A substantial amount of money in the economy is held by deposit-takers

Someone deposits money into their bank, they pay little interest to them, they lend that money to someone else, while charging a higher interest rate, so they make a profit

This process is done by the roles played by cash reserves and profit motive

12.3 - Money Creation

Desired Reserves are the minimum amount of cash necessary that chartered banks are required to have to satisfy anticipated withdrawal demands

The Reserve Ratio: The deposit taker must hold a certain portion of deposits in the form of cash reserves EX. If a bank has a reserve ratio of 0.10, and the bank

has deposits of $100 million, then it will hold 10% of this dollar value as desired reserves

Money Creation

𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑟𝑎𝑡𝑖𝑜=𝑑𝑒𝑠𝑖𝑟𝑒𝑑 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠

𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠=$ 10𝑚𝑖𝑙𝑙𝑖𝑜𝑛$ 100𝑚𝑖𝑙𝑙𝑖𝑜𝑛

=0.10

Different types of reserves have different reserve ratios

EX. Banks want to hold higher reserves against demand deposits than against notice deposits

Excess Reserves exist when deposit-takers find that their cash reserves exceed desired levels

Money Creation

Idle cash reserves no profit, so deposit-takers will try to transform any excess reserves into income-producing assets as soon as possible

Let’s see how lending out excess reserves creates more money

Assume: (1) Public money is in the form of deposits and all payments are made by cheque; (2) All deposits are made to one type of deposit-taker (banks); (3) Reserve ratio is 0.10 (10%)

Note: a bank’s main assets are its cash reserves and loans A bank’s main liabilities are its customers’ deposits

The Money Creation Process

1. At Cabot Bank, cash reserves = desired reserves 2. Saver A makes $1000 and deposits it into Cabot

Bank 3. Cabot Bank now has new cash assets and

deposit liabilities of $1000

First Transaction

Cabot BankAssets Liabilities

Cash Reserves + $1000

Saver A’s Deposit + $1000

Cabot Bank only wants to keep 10% of the $1000 = $100 on hand

Cabot Bank now has an excess of $900 Cabot Bank now lends $900 to Borrower X

Second Transaction

Cabot BankAssets Liabilities

Cash Reserves $1000

Saver A’s Deposit $1000

Loan to Borrower X + $900

Borrower X’s Deposit + $900

The money supply has now risen by $900.

Borrower X withdraws the $900 from his deposit Cabot Bank’s cash assets and deposit liabilities

each fall by $900

Third Transaction

Cabot BankAssets Liabilities

Cash Reserves $100 (=$1000 - $900)

Saver A’s Deposit $1000

Loan to Borrower X $900

Borrower X’s Deposit $0 (=$900 - $900)

Borrower X bought something for $900 from Saver B

Saver B deposits the $900 in her account at Fraser Bank

Fraser Bank’ cash assets and deposit liabilities increase by $900

Thus, the $900 deposit originally created by Cabot Bank has simply moved to Fraser Bank – no change in money supply

Fourth Transaction

Fraser BankAssets Liabilities

Cash Reserves + $900

Saver B’s Deposit + $900

Since Saver B deposits money to Fraser Bank, Fraser Bank’s desired reserves should increase by $90 (= $900 x 0.10)

Since the $900 also increases cash reserves, there are now excess reserves of $810 ( = $900 - $900

Fraser Bank lends the $810 to Borrower Y This created added loans assets and deposit liabilities of

$810 Since Borrower Y’s new deposit is money, the money

supply increases by $810

Fifth Transaction

Fraser BankAssets Liabilities

Cash Reserves $900

Saver B’s Deposit $900

Loan to Borrower Y $810

Borrower Y’s Deposit $810

The number of possible transactions are endless We saw the process of money creation in the few

transactions that we saw Notice how the process of money creation is similar

to the process of the spending multiplier (Ch. 11) In the money creation process, an initial change in

money has a magnified effect on the money supply Money Multiplier is the value by which the amount

of excess reserves is multiplied to give the maximum total change in money supply

The Money Multiplier

h𝐶 𝑎𝑛𝑔𝑒 𝑖𝑛𝑚𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦= h𝑐 𝑎𝑛𝑔𝑒 𝑖𝑛𝑒𝑥𝑐𝑒𝑠𝑠𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠×𝑚𝑜𝑛𝑒𝑦𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

Recall that the spending multiplier is the reciprocal of the marginal propensity to withdraw (MPW) This is how much is taken out of the income-spending

stream with each spending cycle In money creation, the multiplier is the reciprocal of

the reserve ratio Recall, in our previous example, the reserve ratio was

0.10

The Multiplier Formula

Recall, we assumed that all money is in the form of deposits, and that there is only one form of deposit-taker These assumptions do not hold true in reality

Public-Held Currency Rather than all money going to deposit-takers, some

money does circulate and is unaffected by the money multiplier

Differences in Deposit There are a wide range of deposit types, so not all

deposits will be reflected as an increase in the money supply

Adjustments to the Money Multiplier

The money multiplier represents the maximum possible effect of money creation

If someone deposits $9000, the money multiplier formula allows us to specify the maximum amount of $9000 by which the quantity of money rises as a result of the infusion of $900 in new excess cash reserves

Money Multiplier in the Canadian Economic System