Money Creation

Chapter 33

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33-2

Balance Sheet

• Balance sheet: A list of the assets and liabilities.

• Assets: What owned.• Liabilities: What owed.• What do you own? Cash, textbooks, car, etc.

What do you owe? Credit card loan, student loan, utility bill?

33-3

Bank Assets

• Bank assets are what a bank owns or its claims for future payments.• Cash in vault• Deposits at the Federal Reserve Bank• Securities (e.g. Treasury bonds, municipal bonds)• Loans (e.g. Consumer loans, mortgage loans,

student loans, commercial loans)• Fixed assets • e.g. Buildings, ATM machines

33-4

Bank Liabil i t ies and Capital

• Bank liabilities are what a bank owes.• Deposits • Checkable deposits, non-transaction deposits (CDs)

• Borrowings include• Loans from other banks: Federal funds• Loans from the Fed: Discount loans• Long-term bonds that a bank issued

• Bank’s owners’ equity is called “capital” or “net worth”• Owners’ equity is the difference between total

assets and total liabilities.

33-5

Reserves

• Reserves: Sum of Vault cash and deposits at the Fed

• Required Reserves: The Fed requires banks to keep a certain fraction (required reserve ratio) of deposits at banks.

• Excess Reserves: Any extra reserves held by a bank beyond the required reserves.

33-6

Required Reserves

• Bank of America has $100 million of deposits and holds $25 million of reserves. A required reserve ratio is 20%.

• Required reserves are 20% of $100 million deposits, that is $20 million.

• Excess reserves are any reserves held by Bank of America over its required reserves, that is $5 million (= $25 million - $20 million).

33-7

Bank Balance Sheet

• The balance sheet of commercial bank includes various assets and liabilities items. However, for simplicity of analysis, we only focus on the following items in this course.

ReservesSecuritiesLoans

DepositsBorrowingsCapital

Assets Liabilities &Owners’ Equity

33-8

Banking Operations

• What does a bank do? It does not produce or sell anything.

• Basic business of banking is • To borrow funds from depositors• To loan funds to borrowers

• Banks make profits by• Charging interests on loans (Revenue)• Paying interests on deposits (Cost)

33-9

Banking Operation Example

• Bank of American receives $100 deposits (liabilities).• Bank of America is required to keep $20 as required

reserves (assets), and the rest ($80) is excess reserve.

• Bank of America loans out $80 (assets).• Federal Reserve pays 0.5% on required reserves.• If Bank of America pays 1% on deposits and 1% on

loans, will it make profits?

33-10

How Bank Make Profits

• Banks charge high interest rates on loans and give low interest rates on deposits to make profits.

• This difference in interest rates is considered as fee charged on services that the bank provides to its customers.

33-11

Fractional Reserve Banking

Should banks loan all deposits out or keep them?• Banks need cash at vault (excess reserves) to pay off

as depositors request withdrawals of their deposits. • Banks are also required to maintain required

reserves.• To make profits, banks loan out the rest.• Fractional reserve banking: a system under which

bankers keep as reserves only a fraction of the funds they hold on deposit.

33-12

Money Creation Process

• What will happen to the funds once loaned out to borrowers?• Borrowers will spend the borrowed funds ($80).• Sellers receive funds, then deposit to his bank,

Wells Fargo Bank.• What will Wells Fargo Bank do with deposits ($80)?• Do just like Bank of America, but its deposits are

little less – Keeps $16 as required reserves and loans out $64.

• The process continues until funds become $0.

33-13

Money Creation Process

• Where did this process start?• Where did the first depositor get funds to deposit

at Bank of America?• Funds are injected by the Federal Reserves .• Federal Reserve purchased a stuff from Mr. Rich

and paid $100 to him.• In reality, Federal Reserve may not purchase

many stuffs, but securities such U.S. Government bonds (Open Market Operation).

33-14

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves

(3)Excess

Reserves(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

LO4

33-15

Money Creation Process

LO1

• The diagram below summarizes the multiple deposit creation process example.

Fed

Banking System

Public

D +$100M

L + $80M + $64M + $51M + ...

D + $80M + $64M + $51M + ...

1. Initially, the Fed injects $100M, creating excess reserves.

2. Any excess reserves are loaned out. 3. Eventually, they

are deposited back to banks.

33-16

The Banking System

Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks

Bank

(1)AcquiredReserves

and Deposits

(2)RequiredReserves(Reserve

Ratio = .2)

(3)Excess

Reserves(1)-(2)

(4)Amount Bank CanLend; New Money

Created = (3)

$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.74

8.596.875.50

21.99

$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.74

8.596.875.504.40

17.59

$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.74

8.596.875.504.40

17.59$400.00LO4

33-17

Money Creation Process

• Federal Reserve’s $100 injection initiated the process and created deposits in many banks along the process.

• ∆ Deposits in process= $80 + $64 + … = $80/0.2 = $400

• Because deposits are parts of money supply (M1), any increase in deposits leads to the same increase in money supply.

33-18

Money Multipl ier

• Money multiplier: m = 1/R• R: required reserve ratio• If R = 20%, m = 5.

• ∆ Money supply = m x ∆ Excess Reserves• If m = 5 and an initial change in excess reserve is

$80, then 5 x $80 = $400• Initial $80 excess reserves creates additional $400

of money supply in economy.

33-19

The Monetary Multipl ier

Monetarymultiplier =

1

required reserve ratio=

1

R

LO5

33-20

The Monetary Multipl ier

• Maximum amount of new money created by a single dollar of excess reserves

• Higher R, lower m• Reversibility• Making loans creates money• Loan repayment destroys money

33-21

Profits, Liquidity, and the Fed Funds Market

• Bank can make more profits by lending as much as possible.

• What will bank do if depositors come to withdraw deposits? It must comply.

• Banks may maintain liquidity by holding excess reserves and avoid short of cash.

• Alternatively, bank may borrow from the Federal Reserves (discount loan) or other banks (Federal funds: Overnight bank loans)

LO3

33-22

Banking, Leverage, and Financial Instabil i ty

• Leverage is the use of borrowed money to magnify profits and losses

• Modern banks use lots of leverage• Thus small losses can drive banks into

insolvency and bankruptcy• Insolvency: Liabilities exceed assets• Bankruptcy: It cannot meet its obligation

(deposit withdrawal request for bank).