Chapter 26
MONEY CREATION AND
THE BANKING SYSTEM
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
1
Economic Principles
The fractional reserve system
The legal reserve requirement
A bank’s balance sheet, its assets
and liabilities
Demand deposits and bank loans
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
2
Economic Principles
The potential money multiplier
Bank failure
The Federal Deposit Insurance
Corporation (FDIC)
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
3
How Banks Create Money
Fractional reserve system
• A banking system that provides people
immediate access to their deposits but
allows banks to hold only a fraction of those
deposits in reserve.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
4
How Banks Create Money
The fractional reserve system serves
as the basis of all modern banking.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
5
How Banks Create Money
If all depositors lost faith in the
banking system and demanded their
money back, banks would be unable
to meet their demands.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
6
How Banks Create Money
Balance sheet
• The bank’s statement of liabilities (what it
owes) and assets (what it owns).
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
7
How Banks Create Money
Banks make a profit on the loans
they provide, not on their deposits.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
8
How Banks Create Money
Legal reserve requirement
• The percentage of demand deposits banks
and other financial intermediaries are
required to keep in cash reserves.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
9
Cyberspace Banking
What is a cyberspace banking?
• Cyberspace is banking conducted over the
Internet.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
10
How Banks Create Money
1. Suppose that the banking system
initially has $100,000 in demand
deposits, and loans out $80,000.
Those who borrow this money in turn
put it in their demand deposit
accounts. How much money is now
held in demand deposit accounts?
• $100,000 + $80,000 = $180,000.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
11
How Banks Create Money
1. Suppose that the banking system initially
has $100,000 in demand deposits, and
loans out $80,000. Those who borrow this
money in turn put it in their demand
deposit accounts. How much money is
now held in demand deposit accounts?
• Thus fractional reserve banking creates
money through loans.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
12
How Banks Create Money
Financial intermediaries
• Firms that accept deposits from savers and
use those deposits to make loans to
borrowers.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
13
How Banks Create Money
2. What three factors are needed for a
banking system to create money?
• A fractional reserve system operating within
financial intermediaries.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
14
How Banks Create Money
2. What three factors are needed for a
banking system to create money?
• A fractional reserve system operating within
financial intermediaries.
• People willing to make demand deposits.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
15
How Banks Create Money
2. What three factors are needed for a
banking system to create money?
• A fractional reserve system operating within
financial intermediaries.
• People willing to make demand deposits.
• Borrows prepared to take out loans.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
16
How Banks Create Money
Potential money multiplier
• The increase in the money supply that is
potentially generated by a change in demand
deposits.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
17
How Banks Create Money
3. If the legal reserve requirement is 10
percent, what is the potential money
multiplier?
• The potential money multiplier “m” = 1/(legal
reserve requirement) = 1/0.1 = 10
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
18
How Banks Create Money
4. If the legal reserve requirement (LRR)
is 25 percent and the initial demand
deposit (ID) is $100,000, then what is
the maximum potential increase in the
money supply (M)?
• M = ID/LRR
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
19
How Banks Create Money
4. If the legal reserve requirement (LRR)
is 25 percent and the initial demand
deposit (ID) is $100,000, then what is
the maximum potential increase in the
money supply (M)?
• M = $100,000/.25 = $400,000
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
20
How Banks Create Money
5. Why might the actual increase in the
money supply be less than the
maximum potential increase in the
money supply?
• Because there may not be a sufficient
number of borrowers to take advantage of all
the available loanable reserves in the
banking system.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
21
How Banks Create Money
Excess reserves
• The quantity of reserves held by a bank in
excess of the legally required amount.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
22
How Banks Create Money
If there is not a sufficient number of
borrowers to take advantage of all the
available loanable reserves in the
banking system, then the banking
system will end up holding excess
reserves.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
23
How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much
are excess?
• Required reserves are 0.2 × ($100,000)
= $20,000.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
24
How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much
are excess?
• Excess reserves = (total reserves)
– (required reserves)
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
25
How Banks Create Money
6. Suppose that a bank holds $100,000 in
demand deposits, has a legal reserve
requirement of 20 percent, and holds
$35,000 in reserves. How much of these
reserves are required, and how much
are excess?
• Excess reserves = $35,000 – $20,000
= $15,000.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
26
How Banks Create Money
7. How are required reserves recorded
on a bank’s balance sheet?
• Required reserves are an asset.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
27
How Banks Create Money
8. How are excess reserves recorded on
a bank’s balance sheet?
• Excess reserves are an asset.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
28
How Banks Create Money
9. How are loans recorded on a
bank’s balance sheet?
• Loans are an asset.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
29
How Banks Create Money
10. How are demand deposits recorded
on a bank’s balance sheet?
• Demand deposits are a liability.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
30
How Banks Create Money
11. Suppose that a bank’s assets are made
up of required reserves of $10,000,
excess reserves of $5,000 and loans of
$85,000. If the legal reserve requirement
is 10 percent, can we determine how
much money the bank holds in demand
deposits?
• Yes
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
31
How Banks Create Money
11. Suppose that a bank’s assets are made
up of required reserves of $10,000,
excess reserves of $5,000 and loans of
$85,000. If the legal reserve requirement
is 10 percent, can we determine how
much money the bank holds in demand
deposits?
• With required reserves of $10,000 and a legal
reserve requirement is 10 percent, then
demand deposits equal $100,000.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
32
Reversing the Money Creation
Process
1. What will happen if the Federal
Reserve increased the legal reserve
requirement for banks?
• Some excess reserves that may have
otherwise been loaned out will instead be
converted to required reserves.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
33
Reversing the Money Creation
Process
1. What will happen if the Federal
Reserve increased the legal reserve
requirement for banks?
• Banks with no excess reserves will have to
borrow reserves until enough loans are
repaid or enough new deposits are made.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
34
Reversing the Money Creation
Process
1. What will happen if the Federal
Reserve increased the legal reserve
requirement for banks?
• Either way, increasing the legal reserve
requirement will reduce loanable reserves in
the banking system, and thus reduce the
money supply.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
35
Reversing the Money Creation
Process
2. What will happen to a bank’s
assets if the Federal Reserve
increased the legal reserve
requirement?
• Required reserves will increase.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
36
Reversing the Money Creation
Process
2. What will happen to a bank’s assets
if the Federal Reserve increased the
legal reserve requirement?
• Excess reserves will decrease.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
37
Reversing the Money Creation
Process
2. What will happen to a bank’s assets
if the Federal Reserve increased the
legal reserve requirement?
• Loans will decrease.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
38
Why Banks Sometimes Fail
1. What will happen if too many
borrowers are unable to repay
their loans?
• A bank may fail.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
39
Why Banks Sometimes Fail
2. If a bank fails, what will happen to
the depositors?
• If deposits are insured by the federal
government, then the government will step in
and pay depositors up to the maximum
insurable amount.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
40
Why Banks Sometimes Fail
2. If a bank fails, what will happen to
the depositors?
• If deposits are not insured by the federal
government, then depositors may lose their
money.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
41
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Fearing that they may lose their money, and
having lost confidence in the banking
system, some depositors will demand their
money back from their deposits.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
42
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Too many depositors withdrawing their
money from their demand deposit accounts
will overwhelm the fractional reserve system,
and may cause it to fail.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
43
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Many people will lose their money, loanable
funds for investment will be eliminated, and a
recession may result.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
44
Why Banks Sometimes Fail
3. If rumors spread that some
borrowers are defaulting on their
loans, how will some depositors
respond?
• Prior to modern banking regulation and
practices, many recessions were caused by
financial panics and banking system failures.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
45
Safeguarding the System
Federal Deposit Insurance
Corporation (FDIC)
• A government insurance agency that provides
depositors in FDIC-participating banks 100
percent coverage on their first $100,000
of deposits.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
46
Safeguarding the System
Banks participating in the FDIC
insurance program must pay
insurance premiums in return for
FDIC protection.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
47
Safeguarding the System
The FDIC was created in 1933, too
late for the tens of thousands of
people who had been financially
wiped out by bank failures in the
Great Depression.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
48
Federal Deposit Insurance and
Moral Hazard
Fully insuring deposits leads to a
costly side effect known as moral
hazard.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
49
Federal Deposit Insurance and
Moral Hazard
Once a bank is insured, it has an
incentive to take on more risky loans
than it otherwise would if it were not
insured.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
50
Federal Deposit Insurance and
Moral Hazard
Proposed solutions for the moral hazard
problem with deposit insurance include:
• Privatize the deposit insurance system
• Reduce the scope of deposit insurance
Yet any change in the deposit insurance
system may itself destabilize the banking
system.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
51
Safeguarding the System
In addition to deposit insurance, the
FDIC also audits banks to make sure
that they use sound banking
practices.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
52
Safeguarding the System
Despite these safeguards,
approximately 10 banks fail each year.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
53
Safeguarding the System
During the 1970s, high farm
commodity prices inflated the price
of farmland, and high oil prices
inflated the value of property in
Texas and Oklahoma.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
54
Safeguarding the System
Banks made loans with inflated
property values as collateral.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
55
Safeguarding The System
When farm commodity prices and oil
prices collapsed in the recession of the
early 1980s, many farms and
businesses failed, and were unable to
repay their loans.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
56
Safeguarding the System
Banks were left holding collateral—
land, buildings, and other capital—that
was worth less than the amount of
the loan.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
57
Safeguarding the System
Consequently, many banks failed,
particularly in farm states and in
Texas and Oklahoma.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
58
Safeguarding the System
Due to the moral hazard problem, there
were questions regarding proper
lending practices at some of the failed
banks.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
59
EXHIBIT 1
© 2010 Cengage Learning
BANK FAILURES: 1930–2005
Gottheil — Principles of Economics, 6e
60
Exhibit 1: Bank Failures
For years after the Great Depression,
the number of bank failures was
insignificant. All that changed in the
1980s. With the recession of 1982,
bank failures increased dramatically.
In 1988 alone there were more bank
failures than the combined total for
the previous 25 years.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
61
Exhibit 1: Bank Failures
Which of the two time periods
experienced the largest number of
bank failures:
a. The mid- to late-1930s
b. The mid- to late-1980s
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
62
Exhibit 1: Bank Failures
Which of the two time periods
experienced the largest number of
bank failures:
a. The mid- to late-1930s
b. The mid- to late-1980s
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
63
EXHIBIT 2
BANK FAILURES, SELECTED STATES:
1987–1989
Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
64
Exhibit 2: Bank Failures,
Selected States: 1987–1989
Which of the following states had the
largest number of bank failures
between 1987–1989?
a. Alabama
b. Texas
c. California
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
65
Exhibit 2: Bank Failures,
Selected States: 1987–1989
Which of the following states had the
largest number of bank failures
between 1987–1989?
a. Alabama
b. Texas
c. California
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
66
EXHIBIT 3
© 2010 Cengage Learning
THRIFT FAILURES: 1980–1991
Gottheil — Principles of Economics, 6e
67
Exhibit 3: Thrift Failures: 1980–1991
In which of the following years were
there the most thrift failures?
a. 1983
b. 1987
c. 1989
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
68
Exhibit 3: Thrift Failures: 1980–1991
In which of the following years were
there the most thrift failures?
a. 1983
b. 1987
c. 1989
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
69
Safeguarding the System
Many “thrifts” (savings and loans) in
the early 1980s were locked in to longterm mortgage loans that paid the
thrifts less than the interest they paid
on deposits, causing thrifts to lose
money.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
70
Safeguarding the System
This motivated some thrifts to move
in to new, more speculative and
risky loan markets. Another factor
contributing to the failure of so many
thrifts was fraudulent lending
practices.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
71
Safeguarding the System
The large number of thrift failures in the
1980s put the Federal Savings and Loan
Insurance Corporation (FSLIC) in crisis.
Legislation was passed that created the
Resolution Trust Corporation, which
handled the disposal of all failed thrifts.
The FDIC has assumed the insurance
function of the now-defunct FSLIC.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
72
Controlling the Financial Institutions
that Control the Money Supply
Financial institutions cannot create the
proper money flows to foster economic
activity with minimal inflation and
unemployment.
• Control of the money supply is needed.
That’s where the Federal Reserve System
comes in.
© 2010 Cengage Learning
Gottheil — Principles of Economics, 6e
73