Chapter 32
Money
Creation
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• “Fractional Reserve” system
• Actual reserves vs. required
reserves
• How banks create money through
granting loans
• Multiple expansion of loans and
money by the banking system
• The monetary multiplier
32-2
Fractional Reserve Banking
• The Goldsmiths
–Stored gold and gave a receipt
–Receipts used as money by public
–Made loans by issuing receipts
• Characteristics
–Banks create money through
lending
–Banks are subject to “panics”
32-3
Fractional Reserve System
• Balance sheet
–Assets = Liabilities + Net Worth
–Both sides balance
• Necessary transactions
–Create a bank
–Accept deposits
–Lend excess reserves
32-4
Creating a Bank
• Transaction #1
• Vault cash: cash held by the
bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets
Cash
Liabilities and Net Worth
$250,000 Stock Shares
$250,000
32-5
Creating a Bank
• Transaction #2
• Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$10,000 Stock Shares
240,000
$250,000
32-6
Creating a Bank
• Transaction #3
• Commercial bank functions
–Accepting deposits
–Making loans
Accepting Deposits
Assets
Cash
Property
Balance Sheet 3: Wahoo Bank
Liabilities and Net Worth
$110,000
240,000
Checkable
Deposits
Stock Shares
$100,000
250,000
32-7
Creating a Bank
• Transaction #4
• Depositing reserves in a Federal
Reserve bank
–Required reserves
–Reserve ratio
Reserve
ratio
=
Commercial bank’s
Required reserves
Commercial bank’s
Checkable-deposit liabilities
32-8
Reserve Requirements
Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$9.8 Million
$9.3-$43.9 Million
Over $43.9 Million
Noncheckable nonpersonal
savings and time deposits
0%
3
10
3%
3
8-14
0
0-9
• Fed can establish and vary reserve
ratio within limits set by Congress
• Required reserves help Fed control
lending abilities of commercial banks
32-9
Creating a Bank
• Transaction #4
• Assume the bank deposits all
cash on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
110,000
Deposits
Property
240,000 Stock Shares
$100,000
250,000
32-10
Reserve Requirements
• Excess reserves
–Actual reserves - required reserves
• Required reserves
–Checkable deposits x reserve ratio
• Example:
–Checkable deposits $100,000
–Reserve ratio 20%
32-11
Creating a Bank
• Transaction #5
• Clearing a check
–$50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets
Reserves
Property
Liabilities and Net Worth
Checkable
$60,000
Deposits
240,000 Stock Shares
$50,000
250,000
32-12
Money Creating Transactions
• Transaction #6a
• Granting a loan
–$50,000 loan deposited to checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
$100,000
250,000
32-13
Money Creating Transactions
• Transaction #6b
• Using the loan
–$50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$10,000 Checkable
Deposits
50,000
$50,000
240,000 Stock Shares
250,000
A single bank can only lend an amount
equal to their preloan excess reserves
32-14
Money Creating Transactions
• Transaction #7
• Bank buys government securities
from dealer
–Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Assets
Reserves
Securities
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares
New money is created
$100,000
250,000
32-15
Commercial Banks
• Conflicting goals
• Earn profit
–Make loans to earn interest
–Buy securities to earn interest
• Maintain liquidity
• Alternative?
–Overnight bank loans
–Federal funds rate
32-16
The Banking System
• Multiple-deposit expansion
• Assumptions:
–20% required reserves
–All banks “loaned up”
–Banks lend all of excess reserves
• A $100 bill is found and deposited
• Multiple deposits can be created
32-17
The Banking System
(3)
(4)
(2)
Excess Amount Bank Can
Required Reserves Lend; New Money
Reserves
(1)-(2)
Created = (3)
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100
$20
$80
$80
Bank B
$80
$16
$64
$64
Bank C
$64
$12.80
$51.20
$51.20
Bank D
$51.20
$10.24
$40.96
$40.96
The process will continue…
32-18
The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$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
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
32-19
The Monetary Multiplier
Monetary
multiplier
=
Graphic
Example
1
required reserve ratio
=
1
R
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
$20
Required
Reserves
$100
Initial
Deposit
32-20
The Monetary Multiplier
• Maximum amount of new money
created by single dollar of excess
reserves
• Higher R, lower m
• Reversibility
–Making loans creates money
–Loan repayment destroys money
32-21
Bank Panics of 1930-1933
•
•
•
•
•
Before deposit insurance
Bank failure led to mass withdrawals
Forced loan reduction
25-33% decline in money supply
1933 national bank holiday to
evaluate all banks
• Contributed to the Great Depression
• Regulation protects the system today
32-22
Key Terms
•
•
•
•
•
•
•
•
•
fractional reserve banking system
balance sheet
vault cash
required reserves
reserve ratio
excess reserves
actual reserves
Federal funds rate
monetary multiplier
32-23
Next Chapter Preview…
Interest Rates
and Monetary
Policy
32-24