Bob the Goldsmith. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000.

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Presentation transcript:

Bob the Goldsmith

AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000

Bob the Goldsmith AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000 Suppose Bob makes a $1000 loan. Assume he gives the loan in currency.

The money supply increases by $1000. AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Bob the Goldsmith

What if Bob had made the loan as a checking account balance?

The money supply still increases by $1000. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000

General Principle of money and banking:

Whenever a bank makes a loan the money supply increases by the amount of the loan.

What happens when the loan is paid back?

Assume the loan was made in currency (gold coins) and is repaid with currency.

AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Before the loan is repaid. After the loan is repaid with currency. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000

Result: The money supply decreases by $1000.

What happens when the loan is paid back?

Assume the loan was made in currency (gold coins) and is repaid with a check.

AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Before the loan is repaid. After the loan is repaid with a check. AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $99,000

The money supply decreases by $1000. Result:

What happens when the loan is paid back?

Assume the loan was made as a checking account balance and is paid back with a check.

AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000 Before the loan is repaid. After the loan is repaid with a check. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000

Result: The money supply decreases by $1000.

What happens when the loan is paid back?

Assume the loan was made as a checking account balance and is paid back with currency.

AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000 Before the loan is repaid. After the loan is repaid with currency AssetsLiabilities + Owners' Equity Gold coins $101,000Demand Deposits $101,000

Result: The money supply decreases by $1000.

General Principle of money and banking:

When a loan of a financial institution is repaid, the money supply decreases by the amount of the loan repayment.

These first two general principles imply a third.

Individual banks create and destroy money one a one-to- one basis with their loans. Every dollar created through loans is destroyed when the loans are repaid.

Fractional Reserve Banking Reserves = Vault Cash + Deposits with the Fed

Required Reserves = r x (Demand Deposit Liabilities) r = required reserve ratio Total Reserves = Required Reserves + Excess Reserves

Let's impose a 20 percent reserve requirement on Bob (i.e., r=.2). AssetsLiabilities + Owners' Equity Reserves = $100,000Demand Deposits $100,000 Required =.2 ($100,000) = $20,000 Excess = $80,000

Since Bob has excess reserves of $80,000, let's have him make an $80,000 loan. AssetsLiabilities + Owners' Equity Reserves = $100,000 Loan = $80,000 Demand Deposits $180,000 Required =.2 ($180,000) = $36,000 Excess = $64,000 Assume Bob makes the loan as a checking account balance.

Note that Bob still has excess reserves of $64,000. It looks like Bob could make another $64,000 loan. But

What if the person Bob made the $80,000 loan to writes a check for $80,000 to a person who has an account at another bank? Let's go to the board and see what happens to Bob's balance sheet.