = Liabilities + Net Worth –Both sides balance Necessary transactions –Create a bank –Accept deposits –Lend excess reserves 32-4

AssetsLiabilities and Net Worth Creating a Bank Transaction #1 Vault cash: cash held by the bank Creating a Bank Balance Sheet 1: Wahoo Bank Cash$250,000Stock Shares$250,

AssetsLiabilities and Net Worth Creating a Bank Transaction #2 Acquiring property and equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash$10,000Stock Shares$250,000 Property240,

Assets Liabilities and Net Worth Creating a Bank Transaction #3 Commercial bank functions –Accepting deposits –Making loans Accepting Deposits Balance Sheet 3: Wahoo Bank Cash $110,000 Checkable Deposits $100,000 Property 240,000 Stock Shares 250,

Creating a Bank Transaction #4 Depositing reserves in a Federal Reserve bank –Required reserves –Reserve ratio Reserve ratio = Commercial banks Required reserves Commercial banks Checkable-deposit liabilities 32-8

Reserve Requirements Type of Deposit Current Requirement Statutory Limits Checkable deposits: $0-$9.8 Million $9.3-$43.9 Million Over $43.9 Million Noncheckable nonpersonal savings and time deposits 0% % Fed can establish and vary reserve ratio within limits set by Congress Required reserves help Fed control lending abilities of commercial banks 32-9

AssetsLiabilities and Net Worth Creating a Bank Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash$0Checkable Deposits $100,000 Property240,000Stock Shares250,000 Reserves110,000 Transaction #4 Assume the bank deposits all cash on reserve at the Fed 32-10

Reserve Requirements Excess reserves –Actual reserves - required reserves Required reserves –Checkable deposits x reserve ratio Example: –Checkable deposits $100,000 –Reserve ratio 20% 32-11

AssetsLiabilities and Net Worth Creating a Bank Transaction #5 Clearing a check –$50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Checkable Deposits $50,000 Property 240,000 Stock Shares250,000 Reserves $60,

AssetsLiabilities and Net Worth Money Creating Transactions Transaction #6a Granting a loan –$50,000 loan deposited to checking When a Loan is Negotiated Balance Sheet 6a: Wahoo Bank Checkable Deposits $100,000 Property240,000 Stock Shares250,000 Reserves$60,000 Loans50,

AssetsLiabilities and Net Worth Money Creating Transactions Transaction #6b Using the loan –$50,000 loan cashed After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Checkable Deposits $50,000 Property240,000 Stock Shares250,000 Reserves$10,000 Loans50,000 A single bank can only lend an amount equal to their preloan excess reserves 32-14

AssetsLiabilities and Net Worth Money Creating Transactions Transaction #7 Bank buys government securities from dealer –Deposits payment into checking Buying Government Securities Balance Sheet 7: Wahoo Bank Checkable Deposits $100,000 Property240,000 Stock Shares250,000 Reserves$60,000 Securities50,000 New money is created 32-15

Commercial Banks Conflicting goals Earn profit –Make loans to earn interest –Buy securities to earn interest Maintain liquidity Alternative? –Overnight bank loans –Federal funds rate 32-16

The Banking S ystem Multiple-deposit expansion Assumptions: –20% required reserves –All banks loaned up –Banks lend all of excess reserves A $100 bill is found and deposited Multiple deposits can be created 32-17

Bank (1) Acquired Reserves and Deposits (2) Required Reserves (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 The process will continue… The Banking S ystem 32-18

Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks Bank (1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio =.2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) $ $ $ $ $ The Banking S ystem 32-19

The Monetary Multiplier Monetary multiplier = 1 required reserve ratio New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example = 1 R 32-20

The Monetary Multiplier Maximum amount of new money created by single dollar of excess reserves Higher R, lower m Reversibility –Making loans creates money –Loan repayment destroys money 32-21

Bank Panics of Before deposit insurance Bank failure led to mass withdrawals Forced loan reduction 25-33% decline in money supply 1933 national bank holiday to evaluate all banks Contributed to the Great Depression Regulation protects the system today 32-22

Key Terms fractional reserve banking system balance sheet vault cash required reserves reserve ratio excess reserves actual reserves Federal funds rate monetary multiplier 32-23

Next Chapter Preview… Interest Rates and Monetary Policy 32-24