1. Money Creation Chapter 15 McGraw-Hill/IrwinCopyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Functions of Commercial Banks LO1 I. Functions of Commercial Banks 1.Commercial banks take our deposits (chequing, saving, etc.) and lend us money (personal loans, business loans, housing mortgages, etc.). 2. Commercial banks also lend to and borrow money from each other, clear credit cards transactions, and settle cheques. 3.When commercial banks take our deposits and lend to other people, they also “create” money.

3. Functions of Commercial Banks 4. How do the commercial banks’ day-to-day transactions affect the money supply, M1 or M2? (i)The central bank of Thailand, the Bank of Thailand (BOT), supplies the economy with cash (prints bills and mints coins). (ii)This amount of money is called monetary base or high-powered money. The Thailand monetary base is around 1,710 billion baht (2015). - Recall: M1 = 1,778 billion baht (2015), larger than monetary base. - Recall: M2 = 17,552 billion baht (2015), larger than monetary base. - How are M1 and M2 related to the monetary base? Source: https://www.bot.or.th/English/Statistics/Indicators/Pages/default.aspxhttps://www.bot.or.th/English/Statistics/Indicators/Pages/default.aspx (iii)The monetary base is held by the public (you and me, the “non- bank public”) and the commercial banks (ATMs, tellers, vault, etc.) LO1

4. Money Creation LO1 II. Deposit or Money Creation 1. Suppose the Bank of Thailand prints an additional 100 baht and pays its worker Person A. When Person A deposits this 100 baht with a bank, what would the bank typically do? (i)It keeps some of this 100 baht as reserves in case this customer writes a cheque to be drawn on this money, uses the ATM to withdraw some, etc. (ii) This fraction is the bank’s reserve ratio, “R”. (iii)The remaining amount, the bank lends to other people. (iv)Commercial banks “create” money! It does so by “recycling” our deposits in the banks by lending to other people. (v)This process is called “deposit or money creation”.

5. Money Creation LO1 2.Similar to a typical firm, a bank has a balance sheet. (i)Assets versus liabilities and net worth - Example: A house is worth 2,000,000 baht. - Assets = liabilities + net worth. AssetsLiabilities + net worth (ii) For simplicity, assume net worth = 0.

6. LO4 3.Consider a hypothetical money creation process: (i) Person A deposits 100 baht with Bank 1  Bank 1 holds________baht, or ________% as reserves and lends out the remaining _______ baht, or ________% to Person B who needs a loan. (ii)Person B takes this ______ baht and pays Person C  Person C deposits this money with Bank 2  Bank 2 holds ________ baht, or ________% as reserves and lends out the remaining ________ baht, or _________% to Person D who also needs a loan. (iii)Person D gets this _______ baht and pays Person E  Person E deposits this money with Bank 3  Bank 3 holds ________ baht, or ________% as reserves and lends out the remaining ________ baht, or _________% to Person F who also needs a loan … the process continues…  Add up all deposits: Recall deposits are a part of the money supply. Money Creation

7. LO4 4.Assets versus liabilities of a commercial bank (i) Starting with the 100 baht in Bank 1: - 100 baht is deposited by Person A. - 20 baht is reserve held by Bank 1. - 80 baht is newly issued loan by Bank 1 to Person B. (ii)From Bank 1’s perspective, what is (are) its assets? (iii)From Bank 1’s perspective, what is (are) its liabilities? Money Creation

8. LO4 5. How do the balance sheets look like? Bank 1AssetsLiabilities Bank 2AssetsLiabilities Bank 3AssetsLiabilities  This is a power series. From mathematics, we know that … Total = Money Creation

9. III. Money Multiplier 1. The initial 100 baht increase in the monetary base which was subsequently deposited with Bank 1 generated deposits for other banks  Total=______________ baht, much more than the initial 100 baht. 2.Money multiplier=___________________ in this example. 3.Let the reserve ratio be “R”. Money = ΔMoney Supply = ΔM = 1 = 1 Multiplier ΔMonetary Base ΔH 1 - % of deposits lent out R  Does this remind you of something familiar???? Money Multiplier

10. 4. Relate the money multiplier to our previous goods multiplier: Money = ΔMoney Supply = ΔM = 1 = 1 Multiplier ΔMonetary Base ΔH 1 - % of deposits lent out R Goods = ΔCons Confidence = ΔC = 1 = 1 Multiplier ΔIncome ΔY 1 - % of income spent MPS 5.In Thailand, the required minimum reserve ratio is 1%. Commercial banks can hold more than 1%. Source: https://www.bot.or.th/English/AboutBOT/RolesAndHistory/Pages/RolesAndResponsibility.aspxhttps://www.bot.or.th/English/AboutBOT/RolesAndHistory/Pages/RolesAndResponsibility.aspx Money Multiplier

11. IV. Money Supply 1. Money supply (Ms) is defined as the money multiplier multiplying the monetary base. Money Supply (Ms) = 1 * monetary base R 2.Given that our M2 = 17,552 billion baht and monetary base = 1,710 billion baht, our implicit money multiplier is approximately equal to __________________. 3.Changes in the monetary base or the reserve ratio will change the Ms. Money Supply

12. 4.For better visual, let us graph this: Newly printed 100 baht Money Supply