How Banks and Thrifts Create Money
• Most transactions are “created” as a result of loans from banks or thrifts.
• Chapter demonstrates the moneycreating abilities of a single bank or thrift and then looks at the system as a whole.

How Banks and Thrifts Create Money
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This chapter the term “bank” is used generically and applies to all depository institutions.

• A Balance sheets summarize the financial position of the bank at a certain time.
• The value of assets must equal the value of claims
• Claims on a balance sheet are divided into two groups:
– The bank owners’ claim is called net worth
– Non-owners’ claims are called liabilities
– Equation: Assets=Liabilities + Net Worth

• Type of system the U.S. has in which only a fraction of the total money supply is held in reserve as currency.

• In the 16 th century goldsmiths had safes for gold and precious metals, where they kept for consumers and merchants
• Receipts for these deposits were issued.
• Receipts were used as money in place of gold for convenience.
• Goldsmiths realized they could “loan” gold by issuing receipts to borrowers

• The loans began “fractional reserve banking,” because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold.

Significance of fractional reserve banking:
• Banks can create money by lending more than the original reserves on hand
• Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds
• Federal Deposit Insurance Corporation
(FDIC) was created to prevent panics

Money Creation by a Single Bank in
Banking System
• Bank is formed (example - with $250,000 worth of owners’ capital stock)
• Bank obtains property and equipment with some of the capital funds
• Bank begins operations by accepting deposits
• Banks keep reserve deposits in its district Federal
Reserve Bank
• Ex. pg. 254

Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities.
• Banks keep a significant portion of their own reserves in their vaults

• The “specified percentage” of checkable-deposit liabilities that a commercial bank must keep as reserves.
• The Fed has the authority to establish and vary the reserve ration within limits legislated by Congress
(between 8% and 14%)
• First 6 million of checkable deposits held by bank exempt from reserve requirements

• Three percent reserve required on checkable deposits between $6 million and $42.1million
• No reserves are required against noncheckable non-personal (business) savings CDs. (up to 9% can be required)

• Required reserves do not exist to protect against
“runs” because banks must keep their required reserves.
• Required reserves exists to give the Federal Reserve control over the amount of lending or deposits that banks can create
• Required reserves help the Fed control credit and money creation.
• Banks cannot loan beyond their fraction required reserves.

• Reserves are an asset to banks
• Reserves are a Liability to the Fed

Profits, Liquidity, and the Federal Funds
Market
• Profits: Banks are in business to make a profit
• They earn profits primarily from interest on loans and securities they hold
• Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and meet check-clearing transactions

Profits, Liquidity, and the Federal Funds
Market
• Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each other’s available reserves on overnight basis
• The interest rate paid is called the
Federal Funds Rate

• During prosperity, banks will lend as much as possible and reserve requirements provide a limit to the expansion of loans
• During recession, banks may cut lending, which can worsen recession.
• Profit-seeking bankers will be motivated to expand or contract loans that could worsen the business cycle.
• The Fed uses monetary policy to counteract such results in order to prevent worsening recessions or inflation. (Cpt. 15)