Money Creation

Creation of Money The deposit of funds into a bank does not change the size of the money supply. It changes the composition of the money supply (transfers from cash to transaction deposits).

Deposit Creation When a bank lends someone money, it simply credits that individual’s bank account.

Deposit Creation Deposit creation is the creation of transactions deposits by bank lending. n When a bank makes a loan, it effectively creates money because transactions- account balances are counted as part of the money supply.

Deposit Creation There are two basic principles of the money supply: l Transactions-account balances are a large portion of our money supply. l Banks can create transactions-account balances by making loans.

Bank Regulation The deposit-creation activities of banks are regulated by the government. The Federal Reserve System limits the amount of bank lending, thereby controlling the basic money supply.

A Monopoly Bank Assume a student deposits $100 from their piggy bank into the monopoly band and receives a new checking account.

A Monopoly Bank When someone deposits cash or coins in a bank, they are changing the composition of the money supply, not its size.

The Initial Loan The monopoly bank loans $100 to the Campus Radio station and issues a checking account. This loan is accomplished by a simple bookkeeping entry.

The Initial Loan Total bank reserves have remained unchanged. n Bank reserves are assets held by a bank to fulfill its deposit obligations.

The Initial Loan Money has been created because the checking account is considered to be money.

Secondary Deposits In a one bank system, when Campus Radio uses the loan, the money supply does not contract, rather ownership of deposits change.

Fractional Reserves Bank reserves are only a fraction of total transaction deposits. The reserve ratio is the ratio of a bank's reserves to its total deposits.

Fractional Reserves The Federal Reserve System requires banks to maintain some minimum reserve ratio.

The T-account of the Bank The books of a bank must always balance, because all of the assets of the bank must belong to someone (its depositors or its owners).

Money Creation AssetsLiabilities University Bank +$ in coins +$ in deposits Money Supply Cash held by the public–$100 Transactions deposits at bank+$100 Change in M0

Money Creation AssetsLiabilities University Bank +$ in coins +$100 in loans +$ in your account +$ in borrower’s account Cash held by the public no change Transactions deposits at bank+$100 Change in M+$100 Money Supply

Required Reserves Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; Equal to required reserve ratio times transactions deposits. Required reserves = minimum reserve ratio X total deposits

Required Reserves The minimum reserve requirement directly limits deposit-creation possibilities.

A Multibank World In reality, there is more than one bank. The ability of banks to make loans depends on access to excess reserves.

A Multibank World Example: If a bank is required to hold $20 in reserves but has $100 currently, it can lend out the $80 excess.

Excess Reserves Excess reserves are bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves

Excess Reserves So long as a bank has excess reserves, it can make loans. n Excess reserves are reserves a bank is not required to hold.

Changes in the Money Supply The creation of transaction deposits via new loans is the same thing as creating money.

More Deposit Creation As the excess reserves are loaned out again, more deposits are created and thus more money is created.

Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$80 Your account $100 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Deposit Creation AssetsLiabilities University Bank Required Reserves$36 Excess Reserves$64 Loans$80 Your account $100 Campus Radio account$ 80 Total Assets $180 Total Liabilities $180 AssetsLiabilities Eternal Savings Total AssetsTotal Liabilities © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$16 Required Reserves$64 Atlas Antenna account $80 Total Assets $80 Total Liabilities $80 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Deposit Creation AssetsLiabilities University Bank Required Reserves$20 Excess Reserves$ 0 Loans$80 Your account $100 Campus Radio account$ 0 Total Assets $100 Total Liabilities $100 AssetsLiabilities Eternal Savings Required Reserves$29 Required Reserves$51 Loans$64 Atlas Antenna account$80 Herman’s Hardware account$64 Total Assets $144 Total Liabilities $144 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

The Money Multiplier In a multi-bank system, deposits created by one bank invariably end up as reserves in another bank.

The Money Multiplier This process can theoretically continue until all banks have zero excess reserves (no more loans can be made).

The Money Multiplier This is known as the money-multiplier process.

The Money Multiplier The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves.

The Money Multiplier When a new deposit enters the banking system, it creates both excess and required reserves.

The Money Multiplier The required reserves represent leakage from the flow of money, since they cannot be used to create new loans.

The Money Multiplier Excess reserve can be used for new loans. n Once those loans are made, they typically become transactions deposits elsewhere in the banking system.

The Money Multiplier Some additional leakage into required reserves occurs, and further loans are made.

The Money Multiplier The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

The Money Multiplier Process Required reserves Excess reserves Leakage into The public

Excess Reserves as Lending Power Each bank may lend an amount equal to its excess reserves and no more.

Excess Reserves as Lending Power The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier.

The Money Multiplier at Work