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Bob the Goldsmith
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AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000
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Bob the Goldsmith AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000 Suppose Bob makes a $1000 loan. Assume he gives the loan in currency.
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The money supply increases by $1000. AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Bob the Goldsmith
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What if Bob had made the loan as a checking account balance?
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The money supply still increases by $1000. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000
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General Principle of money and banking:
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Whenever a bank makes a loan the money supply increases by the amount of the loan.
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What happens when the loan is paid back?
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Assume the loan was made in currency (gold coins) and is repaid with currency.
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AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Before the loan is repaid. After the loan is repaid with currency. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000
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Result: The money supply decreases by $1000.
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What happens when the loan is paid back?
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Assume the loan was made in currency (gold coins) and is repaid with a check.
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AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $100,000 Loan $1000 Before the loan is repaid. After the loan is repaid with a check. AssetsLiabilities + Owners' Equity Gold coins $99,000Demand Deposits $99,000
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The money supply decreases by $1000. Result:
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What happens when the loan is paid back?
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Assume the loan was made as a checking account balance and is paid back with a check.
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AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000 Before the loan is repaid. After the loan is repaid with a check. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000
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Result: The money supply decreases by $1000.
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What happens when the loan is paid back?
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Assume the loan was made as a checking account balance and is paid back with currency.
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AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $101,000 Loan $1000 Before the loan is repaid. After the loan is repaid with currency AssetsLiabilities + Owners' Equity Gold coins $101,000Demand Deposits $101,000
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Result: The money supply decreases by $1000.
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General Principle of money and banking:
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When a loan of a financial institution is repaid, the money supply decreases by the amount of the loan repayment.
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These first two general principles imply a third.
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Individual banks create and destroy money one a one-to- one basis with their loans. Every dollar created through loans is destroyed when the loans are repaid.
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Fractional Reserve Banking Reserves = Vault Cash + Deposits with the Fed
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Required Reserves = r x (Demand Deposit Liabilities) r = required reserve ratio Total Reserves = Required Reserves + Excess Reserves
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Let's impose a 20 percent reserve requirement on Bob (i.e., r=.2). AssetsLiabilities + Owners' Equity Reserves = $100,000Demand Deposits $100,000 Required =.2 ($100,000) = $20,000 Excess = $80,000
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Since Bob has excess reserves of $80,000, let's have him make an $80,000 loan. AssetsLiabilities + Owners' Equity Reserves = $100,000 Loan = $80,000 Demand Deposits $180,000 Required =.2 ($180,000) = $36,000 Excess = $64,000 Assume Bob makes the loan as a checking account balance.
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Note that Bob still has excess reserves of $64,000. It looks like Bob could make another $64,000 loan. But........
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What if the person Bob made the $80,000 loan to writes a check for $80,000 to a person who has an account at another bank? Let's go to the board and see what happens to Bob's balance sheet.
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