1 Money Creation

2 Overview In order to see how monetary policy can be used to influence economic performance (we saw fiscal policy before) we first have to look at the banking system. We will look at some basic operations of banks. Plus we will see how the actions of people (the public), Federal Reserve action, combined with bank operations, leads to changes in the money supply. Remember we say that money is basically 1 - currency, and 2 - checkable deposits.

3 Bank Balance sheet To understand the banking system we will look at banks from a balance sheet perspective. On a balance sheet you will find bank 1) assets 2) liabilities and net worth. Using a mechanism called a t-account, we have assets on the left and liabilities and net worth on the right. assetsliabilities + NW

4 examples of assets and liabilities Some assets we will talk about are 1) reserves of the bank(BR) 2)loans the bank has made(L) For now we will mention the liability called 1) checkable deposits or demand deposits(D) Note: remember we said money or M1=currency (CU) + checkable deposits (D). By currency, we mean the funds in the hands of the nonbank public. Let’s look at some examples of bank operations.

5 currency deposits A L+NW D+100BR +100 Say you have $100 in currency and you put it into your checking account. The bank now has a liability -> it owes you $100. But it also has what are called reserves, in this case the currency you brought in is put in the bank vault. Note the currency in the vault is not in the hands of the nonbank public, so is not money, but now reserves of the bank. In this example the money supply was not changed, but transformed from currency to checkable deposits.

6 Let’s ponder some more what we just had on the last screen. When people hold these bills the bills are called money. When people put the bills into their checking account the people still have money, but now in the form of checking account balances. The bank then has the bills and the bills are then called reserves!

7 currency withdrawal A L+NW D -100BR -100 Say you want $100 in currency from your checking account. The bank no longer has a liability and it loses an equal amount of reserves, in this case from the bank vault. In this example the money supply was not changed, but transformed from checkable deposits to currency.

8 Imagine the economy is just starting its use of money. Say the Federal Reserve (FED), the central bank in the US, has some guys fly around in a helicopter and they drop 100 single dollar bills over the land where people live. At this point the money supply would be $100 and made up of only currency. If people just used these bills and never put money in a bank, then the money supply would stay at $100 unless the FED put more money in or took money out of the system. A few potential problems of holding money only in the form of currency is that it may be lost, or it could be stolen. Because of this (and a few other things we do not need to worry about here ) folks put their money into a bank. For now let’s assume people do not want to hold any currency. So, they put all $100 into a checking account.

9 All currency is deposited into banks A L+NW D 100BR 100 At this point the money supply is still only $100 but is now made up of checking account balances. Banks customers as a group usually do not want all of their deposits back on a certain day. As an example, maybe on every dollar customers have in a bank they only want to write checks on 5 cents on a given day. What I am trying to express here is that banks have noticed that customers as a group only take out a fraction of their deposits on a given day.

10 Let’s note a few ideas. Bank reserves are held because the bank has to be able to give you these bills if you so desire (and you have balances in your account – otherwise they try to put you in jail;). Bank reserves do not earn the bank any interest (well, very little when the rules where changed after the late 2000’s), but there is the gain of keeping customers happy by being able to give out bills when desired. Banks have noticed that at any point in time depositors do not want all their money to be transformed back from checking account balances to currency. With these three things in mind banks have discovered that they can lend out some of the bank reserves and then interest can be charged on the loan.

11 By remembering what I have here you can score some points on the next few assignments and the final exam. If banks always kept all the reserves in the bank, we would have a 100% reserve banking systems. When banks lend some of the reserves and thus only keep a fraction of its reserves the banking system becomes a fractional reserve banking system. Let’s assume banks desire to keep in reserve 20% of the deposits obtained. This means the banks will lend out the rest. Also remember we said the public does not want to hold currency at this time. Let’s next see what happens in the banking system when bank loans are made.

12 Bank loan A L+NW D +100BR +100 A L+NW BR +20 L +80 At the top you see what the banking system looks like when the public deposits the $100. Next you see how the loan is made. Since the bank wants to hold 20% of deposits as reserves it loans 80 by creating an asset called loans and adds to checkable deposits for the person who gets the loan. The third point is the person with the loan spends the money and the bank loses an equal amount of reserves. At the bottom here you see the final position for the bank. The 100 in new deposits will support 80 in loans. L + 80 A L+NW D +80 D +100 A L + NW BR -80D -80 I have plus signs and minus signs to denote changes in these amounts.

13 Bank loan is money creation At any point in time the bank can only lend out what it has in excess reserve. The bank notes what is excess over a period of time. The bank we saw before had excess reserves of 80 and lent out 80. Once a bank loan is made, a process is started in the economy and the process culminates in a multiple expansion of the money supply. Multiple here means more than the amount that occurred at first. Let’s now turn to the process of multiple deposit expansion.

14 Round 2 A L+NW D +80BR +80 A L+NW BR +16 L +64 The person who obtained the first loan bought something. The seller of that stuff gets the check and deposits it in their bank. We see that first here. Next you see that since the bank wants to only hold 20% of deposits as reserves it loans.8(80) = 64 by creating an asset called loans and adds to checkable deposits for the person who gets the loan. The third point is the person with the loan spends the money and the bank loses an equal amount of reserves. At the bottom here you see the final position for the bank. The 80 in new deposits will support 64 in loans. L + 64 A L+NW D +64 D +80 A L + NW BR -64D -64

15 Before I move on to more of the story, note what happened on the previous screen. 1) In the banking system an aditional 80 dollars in checking account balances occurred because someone was able to get a loan. 2) The bank added to the first round by making another $64 in loans. 3) At the end of the day the bank has looked at its new deposits, evaluated what it wants to hold on to as reserves and lends out the rest. Another round of lending can still occur – let’s see that next.

16 Round 3 A L+NW D +64BR +64 A L+NW BR L The person who obtained the second loan bought something. The seller of that stuff gets the check and deposits it in the bank. We see that first here. Next you see that since the bank wants to only hold 20% of deposits as reserves it loans.8(64) = by creating an asset called loans and adds to checkable deposits for the person who gets the loan. The third point is the person with the loan spends the money and the bank loses an equal amount of reserves. At the bottom here you see the final position for the bank. The 64 in new deposits will support in loans. L A L+NW D D +64 A L + NW BR D

17 Multiple deposit expansion Let’s review again. The first bank received 100 in new deposits and since it only needs to keep 20% (because most folks don’t want all their funds on any one day) it lent out 80. This ended up in another bank because the person who got the loan didn’t want to take the money home, throw it on the floor, and roll in the cash (would you do that?). The person wanted to spend it! That spending meant someone else sold some goods and got a check to put in their bank. That bank evaluated its position and made a loan…… DO you see a pattern here? Note each successive loan is for a smaller amount than the previous loan.

18 BR +100D +100BR +20 L +80 D +100BR +16 L +64 D +80 BR L D +64 Begin Round 1Round 2Round 3 Bit of a review again – bring the last few slides together. On this slide you see the beginning when 100 in cash was put in the bank. Then I show three rounds in the final position of each round, but more will occur. Recall that money is made up of currency and checkable deposits. The beginning and round 1 is the first bank involved. While there is 100 more in checking there is 100 less in cash in the hands of the non-bank public. This means no change in the money supply. But rounds 2, 3 and on have new deposits that are new additions to the money supply. On the next slide I show some math, but you only need to have the end result of that math.

19 New money from the lending process here … = 80( …) (math folks help us get to the next line) = 80[1/(1 -.8)] (wow, look at that!) = 80(1/0.2) = 80(5) = 400 Let’s look at this a little more closely. The 80 was the initial amount of excess reserves in the system when cash was put in the bank. The 5 is the money multiplier (It is similar to the multiplier we saw back with aggregate demand). Note the 5 is from 1/0.2, where the 0.2 is the 20% banks like to hold in reserve to meet the needs of its depositors. These two items make up the money multiplier.

20 Required reserves Hey, you want to know something? Well, listen up! The 20% I mentioned that banks want to hold to meet the needs of the depositors is too high a number. Many banks would really only need to keep way less than 20%. Moreover, some banks would like to earn more money and they might hold less than they really need. The Federal Reserve system has a rule banks must follow so that they don’t have too few reserves. The rule is called reserve requirements. The Fed sets, and does change from time to time, the minimum reserve required amount banks must hold to meet the amount of checking account balances that are in the bank.

21 Required reserves If the reserve requirement is 20% banks have to have in reserves (BR) 20% of the checking account balances. So if D = 100 BR, must be no lower than 20. If D = 500, BR must be no lower than 100. For the most part, we will assume in class that whatever the Fed sets as the reserve requirement will be the target banks shoot for. So, if the reserve requirement is 20% the money multiplier is 5. If the reserve requirement is 10% the money multiplier is 10.

22 Summary 1) FED dropped 100 single dollar bills on public for a money supply of $100, 2) Public put all money in the bank in checking accounts, for a money supply still of $100, 3) Banks only desired to hold reserves equaling 20% (because we now see that is what the FED set) of deposits and they lent out the rest. 4) After many rounds of lending bank deposits end up at $400 of additional checking account balances in addition to the $100 start. 5) The 100 of new bank reserves ends up supporting a money supply of 500, the 400 of new deposits from the lending process and the initial 100 Fed dropped, but transferred to checking by public.