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Money Creation Chapter 33

Goldsmiths and Fractional Reserve Banking Traders used gold to make transactions until they realized it was too difficult to use They began depositing their gold with the Goldsmiths who would give them a receipt for the deposit and charge them a fee for the service Eventually, the goldsmiths' receipts were used to pay for goods, and became the first type of currency At this time, goldsmiths backed their circulating paper money receipts fully with the gold they held in their vaults (it was a 100% reserve system) Goldsmiths realized that the public had completely accepted the receipts as paper money –The amount of gold being deposited in their "reserves" exceeded the amount that was being withdrawn.

Goldsmiths and Fractional Reserve Banking The goldsmiths began to issue paper receipts in excess of the amount of gold being held in their vaults They put these receipts into circulation by making interest-earning loans to merchants, producers and consumers Lenders willingly accepted loans in the form of gold receipts (receipts were accepted as a medium of exchange in the market). The goldsmiths began the fractional reserve system of banking –the reserves in bank vaults are a fraction of the total money supply just as the gold reserves were a fraction of the circulating paper money back then

Characteristics of Fractional Reserve Banking: 1.Banks create money through lending. 2.Banks lend money at higher interest rates than the ones they pay out to create money. 3.Banks have a system of deposit insurance and operate on the basis that fractional reserves are vulnerable to "runs" or "panics." –This is when all the holders demand for their money all at the same time. Although this is highly unlikely, banks still take measures to protect themselves from this disaster that has ruined banks in the past (e.g. in the Great Depression).

A Single Commercial Bank Balance sheet is a statement of assets, liabilities, and net worth (capital stock) of the bank at a certain time –value of assets must equal the amount of claims against the assets When federal reserve ratios change, the balance sheet for banks is skewed –they must recall loans (make your repay right then) and/or take out loans to balance their accounts Assets = liabilities + net worth –Every $1 change in assets must equal a $1 change in liabilities and net worth (and vise versa) Vault cash = cash held by a bank (money you can withdraw)

Bank’s Balance Sheet Typical items on Bank of America’s balance sheet –Checking Deposits (D) $100 million –Bonds (US gov’t securities) $19 million –Loans (L) $70 million –Reserves (R) $11 million What are reserves? –deposits that banks are required to hold on to plus any additional cash they do not loan out (excess reserves)

Bank’s Balance Sheet Bank of America’s Balance sheet Assets Liabilities and Net Worth Checkable Deposits $100 millionBonds $19 million Loans $70 million Reserves $11 million Total: $100 million in Assets Total: $100 million in Liabilities and Net Worth

Reserves and excess reserves Excess reserves = Total Reserves minus Required Reserves Loans are made out of excess reserves –Banks give loans because loans earn a profit (interest) while excess reserves earn nothing Think of your own money—if you put it in your checking account or in your sock drawer it doesn’t make money but if you put it in savings it does Loaned up –When excess reserves = 0, the bank is “loaned up” or “fully loaned” and can’t make any new loans

Profits, Liquidity, and the Federal Funds Market Bank has two conflicting goals: –Earn profit by making loans and buying securities –Balance liquid assets and excess reserves; therefore, must restrict lending When banks lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks, it achieves the two conflicting goals because first it is earning a profit from the interest and second it is a transaction of excess reserves, which preserves the reserve requirement If banks don't have enough excess reserves at the end of the day to fulfill the 10% requirement (in the US) set by the Fed, they must borrow from other banks in order to keep at least 10% of their total checkable deposits. They can also borrow from the Fed, but that's usually a last resort.

Multiple-Deposit Expansion Suppose that r = 0.10 (bank must hold 10% of its deposits as reserves) In our example, does BoA hold any excess reserves? –Required reserves = 10% –$100M x.10 = $10M –If BoA had $11M in reserves then they have an excess of $1M

Multiple-Deposit Expansion What to do with excess reserves? –BoA loans Proctor and Gamble $1M to buy computers –Proctor and Gamble gives loan check to Dell –Dell deposits the check into Wells Fargo

Multiple-Deposit Expansion Changes in balance sheets BoA Bank Assets Liabilities Wells Fargo Bank Assets Liabilities R - $1M L + $1M R + $1MD - $ 1M Notice that their assets total stays the same Notice that they now have $1M in reserves they did not have before

Multiple-Deposit Expansion Did deposits rise? Did deposits fall? Deposits rose by $1M at Wells Fargo but stayed the same at BoA –meaning M1 rose $1M

Multiple-Deposit Expansion Not the end of the story Does Wells Fargo now have any excess reserves? –Required reserves =.10 (1M) = $100K –Excess reserves = 1M – 100K = $900K

Multiple-Deposit Expansion What to do with excess reserves? Wells Fargo loans South Lake Hospital $900K for an addition –South Lake Hospital gives loan check to Marbek Construction –Marbek Construction deposits the check in SunTrust

Multiple-Deposit Expansion Changes in balance sheets Wells Fargo Bank Assets Liabilities SunTrust Bank Assets Liabilities D + $900KR + $900K R - $900K L + $900K

Multiple-Deposit Expansion Did deposits rise? Did deposits fall? Deposits rose by another $900K but did not fall in any other bank M1 rose $900K on this transaction M1 has risen $1.9M ($1M + $900K) when combining the two transactions together

Multiple-Deposit Expansion Not the end of the story Does SunTrust now have any excess reserves? Required reserves =.1 (900K) = $90K Excess reserves = $900K-90K = 810K –YES, SunTrust has excess reserves of $810K

Multiple-Deposit Expansion Process continues over, and over, and over, and over (we could do this all day…but it’s boring) So—let’s use a shortcut to figure out the maximum change in the money supply The maximum change in money supply = the Money Multiplier (1/r) x initial excess reserves

Money Multiplier In our example, what is the maximum change in the money supply? Money multiplier = 1/r = 1/.10 = 10 Initial excess reserves = $1M (BoA) Maximum change in money supply = 10 x (+ $1M) = + $10M Off of BoA’s $1M excess reserve loan the economy has grown by $10M

Money Multiplier When the reserve ratio changes because of the monetary policy, the money multiplier also changes. –As Reserve Ratio increases, Money Multiplier decreases –As Reserve Ratio decreases, Money Multiplier increases

Your Turn! Complete the “Where did that money come from?” worksheet provided