1 Chapter 26 Money Creation and the Banking System 5/25/2015 © ©1999 South-Western College Publishing

2 Commercial Banking System Privately owned, profit seeking 2 major functions, accept deposits and make loans

3 Who were the first bankers? Goldsmiths in the Middle Ages © ©1999 South-Western College Publishing

4 Why are banks called Depository Institutions? Because they accept deposits from the public © ©1999 South-Western College Publishing

5 What is a Fractional Reserve Banking System? A banking system that provides people immediate access to their deposits, but allows banks to hold only a fraction of those deposits in reserve © ©1999 South-Western College Publishing

6 How do banks make profit? They pay depositors a lower interest and lend a fraction of the deposits out at a higher interest © ©1999 South-Western College Publishing

7 What determines a Bank’s Profit? The spread between interest paid to deposits and interest received from loans © ©1999 South-Western College Publishing

8 What is a Bank’s Balance Sheet? The bank’s statement of liabilities (what it owes) and assets (what it owns) © ©1999 South-Western College Publishing

9 Assets and Liabilities of a Bank ASSETS LIABILITIES RESERVES LOANS BONDS BUILDINGS EQUIPMENT DEPOSITS BORROWING ASSETS - LIABILITIES EQUALS NET WORTH

10 Find out about cyberspace banking: html © ©1999 South-Western College Publishing

11 What determines how much a Bank can lend? The legal reserve requirement determines what fraction of a bank’s deposits they can lend © ©1999 South-Western College Publishing

12 What is a Legal Reserve Requirement? The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves © ©1999 South-Western College Publishing

13 What are Excess Reserves? Deposits that a bank has above its required reserves © ©1999 South-Western College Publishing

14 How do Banks multiply money? Because each bank can legally lend its excess reserves, there is a multiple process that take place as money circulates © ©1999 South-Western College Publishing

15 The money multiplier process Assume all excess reserves are loaned out Use a reserve ratio of 10% (.10)

16 What is the Potential Money Multiplier? The increase in the money supply that is potentially generated by a change in demand deposits © ©1999 South-Western College Publishing

17 What is the money multiplier with a reserve requirement of 1/10? 10 © ©1999 South-Western College Publishing

18 $100 $90 $81 $74 $63 $1,000 original deposit total money © ©1999 South-Western College Publishing...

19 What is the Money Multiplier formula? 1/Required reserve ratio © ©1999 South-Western College Publishing

20 If the required reserve ratio is 1/10 and all banks are exactly meeting their reserve requirement - how do we calculate the money multiplier? © ©1999 South-Western College Publishing

21 One divided by one tenth equals = 1 X 1 = Multiplier 10 © ©1999 South-Western College Publishing 21

22 Does this multiplication process work in reverse? Yes! For every dollar taken out of circulation, there is a multiple effect on the money supply © ©1999 South-Western College Publishing

23 Can a Bank fail? If its liabilities are greater than its assets, a bank can fail © ©1999 South-Western College Publishing

24 How do we Safeguard the Banking System? The Federal Deposit Insurance Corporation (FDIC) © ©1999 South-Western College Publishing

25 What is the FDIC? A government insurance agency that provides depositors 100% coverage on their first $100,000 of deposits © ©1999 South-Western College Publishing

26 What else does the FDIC do? It audits and examines banks to detect any weaknesses in its operation © ©1999 South-Western College Publishing

27 Despite the FDIC, can banks still fail? Yes! There were many bank failures as recently as the 1980’s and 1990’s © ©1999 South-Western College Publishing

28 Bank Failures in the 80’s and 90’s Effects of inflation from the 70’s and 80’s Bad loans, energy industry Expanded deposit insurance

29 29 © ©1999 South-Western College Publishing

30 What is a Fractional Reserve Banking System?What is a Fractional Reserve Banking System? How do banks make profit? What is a Legal Reserve Requirement? What are Excess Reserves? How do Banks multiply money? What is the money multiplier formula? What is the FDIC?

31 ENDEND © ©1999 South-Western College Publishing