Chapter 32 How Banks and Thrifts Create Money

The Balance Sheet of a Commercial Bank Balance sheet = a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time. As named, a balance sheet should balance at all times! What does this mean? –Assets = Liabilities + Net Worth –Assets are anything of monetary value owned by a firm or individual (cash, property) –Liabilities are debts with a monetary value; an amount owed by a firm or individual –Net worth are the claims of the owner’s against the firms total assets; an individual’s own wealth

Fractional Reserve Banking System The U.S. has a fractional reserve banking system –Only a fraction of total money supply is held in reserve as currency Two significant characteristics Money Creation and Reserves – Banks create money by lending. The amount created depends on how much currency reserves the bank feels obligated or is required to keep. Bank Panics and Regulation– Banks are vulnerable to “panics” since they would not be able to convert all paper money to hard currency if everyone tried to redeem their hard currency at once because lending exceeds deposits. The U.S. therefore places regulations and holds a system of deposit insurance. How banks create money video

A Single Commercial Bank

Creating a Bank: Balance Sheet 1 – Wahoo Bank AssetsLiabilities and Net Worth 1)Secure a state or national charter 2) Sell $250,000 worth of stocks Cash $250,000 Capital Stock $250,000 Cash from stockholders (known as vault money) Claim held by stockholders Account = each item listed in a balance sheet Transaction 1: Creating a Bank

Property and Equipment: Balance Sheet 2 – Wahoo Bank AssetsLiabilities and Net Worth 1)A portion of the vault money buys equipment and property 2) Buy $240,000 worth of property, $10,000 worth of cash is left Cash $10,000 Capital Stock $250,000 Adds up to $250,000Claim held by stockholders Transaction 2: Acquiring Property and Equipment Property $240,000

Property and Equipment: Balance Sheet 3 – Wahoo Bank AssetsLiabilities and Net Worth 1)Banks have two functions 1) accept deposits; 2) make loans Cash $110,000 Capital Stock $250,000 When the bank accepts a deposit of $100,000 the cash value increases by this amount as an asset The asset input of $100,000 is balanced by a liability in the form of checkable deposits – this is the claim the depositors have toward the money deposited. Transaction 3: Accepting Deposits Property $240,000 Checkable Deposits $100,000

By law, banks that provide checkable deposits must keep required reserves. Required reserves = amount of funds equal to a specific percentage of a bank’s deposit liabilities Reserve Ratio Example – If the reserve ratio is 1/10 then the required reserve is $10,000 out of the total $100,000 liabilities Transaction 4: Depositing Reserves Reserve ratio Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities = 1/10 $ 10,000 $ 100,000 = Fyi – reserve ratio is 3% for $12.4 – 79.5M and 10% for above that amount

If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then how much is the bank required to reserve? Remember: Practice Problem #1 Reserve ratio Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities =

If by law the reserve ratio is mandated to be 20% or 1/5, and a bank’s checkable-deposit liabilities equals $200,000, then how much is the bank required to reserve? Known: Reserve ratio =.20 Commercial bank’s checkable-deposit liabilities = $200,000 Equation: Required reserves = ratio X checkable-deposit liabilities Required reserves =.20 X $200,000 = Practice Problem #1 - Answer Reserve ratio Commercial bank’s required reserves Commercial bank’s checkable-deposit liabilities = $ 40,000

Excess Reserves Excess Reserves Excess Reserves is what determines how much a bank can loan. Transaction 4: Depositing Reserves Excess Reserves – = Actual Reserves Required Reserves

If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then the bank is required to reserve $40,000. If the bank actually reserves $120,000 calculate the excess reserves. Remember: Practice Problem #2 Excess Reserves – = Actual Reserves Required Reserves

If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then the bank is required to reserve $40,000. If the bank actually reserves $120,000 calculate the excess reserves. Known: Actual Reserves=$120,000 Required Reserves=$40,000 Equation: Excess reserves = actual –required reserves Excess reserves = $120,000 - $40,000 = Practice Problem #2 - Answer Excess Reserves – = Actual Reserves Required Reserves $80,000

Depositing Reserves at the Fed: Balance Sheet 4 – Wahoo Bank AssetsLiabilities and Net Worth 1)By law, banks that provide checkable deposits must keep required reserves. Cash $0 Capital Stock $250,000 This is true if a bank deposits all of its cash in the Federal Reserve Bank Transaction 4: Depositing Reserves Property $240,000 Checkable Deposits $100,000 Reserves $110,000

Transaction 5: Clearing a Check Reserves of Wahoo bank -$50,000 Reserves of Surprise bank +$50,000 Checkable deposits +$50,000 Reserves +$50,000 Reserves -$50,000 Checkable deposits -$50,000

Clearing a Check: Balance Sheet 5 – Wahoo Bank AssetsLiabilities and Net Worth 1)By law, banks that provide checkable deposits must keep required reserves. Cash $0 Capital Stock $250,000 Transaction 5: Clearing a Check Property $240,000 Checkable Deposits $100,000 – 50,000 = 50,000 Reserves $110,000 – 50,000 = 60,000 If a check of $50,000 is written against the Wahoo Bank, this amount is subtracted from both Assets and Liabilities/Net Worth

A Loan is Negotiated: Balance Sheet 6a – Wahoo Bank AssetsLiabilities and Net Worth 1)When a bank makes a loan, they turn something that isn’t money – a promise to pay back a loan – into something that is money – a checkable deposit. Reserves $60,000 Capital Stock $250,000 Transaction 6: Granting a Loan Property $240,000 Checkable Deposits $50, ,000 = 100,000 Loans $50,000 A loan creates money. This adds an amount to the bank’s assets. The money goes into checkable deposits as well.

Check is Drawn on the Loan: Balance Sheet 6b – Wahoo Bank AssetsLiabilities and Net Worth 1)The person who took out the loan uses the money to pay someone else, money is transferred to another bank causing similar effects as when a check is cleared on actual reserves. Loans $50,000 Capital Stock $250,000 Transaction 6b: Check is Drawn on Loan Property $240,000 Checkable Deposits $100,000 – 50,000 = 50,000 Reserves $60,000 – 50,000 = 10,000 Reserves and checkable deposits diminish by $50,000 when the loan money is used to pay another person and is put in another bank.

Repaying a Loan: Balance Sheet 7 – Wahoo Bank AssetsLiabilities and Net Worth 1)When a person then comes back and repays a loan with a check, money is destroyed. The “Loans” are subtracted from the “Assets” and the amount is also subtracted from “Checkable Deposits”. Reserves $10,000 Capital Stock $250,000 Transaction 7: Repaying a Loan Property $240,000 Checkable Deposits $50,000 – 50,000 = 0 Loans $50,000 – 50,000 = 0 The money that was created when the loan was made is destroyed when the loan is repaid.

Buying Government Securities: Balance Sheet 8 – Wahoo Bank AssetsLiabilities and Net Worth 1)Buying and then selling government securities has the same effects on a bank’s balance sheet as does loaning and repaying loans accordingly. Reserves $60,000 Capital Stock $250,000 Transaction 8: Buying Gov’t Securities Property $240,000 Checkable Deposits $100,000 Securities $50,000 As with a loan, the buying of securities creates money.

Profits, Liquidity, Federal Funds Market Banks have two conflicting goals: –Profit – Why the banks make loans and buy securities (two major earning assets) –Liquidity – Safety lies with liquidity. Liquid assets are cash and excess reserves. Bankers must protect against depositors wishing to extract cash. Also, they must protect against a net outflow of reserves in which more checks are cleared against the bank than in favor of the bank. Banks can partly find a balance between the two goals by lending temporary excess reserves held at the Federal Reserve Bank to other commercial banks. The interest rate for these overnight loans is called the Federal funds rate.

Multiple – Deposit Expansion Process Bank Acquired reserves and deposits Required reserves Excess reserves Amount bank can lend - New money created A B C D E F G H I J K L M N Other banks $ $ $ $ $ Total amount of money created by the banking system

The Monetary Multiplier Monetary Multiplier exists because the reserves and deposits lost by one bank are received by another bank. Monetary Multiplier Max. Checkable- Deposit Creation Max. Checkable Deposit Creation X = Excess Reserves Monetary Multiplier Monetary Multiplier 1 Required reserve ratio =

Some Modifications Leakages: –Currency drains – some borrowers may request that part or all of their loan to be paid in currency, thereby diminishing the magnitude of the multiplier –Excess reserves – if the bank keeps more as reserve than the legal minimum mandates, this would also diminish the multiplier, though this is less likely since loans earn interest income, thereby increasing profit.

Practice Problem #3 If the required reserve ratio is.20 or 20%, then how big is the monetary multiplier? Remember: Monetary Multiplier Monetary Multiplier 1 Required reserve ratio =

Practice Problem #3 - Answer If the required reserve ratio is.20 or 20%, then how big is the monetary multiplier? Monetary Multiplier Known: Required reserve ratio =.20 Equation: Monetary multiplier = 1 / (required reserve ratio) Monetary multiplier = 1 /.20 = Monetary Multiplier 1 Required reserve ratio = 5

Practice Problem #4 If the monetary multiplier is 5 and the value of excess reserves equals $95,000, then how much will the money supply increase through loans? Remember: Max. Checkable Deposit Creation X = Excess Reserves Monetary Multiplier Max. Checkable Deposit Creation

Practice Problem #4 - Answer If the monetary multiplier is 5 and the value of excess reserves equals $95,000, then how much will the money supply increase through loans? Known: Excess reserves = $95,000 Monetary multiplier = 5 Equation: Max. Checkable Deposit Creation = $95,000 x 5 = Max. Checkable Deposit Creation X = Excess Reserves Monetary Multiplier Max. Checkable Deposit Creation $475,000

Practice Problem #5 If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves?

Practice Problem #5 - Answer If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves? Known: –Checking deposits = $500 –Required Reserves = $50 Equation: –Reserve ratio = required reserve / checking deposits = $50 / $500 = –Excess Reserves = checking deposits – required reserves = $500 - $50 =.1 10 percent $450

Once upon a time there was a and a 10% reserve ratio… 1a. Mrs. Dunnaway deposits $100 to: WHS Bank AssetsLiabilities RR: $10 Mrs. D’s Acct: $100 ER: $90 1b. WHS Bank loans the $90 to Tim for a new bike… WHS Bank AssetsLiabilities RR: $19 Mrs. D’s Acct: $100 ER: $ 81 Loan to Tim: $90Tim’s Acct: $90 2a. Tim gives $90 to Bryce’s Bike’s, who deposits it at Citizens’ Bank… Citizens’ Bank AssetsLiabilities RR: $9Bryce’s Acct: $90 ER: $81 2b. Citizens’ Bank them loans the $81 to Liz for a pair of boots… Citizens’ Bank AssetsLiabilities RR: $17.10Bryce’s Acct: $90 ER: $72.90Liz’s Acct: $81 Loan to Liz: $81 Money Multiplier=1/RR  10; Total Deposit Creation: 10*Initial Deposit=$1,000

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