*HOW BANKS CREATE MONEYMODULE 25

*COMMERCIAL BANKS CREATE AND DESTROY MONEY

*How can a commercial bank create money? If it can create money, it can destroy money, too.

*We’ll begin with the organization of a local commercial bank.

*COMMERCIAL BANKS CREATE AND DESTROY MONEY

*TRANSACTION 1: Creating a Bank

*Suppose the citizens of Nebaj, Quiche decide their town needs a new commercial bank to provide banking services for that growing community. Once they obtain the permit for their bank, they turn to the task of selling Q250,000 worth of capital stock (equity shares) to buyers, both in and out of the community. The Bank of Nebaj comes into existence. What does its balance sheet look like at this stage?

* FORMATION OF A COMMERCIAL BANK

The bank now has Q250,000 worth of capital stock outstanding. This cash is an asset to the bank. Cash held by a bank is called vault cash. These shares of stock outstanding constitute an equal amount of claims that owners have against the bank’s assets. These shares of stock constitute the net worth of the bank.

CREATING A BANKBalance Sheet 1: Nebaj Bank

ASSETS LIABILITIES

Cash Q250,000 Capital Stock Q250,000

* BUYING PROPERTY AND EQUIPMENT

TRANSACTION 2: Acquiring Property and Equipment

The directors of the bank purchase a building for Q220,000 and pay Q20,000 for office equipment. Now the balance sheet looks like this:

ACQUIRING PROPERTY AND EQUIPMENTBalance Sheet 2: Nebaj Bank

ASSETS LIABILITIES

Cash Q10,000 Property Q240,000

Capital Stock Q250,000

* DEPOSITS AT A COMMERCIAL BANK

TRANSACTION 3: Accepting Deposits

Now the bank is operating, suppose the citizens and businesses of Nebaj decide to deposit Q100,000 in the Nebaj bank. What happens to the balance sheet?

ACQUIRING PROPERTY AND EQUIPMENTBalance Sheet 2: Nebaj Bank

ASSETS LIABILITIES

Cash Q110,000 Property Q240,000

Checkable Deposits Q100.000 Capital Stock Q250,000

* CHANGE IN COMPOSITION OF THE MONEY SUPPLY

Now the there has been no change in the economy’s total supply of money as a result of this transaction, but a change has occurred in the composition of the money supply. Bank money, or checkable deposits, has increased by Q100,000, and currency held by the public has decreased by Q100,000. Currency held by a bank, is not part of the economy’s money supply.

A withdrawal of cash will reduce the bank’s checkable deposit liabilities and its holdings of cash by the amount of the withdrawal, which would change the composition, but not the total supply, of the money in the economy.

* REQUIRED RESERVES

All commercial banks that provide checkable deposits must by law keep required reserves. Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. A bank must keep these reserve’s on deposit with the Federal Reserve Bank in its district or as cash in the bank’s vault. To simplify, we’ll the Bank of Nebaj keeps its required reserves entirely as deposits in the Fed. But remember: the vault cash is counted as reserves, and real-world banks keep a significant portion of their own reserves in their vaults.

* REQUIRED RESERVES

The “specified percentage” of checkable-deposit liabilities that a commercial bank must keep as reserves is known as the required reserve ratio (the ratio of the required reserves the commercial bank must keep to the bank’s own outstanding checkable-deposit liabilities:

Reserve Ratio =

* DEPOSITING RESERVES AT THE FED

TRANSACTION 4: Depositing Reserves in a Federal Reserve Bank

Suppose the required reserve ratio for checkable deposits in commercial banks is 1/5 or 20 percent. By depositing Q20,000 in the Federal Reserve Bank, the Nebaj bank will just be meeting the required reserve ratio between its reserves and its own deposit liabilities.

But suppose that the Nebaj Bank anticipates that its holdings of the checkable deposits will grow in the future.

* DEPOSITING RESERVES AT THE FED(2) Vault cash can be counted as reserves, we can assume that all the bank’s cash is deposited in the Fed and therefore constitutes the commercial bank’s actual reserves. This way, we don’t need to bother adding two assets – “cash” and “deposits at the Fed” – to determine “reserves”. After the Nebaj Bank deposits Q110,000 or reserves, its balance sheet becomes:Depositing Reserves at the Fed

Balance Sheet 4: Nebaj Bank

ASSETS LIABILITIES

Cash Q0.00Reserves Q110,000Property Q240,000

Checkable Deposits Q100,000Capital Stock Q250,000

* EXCESS RESERVES

A bank’s excess reserves are found by subtracting its required reserves from its actual reserves:

Excess Reserves =

actual reserves – required reserves

In this case:

Actual reserves Q110,000

Required reserves - 20,000

Excess reserves Q 90,000

* EXCESS RESERVES

The only reliable way to compute the excess reserves is to multiply the banks checkable-deposits by the reserve ratio to obtain the required reserves (Q100,000 X .20 = Q20,000) and then to subtract the required reserves from the actual reserves listed on the asset side of the bank’s balance sheet.

Test your understanding by computing the bank’s excess reserves from balance sheet 4, assuming that the required reserve ratio is: (1) 10 percent, (2) 33⅓ percent, and (3) 50 percent.

* CHECK CLEARING PROCESS

The reserves created in transaction 4 are an asset to the depositing commercial bank because they are a claim this bank has against the assets of another institution – the Federal Reserve Bank.

The checkable deposit you get by depositing money in a commercial bank is an asset to you and a liability to the bank.

In the same way, the reserves that a commercial bank establishes by depositing money in a banker’s bank are an asset to that bank and a liability to the Federal Reserve Bank.

* CLEARING A CHECK DRAWN AGAINST THE BANK

Assume that Juan Perez, a Nebaj farmer, deposited a substantial portion of the Q100,000 in checkable deposits that the Nebaj bank received in Transaction 3. Now suppose that Juan buys Q50,000 of farm machinery from the Caterpillar Company of Guatemala City. Juan pays for his machinery by writing a check for Q50,000, against his account in the Nebaj Bank, to the Caterpillar Co. How is this check collected or cleared, and what effect does the collection of the check have on the balance sheet of the banks involved in the transaction?