Banks create money!!
Remember that bank
deposits are money.
Banks create bank
deposits when they
make loans.
Creating a Bank
To create a bank, you will need to go through
the following 8 steps:
1. Obtain a charter to operate a commercial
bank.
2. Raise some financial capital.
3. Buy some equipment and computer
programs.
4. Accept deposits
5. Establish a reserve account at a Federal
Reserve Bank
6. Clear checks
7. Buy government securities
8. Make loans
Virtual College Bank’s Balance Sheet #1
Assets
Liabilities
Cash
$200,000 Owners' Equity $200,000
A bank charter has been obtained, and Virtual
College Bank has been able to raise $200,000
from private individuals.
Virtual College Bank’s Balance Sheet #2
Assets
Cash
Equipment
Liabilities
$0
$200,000 Owners' Equity
Virtual College Bank uses its financial
resources to purchase servers, database,
software, etc.
$200,000
Virtual College Bank’s Balance Sheet #3
Cash
Assets
Liabilities
$120,000 Checkable deposits $120,000
Equipment
$200,000 Owners' Equity
$200,000
Virtual College Bank accepts $120,000 in new
deposits.
Virtual College Bank’s Balance Sheet #4
Assets
Cash
Liabilities
$0
Reserves at the Dallas FED
Equipment
$120,000
$200,000
Checkable deposits $120,000
Owners' Equity
$200,000
We assume the required reserve ratio is 25
percent. Thus, Virtual College Bank initially has
required reserves of $30,000 ($120,000 × .25)
excess reserves of $90,000
•Virtual College depositor Jay writes a check for
$20,000 to buy some computers from Hal’s PCs.
•Hal’s PCs has a checking account with first
American Bank.
•Virtual College and First American Banks are
both located in the Dallas Federal Reserve district.
•The Dallas FED facilitates the check clearing
process.
Federal Reserve Bank of Dallas
Assets
Liabilities
First American Reserves
+$20,000
Virtual College Reserves
-$20,000
(a) Change in Dallas Fed’s balance sheet
First American Bank
Assets
Reserves at the Dallas FED
Liabilities
+$20,000 Checkable deposits
+$20,000
(b) Change in First American Bank’s balance sheet
Virtual College Bank
Assets
Reserves at the Dallas FED
Liabilities
-$20,000
Checkable deposits
(C) Change in Virtual College Bank’s balance sheet
-$20,000
•Virtual college Banks wishes to purchase
$60,000 in government securities.
•First American Bank wishes to sell $60,000 in
government securities.
•Virtual College pays for the securities with a
check.
Federal Reserve Bank of Dallas
Assets
Liabilities
First American Reserves
+$60,000
Virtual College Reserves
-$60,000
(a) Change in Dallas Fed’s balance sheet
First American Bank
Assets
Liabilities
Reserves at the Dallas FED
+$60,000
Government securities
-$60,000
(b) Change in First American Bank’s balance sheet
Virtual College Bank
Assets
Liabilities
Reserves at the Dallas FED
-$60,000
Government securities
+$60,000
(C) Change in Virtual College Bank’s balance sheet
Banks may make loans
in amounts up to, but not
exceeding, their holding
of excess reserves.
Virtual College Bank’s Balance Sheet #5
Assets
Reserves at the Dallas FED
Gov. securities
Liabilities
$40,000 Checkable deposits $100,000
$60,000
Equipment
$200,000
Total assets
$300,000
Owners' Equity
$200,000
Total liabilities
$300,000
 With a .25 required reserve ratio and $100,000 in checkable
deposits, this bank has required reserves of $25,000.
 Excess Reserves = Total Reserves – Required Reserves.
Thus for this bank:
Excess Reserves = $40,000 - $25,000 = $15,000
Now Virtual College
Bank makes $15,000
in loans. The bank
credits the accounts of
loan recipients by
$15,000. Keep in the
mind that the loans are
an asset for the bank.
Virtual College Bank’s Balance Sheet #6
Assets
Reserves at the Dallas FED
Liabilities
$40,000 Checkable deposits $115,000
Gov. securities
$60,000
Loans
$15,000
Equipment
$200,000
Total assets
$315,000
Owners' Equity
$200,000
Total liabilities
$315,000
 After the loans are made and the new deposits
(money) are created, required reserves are $28,750
($115,000 × .25).
 The bank now has excess reserves = $11, 250. Why
not make more loans?
Virtual College Bank can
anticipate that borrowers
will quickly spend their
loans by drawing checks
on accounts at the bank.
The bank must be
prepared for these
withdrawals.
Virtual College Bank’s Balance Sheet #7
Assets
Reserves at the Dallas FED
Liabilities
$25,000 Checkable deposits $100,000
Gov. securities
$60,000
Loans
$15,000
Equipment
$200,000
Total assets
$300,000
Owners' Equity
$200,000
Total liabilities
$300,000
 Once borrowers have spent their loans, and checks have
cleared, checkable deposits have decreased by $15,000
to $100,000.
 Virtual College Bank “made good” on the checks by
drawing on its reserve account at the FED.
 Excess reserves are now equal to zero.
 Virtual College Bank still has loans outstanding of
$15,000
Multiple Creation of Bank Deposits
The following illustration of the mechanics
of multiple deposit creation is based on the
following assumptions:
•Initially, all banks are “loaned up”—that is,
have zero excess reserves.
•The required reserve ratio is 25 percent (or
.25).
•Proceeds of all checks written are redeposited in the banking system
Steps in the process
1. Tony Soprano deposits $100,000 in cash
into a checking account at Virtual College
Bank. The transaction creates a $75,000
excess reserve for Virtual College Bank.
2. Virtual College Bank makes a $75,000 loan
to Amy.
3. Amy writes a check for $75,000 to
purchase a copy-shop franchise from Barb.
4. Barb deposits a $75,000 check into her
account at First American Bank. This
transaction creates a $56,250 excess
reserve for First American.
5. First American makes a $56,250 loan to Bob.
6. Bob writes a check for $56,250 to Carl to pay off a
business loan.
7. Carl deposits the check for $56,250 into his account at
Fleet PC. This transaction creates a $42,187 excess
reserve for Fleet PC.
8. Fleet PC makes a loan for $42,187 to Emelda.
9. Emelda writes a check for $42,187 to Acme Inc. for
restaurant equipment.
10.Acme Inc. deposits the check for $42, 187 into its
account at First e-bank. This transaction creates a
$31,640 excess reserve for First e-bank.
11.And so on and so on . . .
The running tally
Round
The sequence
Reserves Loans Deposits
Deposit
$100,000
1. Virtual
College
Reserve
$25,000
Loan
$75,000
$25,000 $75,000
$100,000
Deposit
$75,000
2. First
American
Reserve
$18,750
Loan
$56,250
$43,750 $131,250 $175,000
Deposit
$56,250
3. Fleet PC
Reserve
$14,063
Loan
$42,187
$57,813
$173,437 $231,250
The running tally
Round
The sequence
Reserves Loans Deposits
Deposit
$42,187
4. First e-bank
Reserve
$10,547
Loan
$31,640
and
so on . . .
$68,360



$205,077 $273,437






$100,000 $300,000 $400,000
The process summarized
Notice that at each stage of the process the loan is 75
percent (0.75) of the previous loan and the deposit is 75
percent (0.75) of the previous deposit. Let L denote this
proportion. Thus the sequence is described by:
1  L  L  L  L  ...
2
3
4
The total change in deposits when the process
is complete is given by:
1
 Initial change in reserves
1 L
Do the math
$100,000  75,000  56,250  42,187  ...
 $100,000  (1  0.75  0.5625  0.42187  ...)
 $100,000  (1  0.75  0.75  0.75  ...)
2
3
1
 $100,000 
(1  0.75)
1
 $100,000 
 $100,000  4  $400,000
0.25
The Deposit Multiplier
The deposit multiplier is the number by which an increase
in bank reserves is multiplied to find the resulting increase
in bank deposits. That is:
Change in deposits = Deposit multiplier × Change in reserves
The deposit multiplier is linked to the required
reserve ratio by the following equation
1
Deposit Multiplier =
Required reserve ratio
Open Market Operations
Now we will illustrate
how FED open market
operations impact the
reserve positions of
commercial banks—and
hence their ability to
make loans and create
money.
When the FED buys
securities on the open
market, it pays for them
with newly created bank
reserves. We will illustrate
how it works.
FED Buys Securities
Suppose the FED buys $100 million is
securities from Manhattan Commercial
Bank. What happens then?
1. The Manhattan commercial bank has $100
million less in securities, and the FED has
$100 million more in securities.
2. To pay for the securities, the FED increases
Manhattan Commercial Bank’s reserve
account at the New York FED by $100
million.
The FED Buys Securities From a Commercial Bank
Federal Reserve Bank of New York
Assets
Securities
Liabilities
+$100 million
The FED buys securities
from a commercial bank . . .
Reserves of Manhattan
Commercial Bank
+$100 million
. . .and pays for the securities
by increasing the reserves of
the commercial bank .
Manhattan Commercial Bank
Assets
Liabilities
Securities
-$100 million
Reserves
+$100 million
The Multiplier Effect of an Open
Market Operation
•An open market purchase creates excess reserves.
•Banks lend excess reserves.
•Bank deposits increase.
•The quantity of money increases.
•New money is used to make payments.
•Some of the new money is held as currency.
•Some of the new money remains in deposits at the bank.
•Banks’ required reserves increase
•Excess reserves decrease but remain positive.
A Round in the Multiplier Process Following an Open
Market Operation
Excess
reserves
Banks lend
excess
reserves
Open
market
purchase
Banks
deposits
increase
Quantity of
money
increases
Excess
reserves
Required
reserves
increase
Money that
remains in
deposits
Currency
drain
New money
used to make
payments
The Money Multiplier
This version of the multiplier takes into account cash
drains:
Change in the quantity of money  Money multiplier  Change in monetary base
The monetary base consists of bank reserves and
currency in circulation. Thus we have:
Change in the quantity of money  2.5  $100,000  $250,000
The total amount of new money created by as a
result of an open market operation is described by
1
Quantity of money created 
 Open market purchase
1- L
Money multiplier
What is L?
L  (1  C )  (1  R)
Where C is the proportion of new money that is held
as currency and R is the required reserve ratio.
In our example, C = 0.33 and R = .10. Thus:
L  (1  0.33)  (1  0.1)  0.6
Notice that, the value of L is inversely related
to the values of C and R
Do the math
1
Quantity of money created  $100,000 
(1 - 0.6)
1
 $100,000 
0.4
 $100,000  2.5
 $250,000