C hapter 26 Money Creation and the Banking System

CChapter 26hapter 26Money Creation and Money Creation and the Banking Systemthe Banking System

Outline

• The fractional reserve system

• The legal reserve requirement

• A bank’s balance sheet, its assets and liabilities

• Demand deposits and bank loans

Gottheil - Principles of Economics, 4e 2

Outline

•The potential money multiplier

•Bank failure

•The Federal Deposit Insurance Corporation (FDIC)


How Banks Create MoneyHow 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.



The fractional reserve system serves as the basis of all modern banking.



If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands.



Balance sheet

• The bank’s statement of liabilities (what it owes) and assets (what it owns).



Banks make a profit on the loans they provide, not on their deposits.



Legal reserve requirement

• The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves.

•In the example from the textbook, it is assumed 20%.

Balance Sheet


Balance Sheet

• Bank makes loans for profit.• Example: Matt want to borrow money from

PFN for an investment project. PFN lends him $800 (max amount PFN can make under 20% reserve requirement. The bank then opens demand deposit account for him.


Balance Sheet after Loans made


The Interaction of Deposits and Loans

• Suppose Matt hires Charlie to work for him. This service will cost Matt $800. When the job is done, Matt writes out the check to Charlie for $800. Thus, the balance sheet of PFN becomes:




• Suppose Charlie deposits the check in his bank, PSN.

• Below is the balance sheet of PSN.



• Now PSN makes loans to Betty for its max allowed amount $800*0.8=$640.

• Balance sheet of PSN is:



• Betty then pays her loan $640 to Forrest for his consulting service.

• Forrest deposits the check in the bank, PTN. Thus, the balance sheet of PSN is as below.



• In the meantime, the balance sheet of PTN becomes:

• This process can keep going on…



Banks create money by repeating processes we discuss above. That is , we say bank serve as:

•Financial intermediaries

•Firms that accept deposits from savers and use those deposits to make loans to borrowers.



• A fractional reserve system operating within financial intermediaries.

What three factors are needed for a banking system to create money?




• People willing to make demand deposits.






• People willing to make demand deposits.

• Borrows prepared to take out loans.



Potential money multiplier

• The increase in the money supply that is potentially generated by a change in demand deposits.



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.



• M = ID/LRR.

If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $1,000, then what is the maximum potential increase in the money supply (M)?



If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)?

• M = $1,000/.20 = $5,000.



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.



Excess reserves

• The quantity of reserves held by a bank in excess of the legally required amount.

Excess reserves

• Suppose now PFN only makes loans amounted to $400, then its balance sheet eventually will be just:




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.



• Required reserves are 0.2 × ($100,000) = $20,000.

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).

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?



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.

Reversing the Money Creation Reversing the Money Creation ProcessProcess


• Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves.

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.

1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?



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.

Why Banks Sometimes FailWhy Banks Sometimes Fail


1. What will happen if too many borrowers are unable to repay their loans?

• A bank may 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.



• 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.

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.

3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?



•To prevent the spreading of panics, the government should step in.

• On way is to pay depositors up to the maximum insurable amount.

Safeguarding the SystemSafeguarding the System


Federal Deposit Insurance Corporation (FDIC)

• A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $250,000 of deposits.

FDIC Historical insurance limits

• 1934 - $2,500

• 1935 - $5,000

• 1950 - $10,000

• 1966 - $15,000

• 1969 - $20,000

• 1974 - $40,000

• 1980 - $100,000

• 2008 - $250,000




Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection.

Federal Deposit Insurance and Federal Deposit Insurance and Moral HazardMoral Hazard


Fully insuring deposits leads to a costly side effect known as moral hazard.

Federal Deposit Insurance and Federal Deposit Insurance and Moral HazardMoral 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.



In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices.



Despite these safeguards, banks still fail each year.


EXHIBIT 1 BANK FAILURES: 1930–2000


EXHIBIT 2 BANK FAILURES, SELECTED STATES: 1987–89

Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.



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.



Banks made loans with inflated property values as collateral.

Safeguarding The SystemSafeguarding 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.



Banks were left holding collateral —land, buildings, and other capital—that was worth less than the amount of the loan.



Consequently, many banks failed, particularly in farm states and in Texas and Oklahoma.

C hapter 26 Money Creation and the Banking System

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