Copyright 2008 The McGraw-Hill Companies 13-1 The Fractional Reserve System Money Creation Monetary Multiplier Last Word Key Terms End Show 13 Money Creation “The process by which banks create money is so simple that the mind is repelled.” John Kenneth Galbraith My favorite economist

Chapter Objectives Why the U.S. Banking System is Called a “Fractional Reserve” System Distinction Between a Bank’s Actual Reserves and Its Required Reserves How a Bank Can Create Money Through Granting Loans The Multiple Expansion of Loans and Money by the Entire Banking System The Monetary Multiplier and How to Calculate it

Creating Money Fractional Reserve Banking System –Only part (a fraction) of checkable deposits are backed up by cash in bank vaults or in bank’s accounts at the Fed. –Size of the “fraction” held in reserves is regulated by Fed. Characteristics of a Fractional Reserve System –Banks Create Money Through Lending –Fractional Reserve Banks are Subject to “Panics” or “Runs”

How banks create money (increase money supply)  Banks are required to keep a certain percentage of checking account balances on hand in their vault or in their account at the Federal Reserve Bank.  The reserve requirement is a percentage established by the Federal Reserve. Creating Money

How banks create money (increase money supply)  For example, if the reserve requirement is 10%, and Wachovia Bank has $10 million deposited into checking accounts at their banks, Wachovia must always have at least $1 million ($10 million x 10%) on hand in vault cash or in their cash account at the Fed.  Banks can then make loans to consumers and businesses with the other 90% of their checking deposits, thereby creating money in the money supply. Creating Money

Excess Reserves = Loanable Funds Excess Reserves Amount that banks can loan out. What banks have in vaults and accounts at Fed. - Actual Reserves - = Required Reserves What banks are required to have in vaults and Fed accounts. =

How banks create money (increase money supply) Assume a 10% reserve requirement, banks loan all excess reserves (“loaned up”), and borrowers deposit entire amount back into a bank (no leakages). New Deposits Required Reserves (10%) Loanable Funds $ 100,000 $ 10,000$ 90,000 90,0009,00081,000 8,10072,900 7,29065,610 6,56159,049 5,90553,145 $1,000,000$100,000$900,000 Injection into the money supply by the Federal Reserve Bank (we’ll discuss this in Ch 14). Final impact on money supply

How banks create money (increase money supply) With fractional reserve banking, the initial injection into the banking system has a multiplier effect on the money supply. Amount of the impact depends on the reserve requirement. Money (deposit) multiplier = reciprocal of reserve requirement If reserve requirement is 10%, money multiplier = 1/.10 = 10. Deposit of $100,000 can impact the money supply by 10 x $100,000 = $1 million. In order to increase the impact a deposit would have on the money supply, would we raise or lower the reserve requirement? If reserve requirement is 5%, money multiplier = 1/.05 = 20. Deposit of $100,000 can impact the money supply by 20 x $100,000 = $2 million.

The Monetary Multiplier Monetary Multiplier or Checkable- Deposit Multiplier Monetary Multiplier = 1 Required Reserve Ratio (20%) m = 1 R New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example = 5

The Monetary Multiplier Reversibility –Making Loans Creates Money –Loan Repayment Destroys Money

Bank Panics of Series of Bank Panics Before Deposit Insurance (FDIC) Mass Withdrawals From Fear –More than 9,000 banks failed in one year Move to Cash Reduced Money Supply Through Reduction in Loans (money destruction) Multiple Contraction Slowed Lending and the Economy 1933 National Bank Holiday for One Week Resulted in FDIC and 25% Drop in Money Supply Contributed to the Great Depression Regulation Protects the System Today (your author said this, not me!) Last Word

Key Terms fractional reserve banking systemfractional reserve banking system vault cash required reserves reserve ratio excess reserves actual reserves monetary multiplier