How Banks & Thrifts How Banks & Thrifts Create MoneyCreate Money

Chapter 14Chapter 14

IntroductionIntroduction

►Most transaction accounts are created Most transaction accounts are created as a result of loans from banks or as a result of loans from banks or thriftsthrifts

►This chapter demonstrates the money This chapter demonstrates the money creating ability of a single bank and creating ability of a single bank and the system as a wholethe system as a whole

GoldsmithsGoldsmiths

►1616thth century goldsmiths created safes for century goldsmiths created safes for holding gold and other precious metals. holding gold and other precious metals. Receipts were issued for their deposit.Receipts were issued for their deposit.

►The receipts came to be used as currency The receipts came to be used as currency as goldsmiths also discovered that not all as goldsmiths also discovered that not all gold was redeemedgold was redeemed

►The idea of loaning money also was The idea of loaning money also was established with an accompanying established with an accompanying interest chargeinterest charge

Fractional Reserve BankingFractional Reserve Banking

►The idea that there is only a fraction or The idea that there is only a fraction or percentage of gold on hand in relation percentage of gold on hand in relation to the number of receipts issuedto the number of receipts issued

►The significance is that you had banks The significance is that you had banks that were creating moneythat were creating money

►Policies regarding this creation must Policies regarding this creation must be careful and well thought out to be careful and well thought out to avoid “panics” or “runs” on banksavoid “panics” or “runs” on banks

Bank ReservesBank Reserves

►Reserves are kept either with the district Reserves are kept either with the district Federal Reserve Bank or as cash in a Federal Reserve Bank or as cash in a vaultvault

►Cash kept on hand as well to meet needs Cash kept on hand as well to meet needs of customersof customers

►Required reserves are again, a Required reserves are again, a fraction of fraction of depositsdeposits

►Actual Reserves = Excess + Actual Reserves = Excess + RequiredRequired

►Banks may not loan required reservesBanks may not loan required reserves

Balance SheetsBalance Sheets

►All balance sheets must balanceAll balance sheets must balance►Assets = Liabilities (Claims)Assets = Liabilities (Claims)►Bank owner claims are referred to as Bank owner claims are referred to as

net worthnet worth► Items such as reserves, property, Items such as reserves, property,

loans are assets to the bankloans are assets to the bank►Checkable deposits, capital stock, etc. Checkable deposits, capital stock, etc.

would be considered liabilities would be considered liabilities

Bank TransactionsBank Transactions

►Currency held by the bank is not part Currency held by the bank is not part of the money supplyof the money supply

►Reserve ratio – Ratio of required Reserve ratio – Ratio of required reserves the bank is obligated to keep reserves the bank is obligated to keep in its vault.in its vault.

►The reserve ratio is calculated by The reserve ratio is calculated by dividing the required reserves by the dividing the required reserves by the bank’s total checkable depositsbank’s total checkable deposits

Bank TransactionsBank Transactions

►Once lending requirements have been Once lending requirements have been set, a bank will “create” money in the set, a bank will “create” money in the form of loans.form of loans.

►Conversely, money is destroyed once Conversely, money is destroyed once the loan has been repaid.the loan has been repaid.

►Banks also may buy Government Banks also may buy Government securities from the pubic which also securities from the pubic which also creates money creates money

Profits, Liquidity, & Federal FundsProfits, Liquidity, & Federal Funds

►Profits:Profits: Bank profits come Bank profits come primarily from interest on primarily from interest on securities they hold and off the securities they hold and off the interest they earn off of loans they interest they earn off of loans they grantgrant

►Liquidity:Liquidity: Banks must seek safety Banks must seek safety by having liquidity to meet cash by having liquidity to meet cash demands of depositors and check demands of depositors and check clearing transactionsclearing transactions

Profits, Liquidity, & Federal FundsProfits, Liquidity, & Federal Funds

►Federal Funds Rate:Federal Funds Rate: Banks Banks borrow from one another in the borrow from one another in the Federal Funds Market. Rate at Federal Funds Market. Rate at which they borrow is the Federal which they borrow is the Federal Funds RateFunds Rate

Multiple Deposit ExpansionMultiple Deposit Expansion

►Reserves lost by a single bank are not Reserves lost by a single bank are not lost by the banking system as a whole.lost by the banking system as a whole.

►The result is a system that allows for The result is a system that allows for “the banking system” to lend by a “the banking system” to lend by a multiple of its reserves. (Monetary multiple of its reserves. (Monetary Multiplier)Multiplier)

►This is calculated by dividing one by This is calculated by dividing one by the reserve ratio or M=1/Rthe reserve ratio or M=1/R

Multiple Deposit ExpansionMultiple Deposit Expansion

An individual bank may loan only An individual bank may loan only what they have in their “excess what they have in their “excess reserves” on a dollar for dollar reserves” on a dollar for dollar basis.basis.

We use the monetary multiplier We use the monetary multiplier to illustrate how much money is to illustrate how much money is created throughout the system w/ created throughout the system w/ a single deposit a single deposit