Lecture Economics (18th edition): Chapter 32 - McConnell, Brue, Flynn''s

Chapter 32
Money
Creation
McGraw­Hill/Irwin

        Copyright © 2009 by The McGraw­Hill Companies, Inc. All rights reserved.


Chapter Objectives
• “Fractional Reserve” 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
32-2


Fractional Reserve Banking
• The Goldsmiths
– Stored gold and gave a receipt
– Receipts used as money by public
– Made loans by issuing receipts

• Characteristics
– Banks create money through
lending
– Banks are subject to “panics”
32-3

Fractional Reserve System
• Balance sheet
– Assets = Liabilities + Net Worth
– Both sides balance

• Necessary transactions
– Create a bank
– Accept deposits
– Lend excess reserves
32-4


Creating a Bank
• Transaction #1
• Vault cash: cash held by the
bank
Creating a Bank

Balance Sheet 1: Wahoo Bank
Assets
Cash

Liabilities and Net Worth
$250,000 Stock Shares

$250,000

32-5

Creating a Bank
• Transaction #2
• Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank

Assets
Cash
Property

Liabilities and Net Worth
$10,000 Stock Shares
240,000

$250,000

32-6


Creating a Bank
• Transaction #3
• Commercial bank functions
– Accepting deposits
– Making loans
Accepting Deposits
Assets
Cash
Property

Balance Sheet 3: Wahoo Bank

Liabilities and Net Worth

$110,000
240,000

Checkable
Deposits
Stock Shares

$100,000
250,000

32-7


Creating a Bank
• Transaction #4
• Depositing reserves in a Federal
Reserve bank
– Required reserves
– Reserve ratio
Reserve
ratio

=

Commercial bank’s

Required reserves
Commercial bank’s
Checkable-deposit liabilities
32-8


Reserve Requirements
Type of Deposit

Current
Requirement

Statutory
Limits

Checkable deposits:
$0-$9.8 Million
$9.3-$43.9 Million
Over $43.9 Million
Noncheckable nonpersonal
savings and time deposits

0%
3
10

3%
3
8-14

0

0-9

• Fed can establish and vary reserve
ratio within limits set by Congress
• Required reserves help Fed control
lending abilities of commercial banks
32-9


Creating a Bank
• Transaction #4
• Assume the bank deposits all
cash on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank

Assets

Liabilities and Net Worth

Cash
Reserves

$0 Checkable
110,000
Deposits

Property

240,000 Stock Shares

$100,000
250,000

32-10


Reserve Requirements
• Excess reserves
– Actual reserves - required reserves

• Required reserves
– Checkable deposits x reserve ratio

• Example:
– Checkable deposits $100,000
– Reserve ratio 20%
32-11


Creating a Bank
• Transaction #5
• Clearing a check
– $50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets

Reserves
Property

Liabilities and Net Worth
Checkable
$60,000
Deposits
240,000 Stock Shares

$50,000
250,000
32-12


Money Creating Transactions
• Transaction #6a
• Granting a loan
– $50,000 loan deposited to checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank

Assets
Reserves
Loans
Property

Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000

240,000 Stock Shares

$100,000
250,000

32-13


Money Creating Transactions
• Transaction #6b
• Using the loan
– $50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank

Assets
Reserves
Loans
Property

Liabilities and Net Worth
$10,000 Checkable
Deposits
50,000

$50,000

240,000 Stock Shares

250,000

A single bank can only lend an amount
equal to their preloan excess reserves

32-14


Money Creating Transactions
• Transaction #7
• Bank buys government securities
from dealer
– Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank

Assets
Reserves
Securities
Property

Liabilities and Net Worth
$60,000 Checkable
Deposits
50,000
240,000 Stock Shares

New money is created

$100,000
250,000

32-15


Commercial Banks
• Conflicting goals
• Earn profit
– Make loans to earn interest
– Buy securities to earn interest

• Maintain liquidity
• Alternative?
– Overnight bank loans
– Federal funds rate
32-16


The Banking System
• Multiple-deposit expansion
• Assumptions:
– 20% required reserves
– All banks “loaned up”
– Banks lend all of excess reserves

• A $100 bill is found and deposited
• Multiple deposits can be created
32-17


The Banking System

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

Bank

(1)
Acquired
Reserves
and Deposits

Bank A

$100

$20

$80

$80

Bank B

$80

$16

$64

$64

Bank C

$64

$12.80

$51.20

$51.20

Bank D

$51.20

$10.24

$40.96

$40.96

The process will continue…
32-18

The Banking System
Bank

(1)
Acquired
Reserves
and Deposits

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

(2)
Required
Reserves
(Reserve
Ratio = .2)

(3)
Excess
Reserves
(1)-(2)

$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

(4)
Amount Bank Can
Lend; New Money
Created = (3)

$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
$400.00

32-19


The Monetary Multiplier
Monetary
multiplier

=

Graphic
Example

1
required reserve ratio

=

1
R

New Reserves
$100
$80
Excess
Reserves

$400
Bank System Lending
Money Created

$20
Required
Reserves

$100
Initial
Deposit
32-20


The Monetary Multiplier
• Maximum amount of new money
created by single dollar of excess
reserves
• Higher R, lower m
• Reversibility
– Making loans creates money

– Loan repayment destroys money
32-21


Bank Panics of 1930-1933
•
•
•
•
•

Before deposit insurance
Bank failure led to mass withdrawals
Forced loan reduction
25-33% decline in money supply
1933 national bank holiday to
evaluate all banks
• Contributed to the Great Depression
• Regulation protects the system today
32-22


Key Terms
•
•
•
•
•
•
•

•
•

fractional reserve banking system
balance sheet
vault cash
required reserves
reserve ratio
excess reserves
actual reserves
Federal funds rate
monetary multiplier
32-23


Next Chapter Preview…

Interest Rates
and Monetary
Policy

32-24