Chapter 25
Money Creation
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
In the Middle
Ages, what was
used for money?
Gold was the money
of choice in most
European nations
2
Who were the
founders of our
modern-day banking?
Goldsmiths, people
who would keep other
people’s gold safe for
a service charge
3
What was the
first currency?
People would use the
receipts they received
from goldsmiths as
paper money
4
How did the early
goldsmiths act as
the first banks?
Some goldsmiths made
loans and received
interest for more gold
than the actual gold
held in their vaults
5
What is fractional
reserve banking?
A system in which
banks keep only a
percentage of their
deposits on reserve as
vault cash and
deposits at the Fed
6
What are
required reserves?
The minimum balance
that the Fed requires
a bank to hold in vault
cash or on deposit
with the Fed
7
What is a
required reserve ratio?
The percentage of
deposits that the Fed
requires a bank to hold
in vault cash or on
deposit with the Fed
8
What are
excess reserves?
Potential loan balances held
in vault cash or on deposit
with the Fed in excess of
required reserves
9
Typical Bank - Balance Sheet 1
Assets
Required
Reserves
Liabilities
$5 million Checkable $50 million
Deposits
Excess
Reserves
Loans
$45 million
Total
$50 million
0
Total
$50 million
Note: The Fed requires the bank to keep 10% of its
checkable deposits in reserve.
10
What are
total reserves?
Total Reserves =
required reserves +
excess reserves
11
Required Reserve Ratio of the Fed
Type of Deposit
Required
Reserve Ratio
Checkable deposits
0 - $46.5 million
3%
Over $46.5 million
10%
12
Best National Bank - Balance Sheet 2
Assets
Required
Reserves
Liabilities
$10,000 Brad Rich $100,000
Account
 in M1
0
Excess
Reserves +$90,000
Total
$100,000
Total
$100,000
Note: The Fed requires the bank to keep 10% of
its checkable deposits in reserve.
13
Best National Bank - Balance Sheet 3
Assets
Liabilities
 in M1
Required $19,000 Brad Rich $100,000
Reserves
Account
Excess $81,000
Reserves
Loans
+$90,000
Total
$190,000
Connie
Jones
Account
Total
+$90,00
0
$90,000
$190,000
Note: The Fed requires the bank to keep 10% of
its checkable deposits in reserve.
14
Best National Bank - Balance Sheet 4
Assets
Liabilities
 in M1
Required $10,000 Brad Rich $100,000
Reserves
Account
Excess
Reserves
0
Loans
$90,000
Total
$100,000
Connie
Jones
Account
0
0
$100,000
Note: The Fed requires the bank to keep 10% of
its checkable deposits in reserve.
15
Yazoo Bank - Balance Sheet 5
Assets
Liabilities
Required
Reserves
+$9,000
Excess
Reserves
+$81,000
Total
$90,000
Better
Health Span
Account
+$90,000
Total
$90,000
Note: The Fed requires the bank to keep 10% of
its checkable deposits in reserve.
16
Expansion of the Money Supply
#
Bank
Increase in Increase in Increase in
Required
Excess
Deposits
Reserves Reserves
1 Best Nat’l Bank $100,000
2 Yazoo Nat’l Bank 90,000
Bank A
3
81,000
Bank B
4
72,900
Bank C
5
65,610
6
59,049
Bank D
7
Bank E
53,144
$10,000
9,000
8,100
7,290
6,561
5,905
5,314
$90,000
81,000
72,900
65,610
59,049
53,144
47,830
Total all other banks 478,297
Total increase $1,000,000
47,830
430,467
$100,00
0
$900,00
0 17
What is the
money multiplier?
The maximum change in the
money supply due to an
initial change in the excess
reserves banks hold
18
What is the money
multiplier equal to?
1 / required reserve ratio
19
Actual money supply change
 M1 = ER x m
Initial change in excess reserves
Money multiplier
20
Can the multiplier be
smaller than indicated?
Yes, because of cash
leakages and the chance
that banks will not use all
of their excess reserves to
make loans
21
What would the Fed
with inflation?
Decrease the money supply
What would the Fed do
with unemployment?
Increase the money supply
22
What is
monetary policy?
The Fed’s use of • open market operations
•  in discount rate
•  in required reserve
ratio
23
What are open
market operations?
The buying and selling of
government securities by
the Federal Reserve
System
24
Federal Reserve System - Balance Sheet 6
Assets
Government
securities
Loans to
banks
Other
assets
Total
Liabilities
$472
1
75
$548
Fed notes
$492
Deposits
34
Other
liabilities and
net worth
Total
22
$548
25
Federal Reserve Bank - Balance Sheet 7
Initial 
in M1
Government +$100,00 Reserves +$100,000 +$100,00
securities
of Best
0
0
Nat’l bank
Assets
Liabilities
Note: The Fed conducted open market operations in
order to increase the money supply by purchasing
$100,000 in government securities.
26
Federal Reserve Bank - Balance Sheet 8
Initial 
in M1
Government-$100,000 Reserves -$100,000
securities
of Best
$100,000
Nat’l bank
Assets
Liabilities
Note: The Fed conducted open market operations in
order to decrease the money supply by selling
$100,000 in government securities.
27
Fed
$
$
Banks
$
$
Fed sells government
securities and banks
loose reserves
Fed buys government
securities and banks
gain reserves
Public
28
What is the
discount rate?
The interest rate the Fed
charges on loans of
reserves to banks
29
What would the Fed do
if we have inflation?
A higher discount rate
discourages banks from
borrowing reserves and
making loans
30
What would the Fed do
if we have
unemployment?
A lower discount rate
encourages banks to
borrow reserves and
make more loans
31
What is the federal
funds market?
A private market in
which banks lend
reserves to each other
for less than 24 hours
32
What is the federal
funds rate?
The interest rate banks
charge for overnight
loans to other banks
33
What would the Fed do
if we had inflation?
A higher federal funds
rate discourages banks
from borrowing reserves
and making loans
34
What would the Fed do
if we had
unemployment?
A lower federal funds
rate encourages banks
to borrow reserves and
make more loans
35
What is a required
reserve requirement?
The Fed determines how
much a financial
institution must keep in
reserve as a percentage
of its total assets
36
What is the required
reserve ratio?
That percentage the Fed
stipulates that financial
institutions must keep in
reserve to meet its
reserve requirement
37
If the reserve ratio
is one tenth, what
is the multiplier?
1  1/10 = 10
38
If the reserve ratio is
one twentieth, what
is the multiplier?
1  1/20 = 20
39
What would the fed do if
we had inflation?
Increase the reserve ratio
What would the fed do if
we had unemployment?
Decrease the reserve ratio
40
Is changing the
reserve ratio a popular
monetary tool?
No, changing the reserve
ratio is considered a heavyhanded approach and is
thus infrequently used
41
What are the
shortcomings of
monetary policy?
• Money multiplier inaccuracy
• Nonbanks
• Which money definition
should the Fed control?
• Lag effects
42
Key Concepts
43
Key Concepts
• Who were the founders of our modern-day
banking?
• What is fractional reserve banking?
• What are required reserves?
• What is a required reserve ratio?
• What are excess reserves?
• What are total reserves?
• What is the money multiplier?
• What is the money multiplier equal to?
44
Key Concepts cont.
•
•
•
•
•
•
•
What is monetary policy?
What are open market operations?
What is the discount rate?
What is the federal funds rate?
What is a required reserve requirement?
What is the required reserve ratio?
What are the shortcomings of monetary
policy?
45
Summary
46
Fractional reserve banking,
the basis of banking today,
originated with the goldsmiths
in the Middle Ages.
47
Because depository institutions
(banks) are not required to keep all
their deposits in vault cash or with
the Federal Reserve, banks create
money by making loans.
48
Required reserves are the
minimum balance that the Fed
requires a bank to hold in vault
cash or on deposit with the
Fed. The percentage of
deposits that must be held as
required reserves is called the
required reserve ratio.
49
Excess reserves exist when a
bank has more reserves than
required. Excess reserves allow a
bank to create money by
exchanging loans for deposits.
Money is reduced when excess
reserves are reduced and loans
are repaid.
50
The money multiplier is used to
calculate the maximum change
(positive or negative) in checkable
deposits (money supply) due to a
change in excess reserves. As a
formula:
$ multiplier = 1/required reserve ratio.
51
Monetary policy is action taken by
the Fed to change the money
supply. The Fed uses three basic
tools: (1) open market operations
(2) changes in the discount rate
and (3) changes in the required
reserve ratio.
52
Open-market operations are the
buying and selling of government
securities by the Fed through its
trading desk at the New York
Federal Reserve Bank.
53
Buying government securities
creates extra bank reserves and
loans, thereby expanding the
money supply. Selling
government securities reduces
bank reserves and loans, thereby
contracting the money supply.
54
Fed
$
$
Banks
$
$
Fed sells government
securities and banks
loose reserves
Fed buys government
securities and banks
gain reserves
Public
55
Changes in the discount rate
occur when the Fed changes the
rate of interest it charges on
loans of reserves to banks.
56
Dropping the discount rate
makes it easier for banks to
borrow reserves from the Fed
and expands the money supply.
57
Raising the discount rate
discourages banks from
borrowing reserves from the Fed
and contracts the money supply.
58
Changes in the required reserve
ratio and the size of the money
multiplier are inversely related.
Thus, if the Fed decreases the
required reserve ratio the money
multiplier and money supply
increase. If the Fed increases the
required reserve ratio the money
multiplier and money supply
decrease.
59
Monetary policy limitations include
the following: (1) The money
multiplier can vary (2) Nonbanks,
such as insurance companies,
finance companies, and Sears, can
offer loans and other financial
services not directly under the Fed’s
control (3) The Fed might control M1
while the public can shift funds to
M2, M3, or another money supply
definition (4) Time lags occur.
60
Chapter 25 Quiz
©2002 South-Western College Publishing
61
1. If a bank has total deposits of
$100,000 set aside to meet reserve
requirements of the Fed, its required
reserve ratio is
a. $10,000
b. 10 percent
c. 0.1 percent
d. 1 percent
B. Required reserve ratio =
required deposits  total
deposits x 100 = $10,000 
$100,000 x 100
62
2. Assume a simplified banking system in
which all banks are subject to a uniform
required reserve ratio of 30 percent and
demand deposits are the only form of
money. A bank that received a new deposit
of $10,000 would be able to extend new
loans up to a maximum of
a. $3,000
b. $7,000
c. $10,000
d. $30,000
B. Excess reserves can be loaned. Excess
reserves = total reserves - required
reserves = $10,000 - (0.3 x $10,000) =
$10,000 - $3,000 = $7,000
63
3. The Best National Bank operates with a 10
percent required reserve ratio. One day a
depositor withdraws $400 from his or her
checking account at the bank. As a result,
the bank’s excess reserves
a. fall by $400
b. fall by $360
c. fall by $40
d. rise by $400
B. Excess reserves = total reserves required reserves = -$400 - (0.10 x
$400) = -$400 + $40 = -$360
64
4. If an increase in excess reserves of
$100 in a simplified banking system
can lead to a total expansion in bank
deposits of $400, the required reserve
ratio must be
a. 40 percent
b. 400 percent
c. 25 percent
d. 4 percent
C. $ multiplier =  in bank deposits 
initial  in excess reserves = 400 
$100 = 4 = 1  required reserve ratio
= 1  money multiplier x 100.
65
5. In a simplified banking system in which all
banks are subject to a 25% required
reserve ratio, a $1,000 open sale by the
Fed would cause the money supply to
a. increase by $1,000.
b. decrease by $200.
c. decrease by $5,000.
d. increase by $5,000.
C. Money supply change ( M1) = initial  in
excess reserves x money multiplier (MM).
MM = 1  required reserve ratio = 1  25/100 = 4 .
 M1 = $1,000 x 4 = -$4,000.
66
6. In a simplified banking system in which
all banks are subject t a 20% required
reserve ratio, a $1,000 open market
purchase by the Fed would cause the
money supply to
a. increase by $100.
b. decrease by $200.
c. decrease by $5,000.
d. increase by $5,000.
D. Money supply change ( M1) = initial change
in excess reserves x money multiplier (MM)
MM = 1  required reserve ratio = 1  20/100 = 5
 M1 = $1,000 x 5 = $5,000.
67
7. The cost to a member bank of
borrowing from the Federal Reserve is
measured by the
a. reserve requirement.
b. price of securities in the open
market.
c. discount rate.
d. yield on government bonds.
C. The Fed provides a discount window at
each of the Federal Reserve districts
banks to make loans of reserves to
banks and change an interest rate called
the discount rate.
68
Exhibit 5
Balance Sheet of Best National Bank
Assets
Liabilities
$
Required
Reserves
Excess
Reserves
Loans
80,000
Total
$100,000
Checkable $100,00
deposits
0
Total
$100,000
69
8. The required reserve ratio in Exhibit 5
is
a. 10%.
b. 15%.
c. 20%.
d. 25%.
C. Excess reserves = total reserves required reserves = $80,000 =
$100,000 - required reserves =
$20,000
Required reserve ratio = required
deposits  total deposits = $20,000 
$100,000 x 100 = 20%
70
9. If the bank in Exhibit 5 received $100,000
in new deposits, its required reserves
would be
a. $10,000.
b. $20,000.
c. $30,000.
d. $40,000.
B. Required reserves = required reserve
ratio x new deposits = .20 x $100,000 =
$20,000
71
10. Suppose Brad Rich deposits $1,000 in
the bank shown in Exhibit 25.1. The
result would be
a. a $200 increase in excess reserves.
b. a $200 increase in required reserves.
c. a $1,200 increase in required
reserves.
d. zero change in required reserves.
B. Required reserves = required reserve
ratio x new deposits = .20 x $1,000 = $200
72
11. If all banks in the system are identical
to Best National Bank, shown in Exhibit
5. A $1,000 open market sale by the Fed
would
a. 5.
b. 10.
c. 15.
d. 20.
A. Money multiplier = 1  required
reserve ratio = 1  20/100 = 5
73
12. Assume all banks in the system are
identical to Best National Bank, shown in
Exhibit 5. A $1,000 open market sale by the
Fed would
a. expand the money supply by $1,000.
b. expand the money supply by $15,000.
c. contract the money supply by $1,000.
d. contract the money supply by $5,000.
D. Money supply change ( M1) = initial
change in excess reserves x money
multiplier (MM)
MM = 1  required reserve ratio = 1 
20/100 = 5
 M1 = $1,000 x 5 = -$5,000.
74
END
75