1. How banks create money

2. Learning objectives
Describe the simplified balance sheets of a single bank and the banking system
Explain the money-creating abilities of a single bank that is part of a multibank system
Explain the money-creating abilities of the banking system as a whole through multiple-deposit expansion, and compare this with the money-creating abilities of the single bank

3. Learning objectives (cont.)
Define the monetary (or credit) multiplier
Discuss some of the limitations on the banking system’s ability to create deposits and expand the money supply
Describe how the banks’ lending activities may contribute to financial instability and to increased fluctuations in the level of economic activity

4. Balance sheet
A statement of assets and claims that summarises the financial position of a firm at a point in time
Each side balances:
Assets are items of economic and financial value
Assets = Liabilities + Net worth

5. Formation of a bank Transaction (1): The birth of a bank
New owners sell $ worth of shares in the bank

6. Formation of a bank (cont.)
Transaction (2): Becoming a going concern
Acquisition of property and equipment

7. Formation of a bank (cont.)
Transaction (3): Accepting deposits
Citizens and businesses deposit $
Change in composition not total supply of money

8. Formation of a bank (cont.)
Required reserve ratio
The ratio of reserves to deposits to meet official liquidity requirements
Transaction (4): Setting aside required reserves
Assume reserve ratio is 20%
Bank must keep $ (required reserves)
banks required reserve
banks deposit liabilities
Reserve ratio =

9. Formation of a bank (cont.)
Bank decides to keep $ (actual reserves), which is $ more than required (excess reserves)
Bank’s required reserves are 20% of $

10. Formation of a bank (cont.)
Transaction (5): Drawing a cheque
A citizen who has substantial deposits in the bank draws a cheque for $ to buy goods
The seller of the goods deposits the cheque in another bank
The banking system as a whole has not lost or gained

11. Formation of a bank (cont.)
Transaction (5): Drawing a cheque (cont.)

12. Creating money Transaction (6): Granting a loan
A company borrows $ from the bank
Money is created
Balance sheet after loan is negotiated:

13. Creating money (cont.) Now, bank has no excess reserves
Balance sheet after cheque drawn on loan has been cancelled:
Now, bank has no excess reserves

14. Creating money (cont.) Transaction (7): Buying government bonds
Bank buys $ of government bonds instead of lending $50 000
Money is created

15. The banking system Multiple banks: multiple-deposit expansion
Money is created by a multiple of the banking system’s excess reserves

16. Multiple-deposit expansion
Assume initially: 20% reserve requirement
Bank A
Accepts a deposit for $100
Does not alter money supply
Excess reserves of $80
A loan of $80 is negotiated

17. Multiple-deposit expansion (cont.)
Balance sheet: Bank A

18. Multiple-deposit expansion (cont.)
Loan cheque of $80 is drawn on Bank A and deposited in Bank B
Bank B
Gains $80 in reserves and deposits
Excess reserves of $64
Loans $64

19. Multiple-deposit expansion (cont.)
Bank B
Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on …

20. Multiple deposit expansion process
Acquired reserves
and deposits
Required
reserves
Excess
New money
created
Bank 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
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
21.97
$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
17.57
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
Total amount of money created by the banking system

21. Multiple-deposit expansion (cont.)
Total banking system has created $400
How?
Via the monetary multiplier
Where m is the monetary multiplier 1
reserve ratio
monetary multiplier = 1 R
m =

22. Multiple-deposit contraction
The multiple credit expansion process is reversible and leads to a multiple reduction in the level of deposits — and hence the supply of money — if reserves are withdrawn

23. Possible leakages Currency drains
Loan may be paid in cash and remain in circulation
Transfer of deposits to non-bank financial institutions
Excess reserves
Individual banks may choose to have larger reserves than required (say 25% instead of 20%)

24. Willingness to borrow For the full multiplier effect to take place:
Borrowers must be willing and able to utilise the loans
Borrowing is likely to be low during a recession

25. Banks and financial instability
Banks may contribute to business fluctuations
Can exacerbate recession, by holding back on credit expansion
May amplify inflationary pressures, by increasing lending and credit creation, during recovery and business cycle peaks