6 Money Creation (1)

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Money

Creation

Chapter 32

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


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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 bankingsystem

The monetary multiplier

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Fractional Reserve Banking

CharacteristicsBanks create money through

lending

Banks are subject to panics

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Balance sheet

Assets = Liabilities + Net Worth

AssetsCash, properties, Loans, Reserve

LiabilitiesCapital 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


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Assets Liabilities and Net Worth

Creating a BankTransaction #1: Creating a bank

Suppose: The founders of the bank have sold $250,000worth of shares of stock (equity shares ) to buyers toobtain 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

Cash $250,000 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.


Cash $10,000 Stock Shares $250,000Properties 240,000

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AssetsLiabilities and Net Worth

Transaction #3:Commercial bank functions of accepting deposits.

Suppose Wahoo citizen, Bradshaw (a farmer)deposits money in the form of checkable depositsworth $100,000 in the Wahoo bank.


Cash $110,000 Checkable Deposits $100,000

Property 240,000 Stock Shares 250,000

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All commercial banks are required to deposit certainpercent of the banks total CDs at the Fed.

Required reserves help Fed control lending abilities ofcommercial banks.

Required reserves : % rr X CDS

Reserve ratio

Example:

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

Reserveratio =

Commercial banksRequired reserves

Commercial banksCheckable-deposit liabilities

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Depositing reserves in a Federal Reserve bank.


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Reserve Requirements

Type of DepositCurrent

RequirementStatutory

Limits

Checkable deposits:

$0-$9.8 Million$9.3-$43.9 Million

Over $43.9 MillionNoncheckable nonpersonalsavings and time deposits

0%3

10

3%3

8-14

0 0-9

Fed can establish and vary reserve ratio within limits setby Congress.

Required reserves help Fed control lending abilities ofcommercial banks.

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Cash $0 Checkable Deposits $100,000

Property 240,000Stock Shares 250,000

Reserves 110,000

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 itearns interest

andbuilds the banks loan capacity.)

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


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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 AjaxCo. and pays Ajaxs company by writing a $50,000check against his deposit in Wahoo bank. Ajax Co.

later deposit the check into his bank, the SunriseBank.

NOTE: involves check clearing between the sunrisebank, FRB and the Wahoo Bank.


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3. Balance Sheet: FRB

Assets Liabilities

Reserve of Wahoo Bk. - $50,000Reserve of Sunrise Bk. +$50,000

4. Balance sheet: Wahoo Bank

Assets Liabilities

ii. Res. -$50,000 i. CDs -$50,0002. Balance Sheet : Sunrise Bank

Assets Liabilities

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

The check is clearedand sent back toWahoo Bank

The check is sent to

FRB for collection

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


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Transaction #5:Wahoos Balance Sheet after Check clearance

Taking account the last transaction into account,the Wahoos balance sheet now looks like this.

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

Balance sheet 5: Wahoo BankAssets Liabilities

Reserve $60,000Properties $240,000

CDs $50,000Stock Shares $250,000


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Money Creating TransactionsTransaction #6a: Granting a loan

Twinkle goes to Wahoo Bank and request a loan worth $50,000. Afterthe loan is granted, the $50,000 worth of loan is deposited (back) intoher checking account at the Wahoo Bank

RR = .2 x 100k = 20kER = 60k 20k = 40k

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

Balance Sheet 6a: Wahoo Bank

Checkable Deposits (+) $100,000

Property 240,000

Stock Shares 250,000

Reserves $60,000

Loans (+) 50,000


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Balance Sheet 6b: Wahoo Bank

Checkable Deposits $50,000


Reserves $10,000

Loans 50,000

A sing le bank can only lend an amoun t equal to their pre-loan excess reserves

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 inCanyon Bank.Note: the clearance process repeats as in transaction #5.Adjustments in the Wahoo bank involves a ( )CDS, and (-) Reserve.

New RR = .2 X 50K = 10K

New ER = 10K -10K = 0


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Transaction #7: Loan Repayment

Suppose Twinkle writes a check of $50,000 against herCDs. As the result, the Wahoo Banks Reserves increasesby $50,000 while loan decreases by $50,000.

RR = .2 x 50 = 10k

New ER = 60K -10K = 50K

Balance sheet 7: Wahoo Bank

Assets Liabilities

Reserve $60,000

Loans $ 0Properties $240,000

CDs $ 50

Stock Shares $250,000


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Money Creating TransactionsTransaction #7: Buying govt. securities.

Suppose Wahoo Bankbuys g overnment secur i t ies wo rth 50,000from dealer.

This transaction will (+)CDs and (+)Securities items.


Checkable Deposits $100,000


Reserves $60,000

Securities 50,000

Note: an increase in CDs provide indication that new money iscreated.RR = .2 X 100,000 = 20,000ER = 60K 20K = 40K (ER from 0 now increase to 40K)

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Commercial Banks:Goals and ConflictGoals of Commercial Banks is to;

Make profit by giving out loans (as making loans createmoney) or buy securities.

Maintain liquidity ability to maintain enough/sufficientamount of liquid assets such as cash and ER for depositors whowant 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, bankslend excess reserves held at the FRB on overnig ht basis in the federal

funds m arket, and receive interest know n as the federal funds rate.

Reversibility:

Making loans creates money

Loan repayment destroys money


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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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Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves

(3)ExcessReserves

(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

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

The Banking System

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Bank ABank BBank CBank DBank EBank FBank GBank H

Bank IBank JBank KBank LBank MBank N

Other Banks

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves(ReserveRatio = .2)

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

$100.0080.0064.0051.2040.9632.7726.2120.97

16.7813.4210.74

8.596.875.50

21.99

$20.0016.0012.8010.248.196.555.244.20

3.362.682.151.721.371.10

4.40

$80.0064.0051.2040.9632.7726.2120.9716.78

13.4210.748.596.875.504.40

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$80.0064.0051.2040.9632.7726.2120.9716.78

13.4210.748.596.875.504.40

17.59$400.00

The Overall Process of Banking System

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Amountofnewmoneycreated


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The Monetary Multiplier

Monetarymultiplier =

1required reserve ratio

New Reserves$100

$20RequiredReserves

$80Excess

Reserves

$100Initial

Deposit

$400Bank System Lending

Money Created

Graphic

Example

= 1R

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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


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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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6 Money Creation (1)