1. Money Creation
Chapter 32

2. Goldsmiths and Fractional Reserve Banking
Traders used gold to make transactions until they realized it was too difficult to use
They began depositing their gold with the Goldsmiths who would give them a receipt for the deposit and charge them a fee for the service
Eventually, the goldsmiths' receipts were used to pay for goods, and became the first type of currency
At this time, goldsmiths backed their circulating paper money receipts fully with the gold they held in their vaults (it was a 100% reserve system)
Goldsmiths realized that the public had completely accepted the receipts as paper money
The amount of gold being deposited in their "reserves" exceeded the amount that was being withdrawn.

3. Goldsmiths and Fractional Reserve Banking
The goldsmiths began to issue paper receipts in excess of the amount of gold being held in their vaults
They put these receipts into circulation by making interest-earning loans to merchants, producers and consumers
Lenders willingly accepted loans in the form of gold receipts (receipts were accepted as a medium of exchange in the market).
The goldsmiths began the fractional reserve system of banking
the reserves in bank vaults are a fraction of the total money supply just as the gold reserves were a fraction of the circulating paper money back then

4. Characteristics of Fractional Reserve Banking:
Banks create money through lending.
Banks lend money at higher interest rates than the ones they pay out to create money.
Banks have a system of deposit insurance and operate on the basis that fractional reserves are vulnerable to "runs" or "panics."
This is when all the holders demand for their money all at the same time. Although this is highly unlikely, banks still take measures to protect themselves from this disaster that has ruined banks in the past (e.g. in the Great Depression).

5. A Single Commercial Bank
Balance sheet is a statement of assets, liabilities, and net worth (capital stock) of the bank at a certain time
value of assets must equal the amount of claims against the assets
When federal reserve ratios change, the balance sheet for banks is skewed
they must recall loans (make you repay right then) and/or take out loans to balance their accounts
Assets = liabilities + net worth
Every $1 change in assets must equal a $1 change in liabilities and net worth (and vise versa)
Vault cash = cash held by a bank (money you can withdraw)

6. Bank’s Balance Sheet Typical items on Bank of America’s balance sheet
Checking Deposits (D) $100 million
Bonds (US gov’t securities) $19 million
Loans (L) $70 million
Reserves (R) $11 million
What are reserves?
deposits that banks are required to hold on to plus any additional cash they do not loan out (excess reserves)

7. Bank of America’s Balance sheet
Bank’s Balance Sheet
Bank of America’s Balance sheet
Assets Liabilities and Net Worth
Bonds $19 million
Checkable Deposits $100 million
Loans $70 million
Reserves $11 million
Total: $100 million in Assets
Total: $100 million in Liabilities and Net Worth

8. Reserves and excess reserves
= Total Reserves minus Required Reserves
Loans are made out of excess reserves
Banks give loans because loans earn a profit (interest) while excess reserves earn nothing
Think of your own money—if you put it in your checking account or in your sock drawer it doesn’t make money but if you put it in savings it does 
Loaned up
When excess reserves = 0, the bank is “loaned up” or “fully loaned” and can’t make any new loans

9. Profits, Liquidity, and the Federal Funds Market
Bank has two conflicting goals:
Earn profit by making loans and buying securities
Balance liquid assets and excess reserves; therefore, must restrict lending
When banks lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks, it achieves the two conflicting goals because first it is earning a profit from the interest and second it is a transaction of excess reserves, which preserves the reserve requirement
If banks don't have enough excess reserves at the end of the day to fulfill the 10% requirement (in the US) set by the Fed, they must borrow from other banks in order to keep at least 10% of their total checkable deposits. They can also borrow from the Fed, but that's usually a last resort.

10. Multiple-Deposit Expansion
Suppose that r = (bank must hold 10% of its deposits as reserves)
In our example, does BoA hold any excess reserves?
Required reserves = 10%
$100M x .10 = $10M
If BoA had $11M in reserves then they have an excess of $1M

11. Multiple-Deposit Expansion
What to do with excess reserves?
BoA loans Proctor and Gamble $1M to buy computers
Proctor and Gamble gives loan check to Dell
Dell deposits the check into Wells Fargo

12. Multiple-Deposit Expansion
Changes in balance sheets
BoA Bank
Assets Liabilities
Wells Fargo Bank
Assets Liabilities
R $1M
L $1M
Notice that their assets total stays the same
Notice that they now have $1M in reserves they did not have before
R $1M
D $ 1M

13. Multiple-Deposit Expansion
Did deposits rise? Did deposits fall?
Deposits rose by $1M at Wells Fargo but stayed the same at BoA
meaning M1 rose $1M

14. Multiple-Deposit Expansion
Not the end of the story
Does Wells Fargo now have any excess reserves?
Required reserves = .10 (1M) = $100K
Excess reserves = 1M – 100K = $900K

15. Multiple-Deposit Expansion
What to do with excess reserves?
Wells Fargo loans Waterman Hospital $900K for an addition
Waterman Hospital gives loan check to Marbek Construction
Marbek Construction deposits the check in SunTrust

16. Multiple-Deposit Expansion
Changes in balance sheets
Wells Fargo Bank
Assets Liabilities
SunTrust Bank
Assets Liabilities
R $900K
L $900K
R $900K
D $900K

17. Multiple-Deposit Expansion
Did deposits rise? Did deposits fall?
Deposits rose by another $900K but did not fall in any other bank
M1 rose $900K on this transaction
M1 has risen $1.9M ($1M + $900K) when combining the two transactions together

18. Multiple-Deposit Expansion
Not the end of the story
Does SunTrust now have any excess reserves?
Required reserves = .1 (900K) = $90K
Excess reserves = $900K-90K = 810K
YES, SunTrust has excess reserves of $810K

19. Multiple-Deposit Expansion
Process continues over, and over, and over, and over (we could do this all day…but it’s boring)
So—let’s use a shortcut to figure out the maximum change in the money supply
The maximum change in money supply = the Money Multiplier (1/r) x initial excess reserves

20. Money Multiplier
In our example, what is the maximum change in the money supply?
Money multiplier = 1/r
= 1/.10 = 10
Initial deposit or loan = 1M
Maximum change in money supply
= 10 x $1M = $10M
Off of BoA’s $1M excess reserve loan M1 has grown by $10M

21. Money Multiplier
When the reserve ratio changes because of the monetary policy, the money multiplier also changes.
As Reserve Ratio increases, Money Multiplier decreases
As Reserve Ratio decreases, Money Multiplier increases