Chapter 26 MONEY CREATION AND THE BANKING SYSTEM Gottheil — Principles of Economics, 6e © 2010 Cengage Learning 1

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 2 The fractional reserve system The legal reserve requirement A bank’s balance sheet, its assets and liabilities Demand deposits and bank loans

Economic Principles © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 3 The potential money multiplier Bank failure The Federal Deposit Insurance Corporation (FDIC)

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 4 Fractional reserve 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.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 5 The fractional reserve system serves as the basis of all modern banking.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 6 If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 7 Balance sheet The bank’s statement of liabilities (what it owes) and assets (what it owns).

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 8 Banks make a profit on the loans they provide, not on their deposits.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 9 Legal reserve requirement The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves.

Cyberspace Banking © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 10 What is a cyberspace banking? Cyberspace is banking conducted over the Internet.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 11 $100,000 + $80,000 = $180, Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 12 1.Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts? Thus fractional reserve banking creates money through loans.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 13 Financial intermediaries Firms that accept deposits from savers and use those deposits to make loans to borrowers.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 14 A fractional reserve system operating within financial intermediaries. 2.What three factors are needed for a banking system to create money?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 15 A fractional reserve system operating within financial intermediaries. People willing to make demand deposits. 2.What three factors are needed for a banking system to create money?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 16 2.What three factors are needed for a banking system to create money? A fractional reserve system operating within financial intermediaries. People willing to make demand deposits. Borrows prepared to take out loans.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 17 Potential money multiplier The increase in the money supply that is potentially generated by a change in demand deposits.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 18 3.If the legal reserve requirement is 10 percent, what is the potential money multiplier? The potential money multiplier “ m ” = 1/(legal reserve requirement) = 1/0.1 = 10

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 19 M = ID/LRR 4.If the legal reserve requirement ( LRR ) is 25 percent and the initial demand deposit ( ID ) is $100,000, then what is the maximum potential increase in the money supply ( M )?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 20 4.If the legal reserve requirement ( LRR ) is 25 percent and the initial demand deposit ( ID ) is $100,000, then what is the maximum potential increase in the money supply ( M )? M = $100,000/.25 = $400,000

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 21 5.Why might the actual increase in the money supply be less than the maximum potential increase in the money supply? Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 22 Excess reserves The quantity of reserves held by a bank in excess of the legally required amount.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 23 If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 24 Required reserves are 0.2 × ($100,000) = $20, Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 25 Excess reserves = (total reserves) – (required reserves) 6.Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 26 6.Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? Excess reserves = $35,000 – $20,000 = $15,000.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 27 7.How are required reserves recorded on a bank’s balance sheet? Required reserves are an asset.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 28 8.How are excess reserves recorded on a bank’s balance sheet? Excess reserves are an asset.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 29 9.How are loans recorded on a bank’s balance sheet? Loans are an asset.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e How are demand deposits recorded on a bank’s balance sheet? Demand deposits are a liability.

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 31 Yes 11.Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits?

How Banks Create Money © 2010 Cengage Learning Gottheil — Principles of Economics, 6e Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits? With required reserves of $10,000 and a legal reserve requirement is 10 percent, then demand deposits equal $100,000.

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 33 Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves. 1.What will happen if the Federal Reserve increased the legal reserve requirement for banks?

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 34 Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made. 1.What will happen if the Federal Reserve increased the legal reserve requirement for banks?

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e What will happen if the Federal Reserve increased the legal reserve requirement for banks? Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply.

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 36 2.What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Required reserves will increase.

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 37 2.What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Excess reserves will decrease.

Reversing the Money Creation Process © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 38 2.What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? Loans will decrease.

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 39 1.What will happen if too many borrowers are unable to repay their loans? A bank may fail.

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 40 2.If a bank fails, what will happen to the depositors? If deposits are insured by the federal government, then the government will step in and pay depositors up to the maximum insurable amount.

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 41 2.If a bank fails, what will happen to the depositors? If deposits are not insured by the federal government, then depositors may lose their money.

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 42 Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits. 3.If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 43 Too many depositors withdrawing their money from their demand deposit accounts will overwhelm the fractional reserve system, and may cause it to fail. 3.If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 44 Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result. 3.If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?

Why Banks Sometimes Fail © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 45 3.If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? Prior to modern banking regulation and practices, many recessions were caused by financial panics and banking system failures.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 46 Federal Deposit Insurance Corporation (FDIC) A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $100,000 of deposits.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 47 Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 48 The FDIC was created in 1933, too late for the tens of thousands of people who had been financially wiped out by bank failures in the Great Depression.

Federal Deposit Insurance and Moral Hazard © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 49 Fully insuring deposits leads to a costly side effect known as moral hazard.

Federal Deposit Insurance and Moral Hazard © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 50 Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured.

Federal Deposit Insurance and Moral Hazard © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 51 Proposed solutions for the moral hazard problem with deposit insurance include: Privatize the deposit insurance system Reduce the scope of deposit insurance Yet any change in the deposit insurance system may itself destabilize the banking system.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 52 In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 53 Despite these safeguards, approximately 10 banks fail each year.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 54 During the 1970s, high farm commodity prices inflated the price of farmland, and high oil prices inflated the value of property in Texas and Oklahoma.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 55 Banks made loans with inflated property values as collateral.

Safeguarding The System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 56 When farm commodity prices and oil prices collapsed in the recession of the early 1980s, many farms and businesses failed, and were unable to repay their loans.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 57 Banks were left holding collateral— land, buildings, and other capital—that was worth less than the amount of the loan.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 58 Consequently, many banks failed, particularly in farm states and in Texas and Oklahoma.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 59 Due to the moral hazard problem, there were questions regarding proper lending practices at some of the failed banks.

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 60 EXHIBIT 1BANK FAILURES: 1930–2005

Exhibit 1: Bank Failures © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 61 For years after the Great Depression, the number of bank failures was insignificant. All that changed in the 1980s. With the recession of 1982, bank failures increased dramatically. In 1988 alone there were more bank failures than the combined total for the previous 25 years.

Exhibit 1: Bank Failures © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 62 Which of the two time periods experienced the largest number of bank failures: a.The mid- to late-1930s b.The mid- to late-1980s

Exhibit 1: Bank Failures © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 63 Which of the two time periods experienced the largest number of bank failures: a.The mid- to late-1930s b.The mid- to late-1980s

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 64 EXHIBIT 2BANK FAILURES, SELECTED STATES: 1987–1989 Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.

Exhibit 2: Bank Failures, Selected States: 1987–1989 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 65 Which of the following states had the largest number of bank failures between 1987–1989? a.Alabama b.Texas c.California

Exhibit 2: Bank Failures, Selected States: 1987–1989 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 66 Which of the following states had the largest number of bank failures between 1987–1989? a.Alabama b.Texas c.California

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e 67 EXHIBIT 3THRIFT FAILURES: 1980–1991

Exhibit 3: Thrift Failures: 1980–1991 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 68 In which of the following years were there the most thrift failures? a.1983 b.1987 c.1989

Exhibit 3: Thrift Failures: 1980–1991 © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 69 In which of the following years were there the most thrift failures? a.1983 b.1987 c.1989

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 70 Many “thrifts” (savings and loans) in the early 1980s were locked in to long- term mortgage loans that paid the thrifts less than the interest they paid on deposits, causing thrifts to lose money.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 71 This motivated some thrifts to move in to new, more speculative and risky loan markets. Another factor contributing to the failure of so many thrifts was fraudulent lending practices.

Safeguarding the System © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 72 The large number of thrift failures in the 1980s put the Federal Savings and Loan Insurance Corporation (FSLIC) in crisis. Legislation was passed that created the Resolution Trust Corporation, which handled the disposal of all failed thrifts. The FDIC has assumed the insurance function of the now-defunct FSLIC.

Controlling the Financial Institutions that Control the Money Supply © 2010 Cengage Learning Gottheil — Principles of Economics, 6e 73 Financial institutions cannot create the proper money flows to foster economic activity with minimal inflation and unemployment. Control of the money supply is needed. That’s where the Federal Reserve System comes in.