Money Creation
44
Copyright 2008 The McGraw-Hill Companies 13-1 The Fracti onal Reser ve System Creating a Bank Money Crea tion The Bankin g System Monetary M ultiplier Last Word Key Terms End Show 13 Money Creation
description
13. Money Creation. Chapter Objectives. Why the U.S. Banking System is Called a “Fractional Reserve” System Distinction Between a Bank’s Actual Reserves and Its Required Reserves How a Bank Can Create Money Through Granting Loans - PowerPoint PPT Presentation
Transcript of Money Creation
Copyright 2008 The McGraw-Hill Companies13-1
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
13MoneyCreation
Copyright 2008 The McGraw-Hill Companies13-2
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Chapter Objectives• Why the U.S. Banking System is
Called a “Fractional Reserve” System
• Distinction Between a Bank’s Actual Reserves and Its Required Reserves
• How a Bank Can Create Money Through Granting Loans
• The Multiple Expansion of Loans and Money by the Entire Banking System
• The Monetary Multiplier and How to Calculate it
Copyright 2008 The McGraw-Hill Companies13-3
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Fractional Reserve System• Only a portion(fraction) of
checkable deposits are backed up by cash in bank vaults or deposits at the central bank
• Used in U.S. and most other nations today
• Can show us how banks can create checkable deposits by issuing loans
Copyright 2008 The McGraw-Hill Companies13-4
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Fractional Reserve System• The Goldsmiths• Characteristics
–Banks Create Money Through Lending
–Fractional Reserve Banks are Subject to “Panics” or “Runs”
Copyright 2008 The McGraw-Hill Companies13-5
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
History of Fractional Reserve Banking: Goldsmiths
• Early traders used gold to make transactions, but it was unsafe and inconvenient to carry gold
• 16th century – people began depositing gold with goldsmiths, the goldsmith would give them a receipt, served as first type of paper money
• At first, paper receipts were fully (100%) backed by gold, eventually goldsmiths began issuing receipts in excess of the amount of gold held
• Thus the beginning of fractional reserve banking
Copyright 2008 The McGraw-Hill Companies13-6
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Characteristics of Fractional Reserve Banking
• 1. banks can create money through lending
• 2. banks operating on the basis of fractional reserves are vulnerable to “panics” or “runs” (Ex. Great Depression in U.S.). This explains why bank industry is highly regulated and why U.S. has deposit insurance (FDIC)
Copyright 2008 The McGraw-Hill Companies13-7
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Fractional Reserve System• Balance Sheet
Assets = Liabilities + Net Worth
• Transactions Needed to Enable Banks to Create Money Through Lending
As Follows…
Copyright 2008 The McGraw-Hill Companies13-8
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
A Single Commercial Bank• In order to understand modern
fractional reserve banking.. We must examine a commercial bank’s balance sheet
• Balance sheet – statement of assets and claims on assets that summarizes the financial position of the bank at a certain time
• Every balance sheet must balance; value of assets must equal amount of claims against those assets
Copyright 2008 The McGraw-Hill Companies13-9
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Balance Sheet• Claims on balance sheet divided
into two groups: liabilities (claims of nonowners against the firm’s assets) and net worth (the claims of owners against the firm’s assets)
• Assets = liabilities + net worth
• This can be used to establish how individual banks create money
Copyright 2008 The McGraw-Hill Companies13-10
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 1: Creating a Bank• Once a charter is secured to open
a bank, must sell stock to buyers to open bank
• Founders of bank sell shares of stock in bank—some to themselves and some to other people
• This cash (vault cash) is an asset to bank, shares of stock are net worth
Copyright 2008 The McGraw-Hill Companies13-11
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Creating a Bank• Creating a Bank• Vault Cash
Transaction 1:
Creating a BankBalance Sheet 1: Wahoo Bank
Cash $250,000 Stock Shares $250,000
Copyright 2008 The McGraw-Hill Companies13-12
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 2: Acquiring Property and Equipment
• Cash is then used by board of directors (bank’s owners) to acquire property and equipment
Copyright 2008 The McGraw-Hill Companies13-13
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Creating a Bank• Acquiring Property and
Equipment
Transaction 2:
Acquiring Property and EquipmentBalance Sheet 2: Wahoo Bank
Cash $10,000 Stock Shares $250,000Property $240,000
Copyright 2008 The McGraw-Hill Companies13-14
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 3: Accepting Deposits
• Banks have 2 functions: accept deposits and make loans
• Citizens deposit $ into bank as checkable deposits, these are claims that depositors have against the assets of the bank and are a new liability account
• This does not result in money supply change, but composition of money supply has changed
• Currency held by a bank is not part of economy’s money supply
Copyright 2008 The McGraw-Hill Companies13-15
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Creating a Bank• Accepting Deposits
–Receive $100,000 as a Checkable Deposit
Transaction 3:
Accepting DepositsBalance Sheet 3: Wahoo Bank
Cash $110,000 Checkable Deposits
$100,000Property $240,000
Stock Shares $250,000
Copyright 2008 The McGraw-Hill Companies13-16
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 4: Depositing Reserves into Fed Reserve Bank
• By law, all banks and thrifts must keep required reserves
• Required reserves – amount of funds equal to a specified % of the bank’s own deposit liabilities
• This percentage is known as the reserve ratio – ratio of required reserves the bank must keep on the bank’s own outstanding checkable-deposit liabilities
• See formula next slide• Ratio established by Fed
Copyright 2008 The McGraw-Hill Companies13-17
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Creating a Bank• Depositing Reserves in a
Federal Reserve Bank–Required Reserves–Reserve Ratio
Transaction 4:
ReserveRatio =
Commercial Bank’sRequired Reserves
Commercial Bank’sCheckable-Deposit Liabilities
Copyright 2008 The McGraw-Hill Companies13-18
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Example• Let’s say reserve ratio is 20%
(1/5)• If a bank anticipates it will grow
in future, may send additional reserves to Fed Reserve Bank
• See balance sheet p.247
Copyright 2008 The McGraw-Hill Companies13-19
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Creating a BankTransaction 4:
Depositing Reserves at the FedBalance Sheet 4: Wahoo Bank
Cash $0 Checkable Deposits $100,000
Property $240,000 Stock Shares $250,000
Type of DepositCurrent
RequirementStatutory
LimitsCheckable Deposits:
$0-$7.8 Million$6-$48.3 MillionOver $48.3 Million
Noncheckable NonpersonalSavings and Time Deposits
0% 310
3% 38-14
0 0-9
Reserves $110,000
Copyright 2008 The McGraw-Hill Companies13-20
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Excess Reserves• Found by subtracting its required
reserves from its actual reserves
• The ability of a bank to make loans depends of the existence of excess reserves
• This allows us to understand how the banking system creates money
Copyright 2008 The McGraw-Hill Companies13-21
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Control• A bank’s required reserves are
not enough to meet sudden, massive cash withdrawals
• Required reserves help the Fed control the lending ability of commercial banks
• Control the ability of banks to grant credit
Copyright 2008 The McGraw-Hill Companies13-22
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Asset and Liability• When depositing money into the
Fed, this is an asset to the commercial bank and a liability to the Fed Reserve Bank
Copyright 2008 The McGraw-Hill Companies13-23
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Creating a Bank
• Control–Banking Regulators
• Asset and Liability–Transactions are Both
Transaction 4:
Excess Reserves
ExcessReserves = -Actual
ReservesRequiredReserves
Copyright 2008 The McGraw-Hill Companies13-24
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 5: Clearing a Check Drawn against the Bank• Whenever a check is drawn against
one bank and deposited in another bank, collection of that check will reduce both the reserves and checkable deposits of the bank on which the check was drawn
• If a bank receives a check, their reserves and checkable deposits will increase by amt of check
• What one bank loses, another gains• No loss incurred for the banking
system as a whole
Copyright 2008 The McGraw-Hill Companies13-25
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Creating a BankTransaction 5:
Clearing a CheckBalance Sheet 5: Wahoo Bank
Checkable Deposits $50,000Property $240,000Stock Shares $250,000
Reserves $60,000
• Clearing a Check–$50,000 Check Presented for Payment
Copyright 2008 The McGraw-Hill Companies13-26
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Money Creating Transactions of a Commercial Bank
• Transactions 6 and 7
Copyright 2008 The McGraw-Hill Companies13-27
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 6: Granting a Loan• How does lending affect the balance sheet?• Assets and liabilities increase by size of the
loan• When the bank makes loans, it creates
money• By extending credit, bank has “monetized”
the IOU• Single bank can only loan out amount equal
to its initial excess reserves b/c it faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it
Copyright 2008 The McGraw-Hill Companies13-28
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Money Creating TransactionsTransaction 6a:
When a Loan is NegotiatedBalance Sheet 6a: Wahoo Bank
Checkable Deposits $100,000
Property $240,000 Stock Shares $250,000
Reserves $60,000
• Granting a Loan–$50,000 Loan Deposited
to Checking Account
Loans $50,000
Copyright 2008 The McGraw-Hill Companies13-29
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Money Creating TransactionsTransaction 6b:
After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank
Checkable Deposits $50,000
Property $240,000 Stock Shares $250,000
Reserves $10,000
• Using the Loan–$50,000 Loan Cashed
From Checking Account
Loans $50,000
A Single Bank Can Only Lend An AmountEqual to their Preloan Excess Reserves
W 13.1
Copyright 2008 The McGraw-Hill Companies13-30
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Transaction 7 : Buying Gov. Securities
• When a commercial bank buys securities from the gov, the effect is basically the same as lending (new money created)
• The selling of government bonds to the public by a commercial bank reduces the money supply
• The securities buyer pays by check, reducing assets and liabilities
Copyright 2008 The McGraw-Hill Companies13-31
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Assets Liabilities and Net Worth
Money Creating TransactionsTransaction 7:
Buying Government SecuritiesBalance Sheet 7: Wahoo Bank
Checkable Deposits $100,000
Property $240,000 Stock Shares $250,000
Reserves $60,000
• Buying Government Securities From Dealer–Deposits Payment Into
Checking Account
Securities $50,000
Copyright 2008 The McGraw-Hill Companies13-32
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Money Creating TransactionsProfits, Liquidity, and the Federal Funds Market• Profit
–Loans–Securities
• Liquidity–Impact Upon Reserves
• Overnight Bank Loans• Federal Funds Market
–Federal Funds Rate
Copyright 2008 The McGraw-Hill Companies13-33
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Profits, Liquidity, and the Federal Funds Market
• 2 conflicting goals of a bank: profit and safety
• Profit – commercial banks seek to profit through lending and buying securities
• Liquidity – bank must be on guard for depositors who want to transform checkable deposits into cash and more checks clearing against it than in its favor
Copyright 2008 The McGraw-Hill Companies13-34
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Federal Funds Rate• Day-to-day flow of funds rarely leave
all banks w/exact levels of required reserves
• Funds held at Fed Reserve Banks highly liquid
• Banks lend these excess reserves on an overnight basis as a way of earning interest without sacrificing liquidity
• Interest rate paid on these overnight loans is Federal Funds Rate
Copyright 2008 The McGraw-Hill Companies13-35
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Banking System• Multiple-Deposit
Expansion• The Banking System’s
Lending Potential• Assumptions:
–20% Required Reserves–All Banks “Loaned Up”–Banks Lend All of Excess
Reserves
Copyright 2008 The McGraw-Hill Companies13-36
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Banking System: Multiple-Deposit Expansion
• A single bank can lend one dollar for each dollar of excess reserves
• Banking system as a whole can in reality lend by a multiple of its excess reserves
• Read pages 252-253
Copyright 2008 The McGraw-Hill Companies13-37
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Banking System
Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks
Bank
(1)AcquiredReserves
and Deposits
(2)RequiredReserves(Reserve
Ratio = .2)
(3)Excess
Reserves(1)-(2)
(4)Amount Bank CanLend; New Money
Created = (3)
$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.74
8.596.875.50
21.99
$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40
$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.74
8.596.875.504.40
17.59
$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.74
8.596.875.504.40
17.59$400.00
Copyright 2008 The McGraw-Hill Companies13-38
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Monetary Multiplier• Exists b/c the reserves and deposits
lost by one bank become the reserves of another bank
• It magnifies excess reserves into a larger creation of checkable-deposit money
• Monetary multiplier = 1/required reserve ratio
• Max. Checkable deposit creation = excess reserves x money multiplier
Copyright 2008 The McGraw-Hill Companies13-39
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Monetary MultiplierMonetary Multiplier or Checkable-
Deposit MultiplierMonetaryMultiplier = 1
Required Reserve Ratio
or in Symbols… m = 1RNew Reserves
$100$20
RequiredReserves
$80Excess
Reserves
$100Initial
Deposit
$400Bank System Lending
Money Created
GraphicExample
Copyright 2008 The McGraw-Hill Companies13-40
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
The Monetary Multiplier• Reversibility
–Making Loans Creates Money
–Loan Repayment Destroys Money
–Multiple Step Money Expansion
–Multiple Step Destruction of Money
W 13.2
Copyright 2008 The McGraw-Hill Companies13-41
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Reversibility: The Multiple Destruction of Money
• This process is reversible• Checkable-deposit money is
destroyed when loans are paid off
• Loan repayment sets off a process of multiple destruction of money
Copyright 2008 The McGraw-Hill Companies13-42
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Bank Panics of 1930-1933• Series of Bank Panics• Before Deposit Insurance• Mass Withdrawals From Fear• Move to Cash Reduced Money Supply
Through Reduction in Loans• Multiple Contraction Slowed Lending
and the Economy• 1933 National Bank Holiday for One
Week• Resulted in FDIC and 25% Drop in
Money Supply• Contributed to the Great Depression• Regulation Protects the System Today
Last
Word
Copyright 2008 The McGraw-Hill Companies13-43
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Key Terms• fractional reserve banking syste
m• balance sheet• vault cash• required reserves• reserve ratio• excess reserves• actual reserves• Federal funds rate• monetary multiplier
Copyright 2008 The McGraw-Hill Companies13-44
The Fractional Reserve SystemCreating a BankMoney CreationThe Banking SystemMonetary MultiplierLast Word
Key Terms
End Show
Next Chapter Preview…
Interest Ratesand MonetaryPolicy
