How Banks Create How Banks Create Money!Money!

The Fundamental Accounting Equation

Net Worth = Assets - LiabilitiesAssets –What is owned!

Liabilities-What is owed!

Net worth – The value of the company

Rewritten:

Assets = Net Worth + Liabilities

The T- account*The T- account*

(a balance sheet)(a balance sheet)

AssetsAssets LiabilitiesLiabilities

Net WorthNet Worth

*both sides have to equal each other

Let’s create a bank.

Remember banks are businesses and as such make profits. They are also organized like business and can raise money in similar fashions.

For our bank, the Fifth National, lets assume, ceteris paribus, we sell stock and raise $1,000,000. We will use this money to fund the purchase of property, the building of the bank and the furniture and capital necessary for our bank to operate. Our balance sheet will look like this:

The Fifth NationalThe Fifth National

Buildings Buildings $1,000,000$1,000,000

Net Worth Net Worth $1,000,000$1,000,000

We are in balance, and the bank is now We are in balance, and the bank is now ready to open.ready to open.

The Fifth NationalThe Fifth National

Our friends and neighbors decide that we Our friends and neighbors decide that we will be a good place to keep their money will be a good place to keep their money and they deposit $100,000.and they deposit $100,000.

$100,000 DD$100,000 DDTR $100,000TR $100,000

DD stands for DD stands for Demand Demand Deposits which Deposits which is another way is another way of saying of saying Checking Checking accountsaccounts

TR stands for TR stands for Total Reserves Total Reserves and represents and represents Excess Reserves Excess Reserves (ER) and (ER) and Required Required Reserves (RR)Reserves (RR)

The Federal Reserve Bank has as The Federal Reserve Bank has as one of its functions, the setting of one of its functions, the setting of the Reserve Ratio. The Reserve the Reserve Ratio. The Reserve Ratio is the percentage of Ratio is the percentage of Demand Deposits that the bank Demand Deposits that the bank must maintain at all times. (I must maintain at all times. (I want to emphasize it is want to emphasize it is percentage of Demand Deposits percentage of Demand Deposits and not Reserves)and not Reserves)In our little scenario we will In our little scenario we will assume that the Reserve Ratio assume that the Reserve Ratio is 10%; thus our balance is 10%; thus our balance sheet will look like thissheet will look like this

The Fifth National

$100,000 DDRR $10,000

ER 90,000

The ER (Excess Reserves) tells how much money the bank can

loan out

In this instance that would be..?

If you said $90,000 you are right.

Let’s make a loan.

The Fifth National

$100,000 DDRR $10,000

ER 90,000

Loan 90,000 90,000 DD

We would not loan out cash but write a We would not loan out cash but write a check or possibly deposit the amount in the check or possibly deposit the amount in the borrowers account.borrowers account.

Our borrower uses the money to buy a Our borrower uses the money to buy a new car.new car.

The Jag dealership now deposits the The Jag dealership now deposits the check in their bank.check in their bank.

Plano Bank and Guaranty

$90,000 DDRR $ 9,000

ER 81,000

The dealership’s bank’s balance sheet looks like this.

Plano Bank and GuarantyPlano Bank and Guaranty

$90,000 DD$90,000 DDRR $ 9,000RR $ 9,000

ER 81,000ER 81,000

This bank can now lend out $81,000 more and This bank can now lend out $81,000 more and their demand deposits increase by $81,000their demand deposits increase by $81,000.

Loan 81,000Loan 81,000

81,000 DD81,000 DD

Plano Bank and Guaranty is going to want payment of the check from Fifth National.

Payment of the check is called clearing the check and is done by sending it to the Federal Reserve Bank, which will then send the check to the Fifth National and demand payment. (In reality the entire transaction takes place at the Fed).

The Fifth National Bank’s balance sheet looks like this.

The Fifth National

$100,000 DDRR $10,000

ER 0

Loans 90,000

Notice that the check is paid from the Excess Reserves and that the check is no longer owed.

Plano Bank and GuarantyPlano Bank and Guaranty

$90,000 DD$90,000 DDRR $ 9,000RR $ 9,000

ER 0ER 0

Loan 81,000Loan 81,000

When the FED cleared the check the balance When the FED cleared the check the balance sheet look like this:sheet look like this:

The process is repeated until there is no more money to be created.

As can be noted the total money As can be noted the total money created by these two transactions created by these two transactions amounts to $171,000 exceeding amounts to $171,000 exceeding the initial deposit. If we continue the initial deposit. If we continue the process until infinity we will the process until infinity we will have created even more money. have created even more money. In other words, a multiple of our In other words, a multiple of our beginning deposit.beginning deposit.

The Money MultiplierThe Money Multiplier

Mathematically, the money multiplier can be found by Mathematically, the money multiplier can be found by taking the inverse of the reserve ratio.taking the inverse of the reserve ratio.

1

RR

In our example, the reserve ratio was 10%, therefore In our example, the reserve ratio was 10%, therefore the money multiplier was 10.the money multiplier was 10.

Multiplying the initial increase in Multiplying the initial increase in excess reserves by the money excess reserves by the money

multiplier gives us the total new multiplier gives us the total new money created by the banking money created by the banking

system.system.

10 X $90,000 = $900,000 new 10 X $90,000 = $900,000 new money createdmoney created