Creation of Money
CHAPTER 32
Two Definitions of the Money Supply, January
2005
Currency
Outside banks
$710 billion
Checking deposits
In commercial
Banks $330 billion
Other
checkable
deposits
$321 billions
M1
$1361 billion
Savings
deposits
$4378 billion
Money market
mutual funds
$704 billion
M1 = $1361 billion
M2 = $6443 billion
The Banking System
 Bank Regulation
 Deposit insurance (FDIC)

Moral hazard Problem
The Banking System
 Bank Regulation
 Bank Supervision

Reserve Requirements
The Origins of the Money Supply
 How Bankers Keep Books
 Banks keep balance sheets

Assets = liabilities + net worth

Assets include:

Liabilities include:
The Money Multiplier
 Banking system is not just a guard of the money supply
 This multiplying effect is the work of the infamous money
multiplier.
 Each time a bank receives a deposit from a customer, it is required
by the reserve requirement ratio set by the Fed (a.k.a. required by
law) to keep in its reserves a fraction of the deposit
 The rest of the deposit can be lent out to potential borrowers.
 Called “fractional reserve system”
Fractional Reserve Banking
 The Goldsmiths Principle
 Stored
gold
 Receipts used as money
 Made loans
 Characteristics
 Banks create money
Fractional Reserve System
 Balance sheet
Assets
= Liabilities + Net Worth
Both sides balance
 Necessary transactions

Reserve Requirements
9
Lets create a bank… in the town of Vossdonium
 Transaction #1
 Vault cash: cash held by the bank
 Sold stocks to acquire operating funds
Balance Sheet 1: Vossome Bank
Assets
Cash
Liabilities and Net Worth
Stock Shares
Transaction 2
 Acquiring property and equipment
Balance Sheet : Vossome Bank
Assets
Cash
Property
Liabilities and Net Worth
Stock Shares
Transaction 3
 Commercial bank functions
Accepting
deposits
Making loans
Balance Sheet 3: Vossome Bank
Assets
Cash
Property
Liabilities and Net Worth
Checkable
Deposits
Stock Shares
Transaction 4
 Depositing reserves in a Federal Reserve bank
 Required
reserves
 Reserve ratio
Reserve
ratio


=
Fed establishes and varies rr within limits set by
Congress
rr helps Fed control lending abilities of commercial
banks
Transaction 4
 Assume the bank deposits all cash on
reserve at the Fed
Balance Sheet 4: Vossome Bank
Assets
Cash
Reserves
Property
Liabilities and Net Worth
Checkable
Deposits
Stock Shares
Reserve Requirements
 Excess reserves
 Required reserves
 Example:
Transaction 5a
 Granting a loan
Balance Sheet 6: Vossome Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
Checkable
Deposits
Stock Shares
Transaction 6a
 Using the loan
 $50,000 loan cashed
Balance Sheet 6b: Vossome Bank
Assets
Required Reserves
Excess Reserves
Loans
Liabilities and Net Worth
Checkable
Deposits
Stock Shares
Property
Banks can lend money in their vault that is above
the minimum required reserve ratio.
Transaction 6b
 Bank buys government securities from dealer
 Deposits
payment into checking
Balance Sheet 7: Vossome Bank
Assets
Reserves
Securities
Property
Liabilities and Net Worth
Checkable
Deposits
Stock Shares
New money is created
The Banking System
 Multiple-deposit expansion
 Assumptions:
 A $100 bill is found and deposited
 Multiple deposits can be created
The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
(3)
Excess
Reserves
(1)-(2)
(4)
Amount Bank Can
Lend; New Money
Created = (3)
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…
The Banking System
21
The Monetary Multiplier
Monetary
multiplier
=
1
required reserve ratio
Graphic
Example
=
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
$20
Required
Reserves
$100
Initial
Deposit
1
R
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
Another Illustration of Money Creation
 Assume 20% legal reserve requirement
Suppose Nina deposits $1,000 in her checking account at Citibank.
T-account of Citibank:
______Assets________________Liabilities____________
Reserves
Demand deposits
Loans
 Kevin borrows $800 from Citibank, and buys a computer at BestBuy
 BestBuy deposits Kevin’s check at Fleet Bank.
Fleet Bank’s T-account:
_____Assets________________Liabilities_____________
Required Reserves
Demand Deposits
Loans (Excess)
 Vivian borrows $640 from Fleet Bank and buys a new outfit from
Macy’s.
 Macy’s deposits Vivian’s check at Bank of New York.
T-account of Bank of New York:
______Assets____________________Liabilities_______
Required Reserves
Demand deposits
Loans (Excess)
Total Demand Deposits After
Lending and Re-lending by banks
Banks
Citibank
Fleet
Bank of New York

+ other banks
Demand Deposits
$1,000
800
640

+ additional deposits
___________
= $ 5,000 Total
Banks and Money Creation
 The Process in Reverse: Multiple
Contractions of the Money Supply
Banks
reduce their loan commitments
Contraction in the money supply utilizes the
same formula as for money expansion.
The Need for Monetary Policy
 Left uncontrolled, banks would:
 Changes in the money supply would
exacerbate the business cycle
 One reason for monetary policy:
 Prevent
this behavior on the part of banks.