Chapter 32

Money Creation
McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives
Fractional Reserve system- The US Banking System

Actual reserves vs. required reserves

How banks create money through granting loans

Multiple expansion of loans and money by the banking system

The monetary multiplier

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Fractional Reserve Banking

Characteristics
Banks create money through lending Banks are subject to panics

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 Balance sheet Assets = Liabilities + Net Worth

Assets
Cash, properties, Loans, Reserve

Liabilities
Capital stock, Checkable deposits (CDs) *Both sides balance -------------------------------------------------------------- Necessary transactions 1. Create a bank 2. Accept deposits 3. loan out money (Lend excess reserves)

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 Discussion: the proses and the transaction that takes place.

1. Create a bank 2. Accept deposits 3. saving the required reserve in the central bank 4. using deposits as payment (check clearence case) 5. giving out loans 6. Buy government securities

Creating a Bank
Transaction #1: Creating a bank Suppose: The founders of the bank have sold $250,000 worth of shares of stock (equity shares ) to buyers to obtain fund (vault cash) to set up a bank. (this is also known as Vault cash: cash held by the bank)
Balance Sheet 1: Wahoo Bank Assets
Cash $250,000

Liabilities and Net Worth

Stock Shares $250,000

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Creating a Bank
Transaction #2: Acquiring property and equipment. Suppose: The board of directors purchased properties; which consists of building worth $220,000 and office equipments worth $20,000.

Balance Sheet 2: Wahoo Bank

Assets Liabilities and Net Worth

Cash Properties

$10,000 240,000

Stock Shares

$250,000

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Transaction #3: Commercial bank functions of accepting deposits. Suppose Wahoo citizen, Bradshaw (a farmer) deposits money in the form of checkable deposits worth $100,000 in the Wahoo bank.

Balance Sheet 3: Wahoo Bank

Assets
Cash Property $110,000 240,000 Liabilities and Net Worth Checkable Deposits Stock Shares

$100,000
250,000

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Depositing reserves in a Federal Reserve bank.

All commercial banks are required to deposit certain percent of the banks total CDs at the Fed. Required reserves help Fed control lending abilities of commercial banks. Required reserves : % rr X CDS
Reserve ratio
Reserve ratio = Commercial banks Required reserves Commercial banks Checkable-deposit liabilities

Example: rr = $20,000 / $100,000 = 0.2 = 20%

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Reserve Requirements
Type of Deposit Checkable deposits: $0-$9.8 Million $9.3-$43.9 Million Over $43.9 Million Noncheckable nonpersonal savings and time deposits Current Requirement 0% 3 10 0 Statutory Limits 3% 3 8-14 0-9

Fed can establish and vary reserve ratio within limits set by Congress. Required reserves help Fed control lending abilities of commercial banks.

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Transaction #4: Assume the bank deposits all cash on reserve at the Fed
Suppose: rrr = 20% required reserve rate. Instead of sending just $20,000 (min. percent requested), Wahoo bank send $110,000. (Reason: Keeping in the form of cash is idle while keeping it in the form of Reserve is productive as it earns interest and builds the banks loan capacity.)

Balance Sheet 4: Wahoo Bank

Assets Cash Reserves Property Liabilities and Net Worth

$0
110,000

Checkable Deposits
Stock Shares

$100,000 250,000

240,000

The RESERVE item is comprised of Excess Reserves and Required Reserves.

RESERVE = REQUIRED RESERVE (RR) + EXCESS RESERVE (ER) i. Required Reserves = Checkable deposits (CDs) X reserve ratio (rr) ii. Excess reserves = Reserve (Actual Reserves) - Required Reserves (RR)

Example:
Checkable deposits $100,000,Reserve ratio 20% Therefore: req. reserve = 20,000 How much is ER? 110,000 20,000 = $90,000 (this amount is readied to be loaned out)
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Transaction #5: Clearing a check

Suppose: Bradshaw the farmer (in Transaction 3) buys a $50,000 worth of farm machinery from Ajax Co. and pays Ajaxs company by writing a $50,000 check against his deposit in Wahoo bank. Ajax Co. later deposit the check into his bank, the Sunrise Bank. NOTE: involves check clearing between the sunrise bank, FRB and the Wahoo Bank.

3. Balance Sheet: FRB Assets Liabilities Reserve of Wahoo Bk. Reserve of Sunrise Bk.
The check is cleared and sent back to Wahoo Bank

- $50,000 +$50,000

The check is sent to FRB for collection

4. Balance sheet: Wahoo Bank Assets Liabilities ii. Res. -$50,000 i. CDs -$50,000 2. Balance Sheet : Sunrise Bank

Assets

Liabilities

ii. Reserve +50,000 i. CDS +$50,000

1. Bradshaw pays Ajax Co. worth $50,000 by check and Ajax Co. deposits into Sunrise Bank.

Transaction #5:
Wahoos Balance Sheet after Check clearance

Taking account the last transaction into account,

the Wahoos balance sheet now looks like this. Balance sheet 5: Wahoo Bank

Assets

Liabilities

Reserve $60,000 CDs $50,000 Properties $240,000 Stock Shares $250,000

RR = .2 X 50k = 10k ER = 60k 10k = 50k

Money Creating Transactions

Transaction #6a: Granting a loan Twinkle goes to Wahoo Bank and request a loan worth $50,000. After the loan is granted, the $50,000 worth of loan is deposited (back) into her checking account at the Wahoo Bank
Balance Sheet 6a: Wahoo Bank

Assets
Reserves
Loans (+) Property RR = .2 x 100k = 20k ER = 60k 20k = 40k $60,000

Liabilities and Net Worth

Checkable Deposits (+) Stock Shares $100,000

50,000
240,000

250,000

NOTE: when a bank makes loan, it creates money, as indicated by an increase in CDs and value of ERs.

Transaction #6b:Using the loan (or the $50,000 loan is cashed). Suppose Twinkle pays to Quickbuck Co. (by check worth $50,000) for completing a construction work. Quickbuck in turn deposit the check in Canyon Bank. Note: the clearance process repeats as in transaction #5. Adjustments in the Wahoo bank involves a ( )CDS, and (-) Reserve. Balance Sheet 6b: Wahoo Bank
Assets Reserves Loans Property $10,000 50,000 240,000 Stock Shares 250,000 Liabilities and Net Worth Checkable Deposits $50,000

A single bank can only lend an amount equal to their pre-loan excess reserves

New RR = .2 X 50K = 10K New ER = 10K -10K = 0

Transaction #7: Loan Repayment

Suppose Twinkle writes a check of $50,000 against her CDs. As the result, the Wahoo Banks Reserves increases by $50,000 while loan decreases by $50,000. Balance sheet 7: Wahoo Bank

Assets
Reserve $60,000 Loans $0 Properties $240,000
RR = .2 x 50 = 10k New ER = 60K -10K = 50K

Liabilities
CDs $ 50 Stock Shares $250,000

Money Creating Transactions

Transaction #7: Buying govt. securities.
Suppose Wahoo Bank buys government securities worth 50,000 from dealer. This transaction will (+)CDs and (+)Securities items.

Balance Sheet 7: Wahoo Bank

Assets Reserves Securities Property Liabilities and Net Worth $60,000 Checkable Deposits 50,000 240,000 Stock Shares

$100,000 250,000

Note: an increase in CDs provide indication that new money is created. RR = .2 X 100,000 = 20,000 ER = 60K 20K = 40K (ER from 0 now increase to 40K)
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Commercial Banks:Goals and Conflict

Goals of Commercial Banks is to; Make profit by giving out loans (as making loans create money) or buy securities. Maintain liquidity ability to maintain enough/sufficient amount of liquid assets such as cash and ER for depositors who want to transform their CDs into cash. These two goals conflicts with each other. How do firms compromise these two goals? - To make profit and at the same time maintaining liquidity, banks
lend excess reserves held at the FRB on overnight basis in the federal funds market, and receive interest known as the federal funds rate.

Reversibility: Making loans creates money Loan repayment destroys money

The Banking System

Multiple-deposit expansion Assumptions: 20% required reserves All banks loaned up or lend all of excess reserves. A $100 bill is deposited Multiple deposits can be created.

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The Banking System

Bank (1) Acquired Reserves and Deposits (3) (4) (2) Excess Amount Bank Can Required Reserves Lend; New Money Reserves (1)-(2) Created = (3)

Bank A Bank B Bank C Bank D

$100 $80 $64 $51.20

$20 $16 $12.80 $10.24

$80 $64 $51.20 $40.96

$80 $64 $51.20 $40.96

The process will continue

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The Overall Process of Banking System

(1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3)

Bank

Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99

$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40

$80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59

$80.00 64.00 51.20 40.96 32.77 Amount 26.21 of new 20.97 money 16.78 created 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00

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The Monetary Multiplier

Monetary multiplier

1
required reserve ratio

1 R

Graphic Example

New Reserves $100 $80 Excess Reserves $20 Required Reserves

$400 Bank System Lending

$100 Initial Deposit

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Money Created

The Monetary Multiplier

M = 1/rrr = 1/ 0.2 =5

Note: Higher rrr, lower M

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 Maximum amount of money expansion:

= Initial Deposit X M = $100 X 5 = $500

Maximum amount of new money created by single dollar of excess reserves.

= Max. Money Expansion initial Deposit = $500 -= $100 = $400 Or = initial ER X M = $80 x 5 = $400

Key Terms
fractional reserve banking system balance sheet required reserves reserve ratio excess reserves actual reserves Federal funds rate monetary multiplier
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THE END

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