How Banks Create Money [MS]
MS = Currency + DD of Public
Banks [thru loans] Create More DD
1. Fractional Reserve Banking System – a fraction of DD are kept in
reserve(say, 10%) at either the bank’s vault or at the Fed.
2. Vault cash – cash held by a bank (banks rarely keep more than 2% of their in cash)
3. Required Reserve(RR)–specified percentage of DD that banks must keep as RR.
4. Excess reserves – total reserves(TR) – RR. ER is what can be loaned out.
5.
6.
Also some ER is used to meet sudden withdrawal demands.
Actual(Total) reserves – RR + ER.
Deposit Multiplier – one/RR or 1/.10 or $1/10 cents or 10
Multipliers 1/RR[$1/5 cents = 20]
1/5% = 20
1/25% = 4
1/10% = 10
1/33.3%= 3
1/12.5% = 8
1/40 = 2.5
1/20% = 5
1/50% = 2
7. Balance Sheet–statement of assets & liabilities[assets=liabilities].
8. Discount Rate – when banks borrow from the Fed. [symbolic-emergencies]
“wholesale price of money”
9. Federal Funds Rate – banks borrow from other banks for overnight loans.
10. Prime Rate – when a bank’s prime customers [good credit] get loans.
“retail price of money”
11. Buying Bonds – “buying” bonds means “bigger ” supply of money
and “lower interest rates”. [So, more “C”, “Ig”, and “Xn” ]
12. Selling Bonds – “selling” bonds mea ns “smaller” supply of money and
“higher interest rates”. [So, less “C”, “Ig”, and “Xn”]
FRACTIONAL RESERVE BANKING
YOU deposit $1 with A 10% RR
.10
RR
90 cents
Excess Reserves
Total (Actual) Reserves
One Dollar
One bank’s loan becomes
another bank’s DD.
PMC = M x ER, so 10 x .90 =$9
TMS = PMC[$9] + DD[$1] = $10
[MS = Currency + DD of Public]
Your Bank Borrows $1 From The Fed [10% RR]
Bank
Fed
0
One Dollar
RR Excess Reserves
Total(Actual) Reserves
One Dollar
PMC = M x ER, so 10 x $1 = $10
TMS [$10] = PMC[$10]
[MS = Currency + DD of Public]
$1,000 DD
[MS=Currency+DD of Public]
New Deposits
[New Reserves]
DD
Bank
DD Created By
New Loans
[equal to new ER]
New Required
Reserves
RR=10%
A
$1,000.00
$100.00
900.00
900.00
B
900.00
$90.00
810.00
C
810.00
$81.00
729.00
D
729.00
$72.90
656.10
PMC = ER[$900] x M[10]
DD
+
PMC
$1,000.00 + $9,000.00
=
=
Dog that can YoYo
One year “all u can
eat” hot wings at
Hooters
$729.00 for a
“cat bodyguard”
PMC = $9,000.00
TMS
Smoking cat
$10,000.00
MS grows by
multiple of 10
$1,000 DD
[MS=Currency+DD of Public]
New Deposits
[New Reserves]
DD
Bank
DD Created By
New Loans
[equal to new ER]
New Required
Reserves
RR=20%
A
$1,000.00
$200.00
800.00
B
800.00
$160.00
640.00
C
640.00
$128.00
512.00
D
512.00
$102.40
409.60
PMC = ER[$800 x M[5]
DD
+
PMC
$1,000.00 + $4,000.00
=
=
PMC = $4,000.00
TMS
$5,000.00
MS grows by
multiple of 5
$1,000 DD
[MS=Currency+DD of Public]
New Deposits
[New Reserves]
DD
Bank
DD Created By
New Loans
[equal to new ER]
New Required
Reserves
RR=25%
A
$1,000.00
$250.00
750.00
B
750.00
$188.00
562.00
C
562.00
$140.00
422.00
D
422.00
$105.00
317.00
E
317.00
$80.00
237.00
PMC = ER[$750] x M[4]
DD
+
PMC
$1,000.00 + $3,000.00
PMC = $
=
3,000.00
TMS
=
$4,000.00
MS grows by
multiple of 4
MS = DD + Currency of the Public
[A DD of $10,000 will increase MS by another $40,000($50,000 MS]
RR=20%
MS
$10,000
$8,000
$6,400
$24,400
MS is
$10,000
1. Joe Biker deposits
$10,000 in his bank.
RR = 20%
4. 2nd Bank lends Sports Shop $6,400.
MS
$10,000
$8,000
$18,000
2. Suzie Rah Rah borrows $8,000
5. Eventually the MS will be $50,000
Joe
3. Suzie pays $8,000 for a used car.
GoNow Auto deposits the $ in 2nd Bank.
$10,000+$40,000=$50,000
NOTES:
Banks create money
by lending ER and
destroy money by
loan repayment.
Purchasing bonds
from the public also
creates money.
MULTIPLE DEPOSIT EXPANSION PROCESS
RR= 20%
Bank
Acquired reserves Required
and deposits
reserves
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks 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
P MC in the banking system [MxER]
Excess
reserves
$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
Amount bank
can lend - New
money created
$80.00
64.00
51.20 1st
40.96 10
32.77 $357
26.22 of
20.98 the
16.78 $400
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
TMS = $500.00
THE Money [Deposit] MULTIPLIER
MM
=
1
RR
The MM is the reciprocal of the RR.
Maximum
Potential money
checkableCreation
in the
Bankingdeposit
System
expansion
[PMC]
= ER x MM
AP Econ [MS = Currrency + DD of Public]
RR+ER=TR; TR-RR=ER; TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS
Excess Reserves prior to new currency deposit (DD) = $0
Ben Bigbucks deposits in the banking system = $40 million
Legal Reserve Requirement [RR] = 20%
1. The $40 million deposit of Currency into DD would result in MS
staying at ($8/$40/$160) million. [MS composition changed from currency to DD]
2. The $40 million deposit of currency into
checking accounts will create ER of ($20/$32/$40) million.
3. The Potential Money Creation of the banking system
through loans is ($40/$160/$$200) mil. The Potential TMS
[all DD of the public] could be as much as ($40/$160/$200) mil.
4. The RR applies to checkable deposits at (banks/S&Ls/
credit unions/ all depository institutions).
5. If the Duck National Bank has ER of $6,000 & DD of $100,000
what is the size of the bank’s TR if the RR is 25%?
25,000
6,000
31,000
($25,000/$75,000/$31,000) [RR($____)+ER($___)+TR($____)
[MS = Currrency+DD of Public]
RR+ER=TR; TR-RR=ER; TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS
6. A stranger deposits $1,000 in a bank that has a RR of 10%. The
maximum possible change in the dollar value of the local bank’s loans would
900
be $______.
PMC[M X ER] in the banking system is $_____.
9,000 Potential TMS
10,000
could become as high as $_______.
7. Suppose a commercial bank has DD of $100,000 and the RR is 10%.
If the bank’s RR & ER are equal, then its TR are ($10,000/$20,000/$30,000).
8. Total Reserves (minus/plus) RR = ER.
9. Suppose the Thunderduck Bank has DD of $500,000 & the RR is 10%.
If the institution has ER of $4,000 then its TR are ($46,000/$54,000/$4,000).
10. If ER in a bank are $4,000, DD are $40,000, & the RR is 10%, then
TR are ($4,000/$8,000).
11. The main purpose of the RR is to (have funds for emergency withdrawals/
influence the lending ability of commercial banks).
12. If I write you a check for $1 & we both have our checking accts at the
Poorman Bank, the bank’s balance sheet will (increase/decrease/be unchanged).
13. Banks (create/destroy) money when they make loans and repaying bank
loans (create/destroy) money.
14. When a bank loan is repaid the MS is (increased/decreased).
15. The Fed Funds rate is a loan by one bank (to another bank/from the Fed).
[MS = Currrency+DD of Public]
RR+ER=TR; TR-RR=ER; TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS
16. If the RR was lowered [say, from 50% to 10%], the size of the
monetary multiplier [MM] would (increase/decrease).
Leakages (limitations) of the Money Creating Process
1. Cash leakages [taking part of loan in cash]
2. ER (banks don’t loan it or we don’t borrow]
17. If borrowers take a portion of their loans as cash, the maximum amount by
which the banking system increases the MS by lending will (increase/decrease).
Money Supply = DD + Currency of the Public
ER
“PMC”
Loans
$100[10% RR] [1st Bank] [1st Bank]
Banks/Public DD [$100]
$90
$90
Fed /Public/Banks DD[$100]
$90
$90
“PMC”
Crea. In
“TMS”
“Potential”
System
Total MS
$900
$1,000
$900
$1,000
[*Fed buys bonds from public who put the money in their DD]
Banks/Fed
Fed Loan[$100]
$100
[or sells bonds to Fed]
ER
$100
“PMC”
Loans
$1,000
$100 [20% RR] [1st Bank] [1st Bank]
Banks/Public DD [$100]
$80
$80
Fed/Public/Banks DD [$100]
$80
$80
“PMC”
Crea. In
$1,000
“TMS”
“Potential”
System
Total MS
$400
$500
$400
$500
[*Fed buys bonds from public who put the money in their DD]
Banks/Fed
Fed Loan[$100]
$100
[or sells bonds to Fed]
$100
$500
$500
Banks and the Fed
[RR+ER=TR; TR-RR=ER; TR-ER=RR; MxER=PMC; PMC(Public)+1st DD=TMS; PMC(Fed)=TMS]
MS = Currency + DD of Public
[Money borrowed from the Fed [or gained thru bond sales] is ER & can be loaned out]
9. RR is 25%; Econ Bank borrows $25,000 from the Fed; its ER are increased by
25,000 Potential Money Creation in the system is $_______.
$______.
100,000
100,000 Potential TMS is $_______.
10. RR is 50%; a bank borrows $20,000 from the Fed; this one bank’s ER are increased
40,000
40,000 Potential TMS is $______
by $_____.
20,000 Potential Money Creation in the system is $______.
11. RR is 20%; the Duck Bank sells $10 M of bonds to the Fed; Duck Bank’s ER are
increased by $___million.
PMC in the system is $__________.
50 million
50 million TMS is $__________.
10
12. RR is 20%; Fed buys $50,000 of securities from Keynes Bank. Its ER are
increased by $___________.
Potential Money Creation in the banking system is
50,000
$______________.
Potential TMS is $___________.
250,000
250,000
13. 25% RR; Fed buys $400 million of bonds from the Friar Bank. This one
400
bank’s ER are increased by $_____million.
14. RR is 50%; the Fed sells $200 million of bonds to a bank; its ER are
(increased/decreased) by $_______.
200 M Potential Money Creation in the
400 M
banking system is (increased/decreased) by $________.
15. RR is 10%; a bank borrows $10 million from the Fed; this one bank’s
ER are increased by $_______
million. PMC in the banking system is
10
$_______million.
Potential TMS is $_______million.
100
100
Banks and the Public
RR+ER=TR; TR-RR=ER; TR-ER=RR; M x ER=PMC; PMC(Public)+1st DD=TMS; PMC(Fed)=TMS
MS = currency + DD of Public
Banks & Public (all DD of Public are subject to the RR; rest is ER & can be loaned out)
1. No ER & RR is 20%; DD of $10 M is made in the Thunder Bank. MS is
$___million.
ER increase by $___million.
Potential Money Creation in the
10
8
banking system is $_____M.
Potential TMS is $____million.
40
50
2. There are no ER & RR is 25% & $16,000 is deposited in the Duck Bank. MS is
$_______.
16,000 This one bank can increase its loans by a maximum of
48,000
$_______.
12,000 Potential Money Creation in the banking system is $_______.
64,000
Potential Total Money Supply could be $__________.
3. Econ Bank has ER of $5,000; DD are $100,000; RR is 25%. TR are $_______.
30,000
4. DD are $10,000; ER are $1,000; TR are $3,000; RR are $2,000
_________. [TR-ER=RR].
$50,000
5. Nomics Bank has ER of $10,000; DD of $100,000; RR of 40%. TR are _________.
With ER above, Potential Money Creation in the banking system is $__________.
25,000
6. Friar Bank has DD of $100,000; RR is 20%; RR & ER are equal. TR are $________.
40,000
7. If ER in a bank are $10,000; DD are $200,000, & the RR are 10%. TR are $_______.
30,000
100,000 This single bank can
8. No ER & RR is 25%. DD of $100,000 is made. MS is $_______.
75,000 PMC in the system is $________.
increase its loans by $_______.
300,000 TMS is $________.
400,000
Fed
and the Public
[RR+ER=TR; TR-RR=ER; TR-ER=RR; MxER=PMC; PMC(Public)+1st DD=TMS; PMC(Fed)=TMS]
MS = Currency + DD of the Public
[When Fed buys securities from Public, they will put the money in their DD]
16. RR is 50%; Fed buys $10 M of bonds from the Public. MS is increased by _______.
$10 M
$20 M
ER are increased by $5
____.
_______.
M PMC in the system is $10
M Potential TMS is _______.
17. RR is 25%; Fed buys $100 M of bonds from the Public. The MS is increased _______.
$100 M
ER are increased by ______.
_______.
________.
$75 M PMC in the system is $300
M Potential TMS is $400
M
18. RR is 50%; Fed sells $200 M of bonds to the Public. The MS is (incr/decr) by
$100 M PMC in the banking system is
__________.
$200 M ER are (incr/decr) by _________.
M
(increased/decreased) by $200
_______.
__________.
M Potential TMS is (incr/decr) by $400
19. RR is 20%; Fed buys $5 million of securities from the Public. The MS
$5 M ER are increased by _______.
is increased by _______.
$4 M Potential Money
$25 M
M Potential TMS is _________.
Creation in the banking system is$20
_______.
20. RR is 10%; Fed buys $50 million of bonds from the Public. The MS is
$50 M ER are increased by _______.
$45 M PMC in the banking
increased by _______.
$500 M
$450 M Potential Total Money Supply is __________.
system is __________.
1. The RR is 20% & Joe Smith deposits $10,000 in the Econ Bank
that he has been saving in a coffee can in a tree. The impact of this
transaction on the ER of the Econ Bank & the potential increase in
the money supply would be: [Remember: MS = Currency + DD of public]
(A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000.
(B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000
(C) ER would increase by $8,000 & the maximum increase in MS would be $40,000
(D) ER would increase by $10,000 & the maximum increase in MS would be $40,000.
(E) ER would increase by $40,000 & the maximum increase in MS would be $50,000.
The MS [Cash or DD of the public] was $10,000 cash. When he deposited the $10,000, the Econ
Bank could loan out ER of $8,000. The $8,000 x MM of 5 became $40,000 for TMS of $50,000.
So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of $50,000.
1. RR is 20% & Econ Bank borrows $10,000 from the Fed.
The impact of this loan on the bank’s ER and then TMS are:
[Remember again: MS = Currency + DD of public]
(A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000.
(B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000
(C) ER would increase by $8,000 & the maximum increase in MS would be $40,000
(D) ER would increase by $10,000 & the maximum increase in MS would be $40,000.
(E) ER would increase by $40,000 & the maximum increase in MS would be $50,000.
All of the $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMS
of $50,000. [MM of 10 x $10,000 = $50,000]
Money Creation Problems from the 2005 Macro MC Exam
(87%) 40. Under a fractional reserve banking system, banks are required to
a. keep part of their demand deposits as reserves
b. expand the money supply when requested by the central bank
c. insure their deposits against losses and bank runs
d. pay a fraction of their interest income in taxes
e. charge the same interest rate on all their loans
(72%) 41. If a commercial bank has no ER and the RR is 10%, what is the value of
new loans this single bank can issue if a new customer deposits $10,000?
a. $100,000 b. $90,333 c. $10,000 d. $9,000 e. $1,000
The TR: $15,000, Securities: $70,000, and
Liabilities
Loan: $15,000 total up to the $100,000 DD.
DD: $100,000 This bank would have to keep $12,000 of
their $100,000 in RR. With TR of $15,000,
they have $3,000 in ER to loan.
Assets
Total Reserves: $15,000
Securities:
$70,000
Loan:
$15,000
(37%) 42. A commercial bank is facing the conditions given above. If the RR is 12%
and the bank does not sell any of its securities, the maximum amount of
additional lending this bank can undertake is
a. $15,000 b. $12,000 c. $3,000 d. $1,800 e. 0
(53%) 43. Assume the RR is 20%, but banks voluntarily keep some excess reserves.
A $1 million increase in new reserves will result in
They
could increase
M, but
a. an increase in the MS of $5 million
c. decrease
in MSMS
of by
$1 $5
million
they
keeping
in ER,
somillion
MS
b. an increase in the MS of less than $5 million
d. are
decrease
insome
the MS
of $5
will increase by less than $5 million.
e. a decrease in the MS of more than $5 million
THE Total DEMAND FOR MONEY
Transactions
Demand, Dt
+
Asset
Demand, Da
Nominal Interest Rate
M1
10
7.5
5
2.5
Dt
Independent
of the
interest
rate
Dt
Rate of interest, i (percent)
“Walking around”
money
10
7.5
5
=
Total demand
for money, Dm
Da [M2] – store
of value money
Money that we don’t need for daily, weekly,
or monthly transactions. We will invest more
of it the higher the interest rate. We will hold
less because the opportunity cost increases.
10% Da
Interest Rate
2.5
CDs or
8%
Da
0
0 50 100 150 200 250 300 0 50 100 150 200 250
Opportunity Cost
0
Amount of money
demanded (billions)
Amount of money
demanded (billions)
Da [hold less]
Interest Rate
Da varies inversely Opportunity Cost
with the interest rate.
Da [hold more]
6%
5%
4%
2%
1%
0
0 50 100 150 200
MS
7.5
5
2.5
Dt
=
Total demand
for money, Dm
MS2 MS1
0 50 100 150 200 250 300
Amount of money
demanded [billions]
Asset
Demand, Da
10
7.5
5
2.5
Da
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Nominal Interest Rate
Transactions
Demand, Dt
10
7.5
55
E
2.5
Dm
0
0 50 100 150 200 250 300 0 50 100 150 200 250 300
Amount of money
demanded [billions]
Money market
1. At equilibrium 5% I.R., the amount of money demanded for transactions is
(0/50/100) and the amount demanded as an asset is (0/50/100).
2. If the interest rate were 10%, the amount of money demanded for Dt would
be (0/50/100) & the amount demanded as an asset would be (0/50/100).
3. Da slopes down because lower in. rates (incr/decr) the cost of holding money.
[at “E”, money supplied ($200) = money demanded ($200)]
Nominal Interest Rate
The Dm curve represents the quantity of money
people are willing to hold at various interest rates.
DmMS
7.5
E
5
2.5
0
50
100 150
200
250 300
Money Market
Due to a recession, suppose the money supply
is increased from $200 billion to $250 billion.
S2 S1
P2
P1
# of Bonds
A temporary surplus of
MS1MS2 $50 billion beyond which
the people wish to hold,
10
Nominal Interest Rate
Price of Bonds
[at “E”, money supplied ($200) = money demanded ($200)]
Dm
7.5
E
5
E
2.5
0
50
100
They react by buying
bonds [pushing bond
prices up] to meet the
desired level of liquidity.
150 200 250 300
Money Market
AD AD
PL
YD
GDP
Nominal Interest Rate
LRAS SRAS
MS1 MS2
Dm
E
1%
0
Money Market
500
Liquidity Trap – in a stagnant economy with interest rates near or at zero, an
increase in MS fails to stimulate AD, so recession or depression gets worse.
With low returns expected on financial investments, people hoard their money.
Banks are unwilling to lend in a slack economy. Fiscal policy is needed here.
[at “E”, money supplied ($200) = money demanded ($200)]
Due to inflation, suppose the money supply is
decreased from $200 billion to $150 billion.
Nominal Interest Rate
Dm MS
7.5
E
5
2.5
0
50
100
150 200
Money Market
250 300
P1
P2
# of T-bills
Nominal Interest Rate
Price of Bonds
A temporary shortage of money will require the sale of some
assets [bonds-which will make their price fall] to meet the
money shortage need.
DmMS2 MS1
S1 S2
10
7.5
E
5
0
50
100
150 200
250 300
Money Market
1. [3 pts] Assume that declining stock market prices in the U.S. cause many
U.S. financial investors to sell their stocks and increase their money holdings.
investors sell off stocks when market
prices begin to decline. These new
money holdings will increase the
asset [speculative] demand for money.
In the volatile market, investors will
hold more money while determining
future needs. [2 pts: 1 pt for correct
graph and 1 pt for Dm shifting right.]
Nominal Interest Rate
(a) Draw a correctly labeled graph of the money market and show the
impact of the financial investors’ actions on each of the following.
(i) Demand for money
(ii) Nominal interest rate
DMMS
DM2
Answers for 1. (a) (i) [2 points]
1
r
2
1. (a) (i) In an effort to preserve wealth,
r1
M
Quantity of Money
Tutorial: These will shift the real Dm curve.
1. Changes in real aggregate spending,
2. Advances in banking technology. [ATMs available
24/7 decrease the need for cash (Dm)]
3. Changes in institutions [ability to get interest on
checking accounts lead to an increase in Dm],
4. Riskiness of alternative stores of value [stocks].
Dm increases when stocks are not appealing.
Answers for 1. (a) (ii) [1 point for saying the interest rate increases]
1. (a) (ii) The nominal interest rate would increase because the demand
for money increases as the DM curve shifts up, as shown above.