 A substantial amount of money in the economy is held by deposit-takers  Someone deposits money into their bank, they pay little interest to them, they lend that money to someone else, while charging a higher interest rate, so they make a profit  This process is done by the roles played by cash reserves and profit motive Money Creation

 Desired Reserves are the minimum amount of cash necessary that chartered banks are required to have to satisfy anticipated withdrawal demands  The Reserve Ratio: The deposit taker must hold a certain portion of deposits in the form of cash reserves  EX. If a bank has a reserve ratio of 0.10, and the bank has deposits of $100 million, then it will hold 10% of this dollar value as desired reserves Money Creation

 Idle cash reserves no profit, so deposit-takers will try to transform any excess reserves into income-producing assets as soon as possible

 Let’s see how lending out excess reserves creates more money  Assume: (1) Public money is in the form of deposits and all payments are made by cheque; (2) All deposits are made to one type of deposit-taker (banks); (3) Reserve ratio is 0.10 (10%)  Note: a bank’s main assets are its cash reserves and loans  A bank’s main liabilities are its customers’ deposits The Money Creation Process

 1. At Cabot Bank, cash reserves = desired reserves  2. Saver A makes $1000 and deposits it into Cabot Bank  3. Cabot Bank now has new cash assets and deposit liabilities of $1000 First Transaction Cabot Bank AssetsLiabilities Cash Reserves + $1000Saver A’s Deposit + $1000

 Cabot Bank only wants to keep 10% of the $1000 = $100 on hand  Cabot Bank now has an excess of $900  Cabot Bank now lends $900 to Borrower X Second Transaction Cabot Bank AssetsLiabilities Cash Reserves $1000Saver A’s Deposit $1000 Loan to Borrower X + $900Borrower X’s Deposit + $900 The money supply has now risen by $900.

 Borrower X withdraws the $900 from his deposit  Cabot Bank’s cash assets and deposit liabilities each fall by $900 Third Transaction Cabot Bank AssetsLiabilities Cash Reserves $100 (=$ $900)Saver A’s Deposit $1000 Loan to Borrower X $900Borrower X’s Deposit $0 (=$900 - $900)

 Borrower X bought something for $900 from Saver B  Saver B deposits the $900 in her account at Fraser Bank  Fraser Bank’ cash assets and deposit liabilities increase by $900  Thus, the $900 deposit originally created by Cabot Bank has simply moved to Fraser Bank – no change in money supply Fourth Transaction Fraser Bank AssetsLiabilities Cash Reserves + $900Saver B’s Deposit + $900

 Since Saver B deposits money to Fraser Bank, Fraser Bank’s desired reserves should increase by $90 (= $900 x 0.10)  Since the $900 also increases cash reserves, there are now excess reserves of $810 ( = $900 - $900  Fraser Bank lends the $810 to Borrower Y  This created added loans assets and deposit liabilities of $810  Since Borrower Y’s new deposit is money, the money supply increases by $810 Fifth Transaction Fraser Bank AssetsLiabilities Cash Reserves $900Saver B’s Deposit $900 Loan to Borrower Y $810Borrower Y’s Deposit $810

 The number of possible transactions are endless  We saw the process of money creation in the few transactions that we saw  Notice how the process of money creation is similar to the process of the spending multiplier (Ch. 11)  In the money creation process, an initial change in money has a magnified effect on the money supply  Money Multiplier is the value by which the amount of excess reserves is multiplied to give the maximum total change in money supply The Money Multiplier

The Multiplier Formula

 Recall, we assumed that all money is in the form of deposits, and that there is only one form of deposit-taker  These assumptions do not hold true in reality  Public-Held Currency  Rather than all money going to deposit-takers, some money does circulate and is unaffected by the money multiplier  Differences in Deposit  There are a wide range of deposit types, so not all deposits will be reflected as an increase in the money supply Adjustments to the Money Multiplier

 The money multiplier represents the maximum possible effect of money creation  If someone deposits $9000, the money multiplier formula allows us to specify the maximum amount of $9000 by which the quantity of money rises as a result of the infusion of $900 in new excess cash reserves Money Multiplier in the Canadian Economic System