Chapter 26

Chapter 26Chapter 26

MONEY CREATION AND MONEY CREATION AND THE BANKING SYSTEMTHE BANKING SYSTEM

Gottheil — Principles of Economics, 6e© 2010 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2010 Cengage Learning Gottheil — Principles of Economics, 6e2

The fractional reserve systemThe legal reserve requirementA bank’s balance sheet, its assets and liabilitiesDemand deposits and bank loans

Economic PrinciplesEconomic Principles


The potential money multiplierBank failureThe Federal Deposit Insurance Corporation (FDIC)

How Banks Create MoneyHow Banks Create Money


Fractional reserve system

• A banking system that provides people immediate access to their deposits but allows banks to hold only a fraction of those deposits in reserve.



The fractional reserve system serves as the basis of all modern banking.



If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands.



Balance sheet

• The bank’s statement of liabilities (what it owes) and assets (what it owns).



Banks make a profit on the loans they provide, not on their deposits.



Legal reserve requirement

• The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves.

Cyberspace BankingCyberspace Banking


What is a cyberspace banking?• Cyberspace is banking conducted over the

Internet.



• $100,000 + $80,000 = $180,000.

1. Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts?



1. Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts?

• Thus fractional reserve banking creates money through loans.



Financial intermediaries• Firms that accept deposits from savers and

use those deposits to make loans to borrowers.



• A fractional reserve system operating within financial intermediaries.

2. What three factors are needed for a banking system to create money?




• People willing to make demand deposits.






• People willing to make demand deposits.

• Borrows prepared to take out loans.



Potential money multiplier• The increase in the money supply that is

potentially generated by a change in demand deposits.



3. If the legal reserve requirement is 10 percent, what is the potential money multiplier?

• The potential money multiplier “m” = 1/(legal reserve requirement) = 1/0.1 = 10



• M = ID/LRR

4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)?



4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)?

• M = $100,000/.25 = $400,000



5. Why might the actual increase in the money supply be less than the maximum potential increase in the money supply?

• Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system.



Excess reserves

• The quantity of reserves held by a bank in excess of the legally required amount.



If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves.



• Required reserves are 0.2 × ($100,000) = $20,000.

6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess?



• Excess reserves = (total reserves) – (required reserves)





• Excess reserves = $35,000 – $20,000 = $15,000.



7. How are required reserves recorded on a bank’s balance sheet?

• Required reserves are an asset.



8. How are excess reserves recorded on a bank’s balance sheet?

• Excess reserves are an asset.



9. How are loans recorded on a bank’s balance sheet?

• Loans are an asset.



10. How are demand deposits recorded on a bank’s balance sheet?

• Demand deposits are a liability.



• Yes

11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits?



11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits?

• With required reserves of $10,000 and a legal reserve requirement is 10 percent, then demand deposits equal $100,000.

Reversing the Money Creation Reversing the Money Creation ProcessProcess


• Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves.

1. What will happen if the Federal Reserve increased the legal reserve requirement for banks?



• Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made.





• Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply.



2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement?

• Required reserves will increase.




• Excess reserves will decrease.




• Loans will decrease.

Why Banks Sometimes FailWhy Banks Sometimes Fail


1. What will happen if too many borrowers are unable to repay their loans?

• A bank may fail.



2. If a bank fails, what will happen to the depositors?

• If deposits are insured by the federal government, then the government will step in and pay depositors up to the maximum insurable amount.



2. If a bank fails, what will happen to the depositors?

• If deposits are not insured by the federal government, then depositors may lose their money.



• Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits.

3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond?



• Too many depositors withdrawing their money from their demand deposit accounts will overwhelm the fractional reserve system, and may cause it to fail.




• Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result.





• Prior to modern banking regulation and practices, many recessions were caused by financial panics and banking system failures.

Safeguarding the SystemSafeguarding the System


Federal Deposit Insurance Corporation (FDIC)• A government insurance agency that provides

depositors in FDIC-participating banks 100 percent coverage on their first $100,000 of deposits.



Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection.



The FDIC was created in 1933, too late for the tens of thousands of people who had been financially wiped out by bank failures in the Great Depression.

Federal Deposit Insurance and Federal Deposit Insurance and Moral HazardMoral Hazard


Fully insuring deposits leads to a costly side effect known as moral hazard.



Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured.



Proposed solutions for the moral hazard problem with deposit insurance include:

• Privatize the deposit insurance system

• Reduce the scope of deposit insurance

Yet any change in the deposit insurance system may itself destabilize the banking system.



In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices.



Despite these safeguards, approximately 10 banks fail each year.



During the 1970s, high farm commodity prices inflated the price of farmland, and high oil prices inflated the value of property in Texas and Oklahoma.



Banks made loans with inflated property values as collateral.

Safeguarding The SystemSafeguarding The System


When farm commodity prices and oil prices collapsed in the recession of the early 1980s, many farms and businesses failed, and were unable to repay their loans.



Banks were left holding collateral—land, buildings, and other capital—that was worth less than the amount of the loan.



Consequently, many banks failed, particularly in farm states and in Texas and Oklahoma.



Due to the moral hazard problem, there were questions regarding proper lending practices at some of the failed banks.


EXHIBIT 1 BANK FAILURES: 1930–2005

Exhibit 1: Bank FailuresExhibit 1: Bank Failures


For years after the Great Depression, the number of bank failures was insignificant. All that changed in the 1980s. With the recession of 1982, bank failures increased dramatically. In 1988 alone there were more bank failures than the combined total for the previous 25 years.



Which of the two time periods experienced the largest number of bank failures:a. The mid- to late-1930s

b. The mid- to late-1980s



Which of the two time periods experienced the largest number of bank failures:a. The mid- to late-1930s

b. The mid- to late-1980s


EXHIBIT 2 BANK FAILURES, SELECTED STATES: 1987–1989

Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11.

Exhibit 2: Bank Failures, Exhibit 2: Bank Failures, Selected States: 1987–1989Selected States: 1987–1989


Which of the following states had the largest number of bank failures between 1987–1989?a. Alabama

b. Texas

c. California

Exhibit 2: Bank Failures, Exhibit 2: Bank Failures, Selected States: 1987–1989Selected States: 1987–1989


Which of the following states had the largest number of bank failures between 1987–1989?a. Alabama

b. Texas

c. California


EXHIBIT 3 THRIFT FAILURES: 1980–1991

Exhibit 3: Thrift Failures: 1980–1991Exhibit 3: Thrift Failures: 1980–1991


In which of the following years were there the most thrift failures?a. 1983

b. 1987

c. 1989

Exhibit 3: Thrift Failures: 1980–1991Exhibit 3: Thrift Failures: 1980–1991


In which of the following years were there the most thrift failures?a. 1983

b. 1987

c. 1989



Many “thrifts” (savings and loans) in the early 1980s were locked in to long-term mortgage loans that paid the thrifts less than the interest they paid on deposits, causing thrifts to lose money.



This motivated some thrifts to move in to new, more speculative and risky loan markets. Another factor contributing to the failure of so many thrifts was fraudulent lending practices.



The large number of thrift failures in the 1980s put the Federal Savings and Loan Insurance Corporation (FSLIC) in crisis.

Legislation was passed that created the Resolution Trust Corporation, which handled the disposal of all failed thrifts. The FDIC has assumed the insurance function of the now-defunct FSLIC.

Controlling the Financial Institutions Controlling the Financial Institutions that Control the Money Supplythat Control the Money Supply


Financial institutions cannot create the proper money flows to foster economic activity with minimal inflation and unemployment.• Control of the money supply is needed.

That’s where the Federal Reserve System comes in.

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