1. Please listen to the audio as you work through the slides
How Banks Create Money
Please listen to the audio as you work through the slides

2. How Banks Create Money Learning Objectives:
Students will be able to thoroughly and completely explain:
How banks create and destroy money, the role of the reserve requirement.
How the Money Multiplier works.

3. How banks destroy money
How banks create money
Through lending
Buying bonds from the public
How banks destroy money
Through the payoff of loans
Selling bonds to the public

4. Fractional Reserve System
Balance sheet
Assets = Liabilities + Net Worth
Both sides balance
Necessary transactions to understand
Create a bank
Accept deposits
Lend excess reserves

5. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
TRANSACTION 1
Creating a bank
$250,000 Cash
for
Capital Stock

6. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $250,000
Capital Stock $250,000
Deposit Added to Vault Cash

7. Acquiring Property and
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $250,000
Capital Stock $250,000
TRANSACTION 2
Acquiring Property and
Equipment
$240,000 Cash

8. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $ 10,000
Property ,000
Capital Stock $250,000

9. Deposits into checking accounts
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $ 10,000
Property ,000
Capital Stock $250,000
TRANSACTION 3
Accepting
Deposits into checking accounts
$100,000 Cash

10. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000

11. Formation of a Commercial Bank
NOTES:
Bank deposits are
subject to a reserve
requirement.
Reserve
ratio
Commercial bank’s
required reserves
checkable-deposit
liabilities =
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000

12. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
Three Important Issues...
1 - Excess Reserves = Actual Reserves - Required Reserves
(assume 20% reserve requirement)
$110, ,000 = $90,000
2 – Control of Lending Ability
3 - Asset or Liability to Which Bank?

13. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $110,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 4
Deposit
Into FED account
$110,000 Cash

14. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000

15. A check is drawn against the bank
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 5
A check is drawn against the bank
$50,000

16. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000

17. Formation of a Commercial Bank
NOTES:
Banks create money
by lending excess
reserves and destroy
it by loan repayment.
Purchasing bonds
from the public also
creates money.
LIABILITIES AND
NET WORTH
ASSETS
Cash $
Reserves ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000

18. Make a loan from excess reserves
Formation of a
Commercial Bank
Promisary note
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
TRANSACTION 6
Make a loan from excess reserves
$50,000

19. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Loans ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
Making the loan
created money!

20. Formation of a Commercial Bank*
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
After a check for the $50,000
is drawn against the bank

21. Repaying a loan with cash
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans ,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
TRANSACTION 7
Repaying a loan with cash
$50,000

22. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Loans
Property ,000
Checkable
Deposits $
Capital Stock ,000
$50,000 in money supply
is destroyed!

23. Let’s buy bonds from public
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 60,000
Property ,000
Checkable
Deposits $ 50,000
Capital Stock ,000
Let’s buy bonds from public
$50,000

24. (Assume previous balance sheet)
Formation of a
Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Securities ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
TRANSACTION 8
(Assume previous balance sheet)
Bought Government
Securities
$50,000

25. Formation of a Commercial Bank
LIABILITIES AND
NET WORTH
ASSETS
Reserves $ 10,000
Securities ,000
Property ,000
Checkable
Deposits $100,000
Capital Stock ,000
Banks conflicting goals:
Earn profit
Make loans to earn interest
Buy securities to earn interest
Maintain liquidity
Alternative?
Overnight bank loans
Federal funds rate

26. The Banking System Multiple-deposit expansion
Assumptions:
20% required reserves
All banks “loaned up” no excess reserves
Banks lend all of excess reserves when they get them.
A $100 bill is found and deposited
Multiple deposits can be created
32-26

27. MULTIPLE DEPOSIT EXPANSION PROCESS
Bank
Acquired reserves
and deposits
Required
reserves
Excess
Amount bank
can lend - New
money created A B C D E F G H I J K L M N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
17.59
Total amount of money created by the banking system
$400.00

28. Money destruction works in exactly the same multiple way!
MULTIPLE DEPOSIT EXPANSION PROCESS
Bank
Acquired reserves
and deposits
Required
reserves
Excess
Amount bank
can lend - New
money created A B C D E F G H I J K L M N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
17.59
Money
destruction works
in exactly the same
multiple way!
Total amount of money created by the banking system
$400.00

29. The Monetary Multiplier
Maximum amount of new money created by a single dollar of excess reserves
Higher R, lower m
R = Reserve ratio, m = monetary multiplier
Reversibility
Making loans creates money
Loan repayment destroys money

30. The Monetary Multiplier
Required reserve ratio 1 =
Maximum
checkable-
deposit
creation =
Excess
reserves x
Monetary
Multiplier

31. The Monetary Multiplier= 1
required reserve ratio 1 = R
Graphic
Example
New Reserves
$100
$80
Excess
Reserves
$20
Required
Reserves
$100
Initial
Deposit
$400
Bank System Lending
Money Created