AP Economics
Mr. Bernstein
Module 25:
Banking and Money Creation
February 26, 2015
AP Economics
Mr. Bernstein
Banking and Money Creation
• Objectives - Understand each of the following:
• The role of banks in the economy
• The reasons for and types of banking regulation
• How banks create money
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AP Economics
Mr. Bernstein
How Banks Create Money
• Banks receive deposits
• Banks make loans
• Banks hold reserves against those loans
• If reserves are 10%, loans can be 10x deposits
• This effectively creates money
• Demonstrated by T-Account:
• Fed sets reserve requirements
3
AP Economics
Mr. Bernstein
How Banks Create Money: An Example
• Similar to the Spending Multiplier
4
AP Economics
Mr. Bernstein
Problem of Bank Runs
• If public fears a bank may fold and be unable to pay
back depositors, they rush to the bank to make
withdrawals before others can
• Since deposits are several times reserves, a bank
with solid loans but the subject of rumours may be
unable to meet demand for withdrawals
• Can become a self-fulfilling prophecy
• Preventing bank runs is a primary reason for bank
regulation
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AP Economics
Mr. Bernstein
Bank Regulation
• Deposit Insurance
• Current FDIC insurance is $250,000 per account
• Capital Requirements (= Assets – Liabilities)
• Capital Requirements have been rising since 2008 crisis
• Reserve Requirements
• Currently 10% in the USA
• Discount Window
• Fed stands as short-term lender to banks in need of
capital
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AP Economics
Mr. Bernstein
Reserves, Bank Deposits and the Money Multiplier
• Money Multiplier = 1 / reserve ratio…MM = 1/rr
• Excess Reserves = Total Reserves - rr
• MM tells us how
much money can be
created from each $
of Excess Reserves
• In reality, MM is not
10 – its now < 1.
• Why?
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