Chapter 13: Money Creation

What are the signifigant characteristics of fractional reserve banking?

1. Banks can create money through lending. (goldsmiths created money when they made loans by giving borrowers paper money that was not fully backed by gold reserves). Now, the creation of checkable deposit money by banks (via their lending) is limited by the amount of currency reserves that the banks feel obligated, or are required by law, to keep. 2. Banks operating on the basis of fractional reserves are vulnerable to "panics" or "runs." If everyone that was loaned money went to collect at the same time, there would not be enough. However, bank panic is highly unlikely if the banker's reserve and lending policies are prudent (thought for future).

Excess reserves

A bank's excess reserves are found by substracting its required reserves from its actual reserves. Excess reserves = actual reserves - required reserves

What is true about a single bank granting a loan in a multibank system?

A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves. When it lends, the lending bank faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it. If that happens, the lending bank will lose (to other banks) reserves equal to the amount it lends. So, to be safe, it limits its lending to the amount of its excess reserves.

Transaction 4: Depositing Reserves in a Federal Reserve Bank

All commercial banks and thrift institutions must keep required reserves. A bank must keep these reserves on deposit wiith the Fed in its district or as cash in the bank's vault. In order to simplify, suppose the reserve ratio is 1/5. (obviously higher than the requirement really is). We are only concerned with checkable (spendable) deposits, and we ignore reserves on noncheckable deposits and time deposits. By deposting $20,000 in the Fed, the Wahoo bank will just be meeting the required 20% reserve ratio. But suppose the Wahoo bank anticipates that its holdings of checkable funds will grow in the future. So it may send an extra $90,000 for a total of $110,000 so they avoid the inconvenience of sending additional reserves to Fed each time its own checkable-deposit liabilities increase. Balance Sheet: Assets: -Cash - $0 -Reserves - 110,000 -Property - 240,000 Liabilities and Net worth: -Checkable deposits - $100,000 -Stock shares - 250,000

Required reserves

An amount of funds equal to a specified percentage of the bank's own deposit liabilities. A bank must keep these reserves on deposit with the federal reserve bank in its district or as cash in the bank's vault. To simplify, we suppose the Bank of Wahoo keeps its required serves entirely as deposits in the FED. But remember that vault cash is counted as resrves and real-world banks keep a significant portion of their own reserves in their vaults.

How do banks reconcile their goals of profit and liquidity?

An interesting way in which banks can partly reconcile the goals of profit and liquidity is to lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks. Normal day-to-day flows of funds to banks rarely leave all banks with their exact levels of required reserves. Also, funds held at the Federal Reserve Banks are highly liquid, but they do not draw interest. Banks therefore lend these excess reserves to other banks on an overnight basis as a way of earning additional interest without sacrificing long-term liquidity. Banks that borrow in this Federal funds market—the market for immediately available reserve balances at the Federal Reserve—do so because they are temporarily short of required reserves. The interest rate paid on these overnight loans is called the Federal funds rate.

Transaction 6: Granting a loan (after a check is drawn on the loan)

Assume Gristly awards a $50,000 building contract to Quickbuck OCnstuction company of Omaha. Quickbuck completes the expansion and is paid with a $50,000 check drawn by Gristly against its checkable deposit in the Wahoo bank. They do the checkin transaction explained in Transaction 5. In summary, assuming a check is drawn by th borrower for the enitre amount of the loan (50,000) and is given to a firm that deposits it in some other bank. Balance Sheet: Assets: -Reserves - $10,000 -Loans - 50,000 -Property - 240,000 Liabilities and Net worth -Checkable deposits - $50,000 -stock shares - 250,000 (A single commerical bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves. When it lends, the lending bank faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it. If that happens, the lending bank will lose reserves equal to amount it lends. So to be safe, it limits its lending to the amount of its excess reserves)

checkable/demand deposits

Bank receives cash, which is an asset to the bank. This money is most likely deposited in the bank as checkable deposits (checking account entries), rather than as savings accounts or time deposits. These newly constituted checkable deposits constitute claims that the depositors have against the assets of the Wahoo bank and thus are now a liability account. (claim against asset of cash).

vault cash

Cash held by a bank is sometimes called vault cash or till money.

Transaction 3: Accepting Deposits

Commercial banks have 2 basic function: to accept deposits of money and to make loans. What happens when a citizen decides to deposit money? The bank recieves cash which is an asset. Suppose this money is deposited as checkable deposits (checking account entries), rather than as savings accounts or time deposits. These newly created checkable deposits constitute claims that the depositors have against the assets of the Wahoo bank and thus are a new liability account. Balance sheet: Assets: -Cash - $110,000 -Property - 240,00 Liabilities and Networth -Checkable deposits - $100,000 -Stock shares - 250,000 (after this transaction, no change in the economy's total supply of money. But a change has occured in the composition of the money supply.)

account

Each item listed on a balance sheet is called an account.

How does the monetary multiplier affect the supply of money?

Higher reserve ratios mean lower monetary multipliers and therefore less creation of new checkable-deposit money via loans; smaller reserve ratios mean higher monetary multipliers and thus more creation of new checkabledeposit money via loans.

What is true when a bank grants a loan?

It creates money. The president of Gristly went to the bank with something that was not money, her IOU, and walked out with something that is money, a checkable deposit. By extending credit, the Wahoo bank has "monetized" and IOU. Much of the money we use in our economy is created through the extension of credit by commercial banks.

Federal Funds Rate

Normal day to day flows of funds to banks rarely leave all banks with their exact level of required reserves. Banks therefore lend these excess reserves to other banks on an overnight basis as a way of earning additional interest without sacrficing long term liquidity. Banks that borrow in this Federal Funds Market-- the market for immedietely available reserve balances at the Federal Reserve-- do so bc they are temporarily short of required reserves. The interest rate paid on these overnight loans is called the Federal Funds Rate.

Transaction 2: Acquiring Property and Equipment

Now the owners must make the bank a reality. First, they must acquire property and equipment. Suppose the directors purchase a building for $220,000 and pay $20,000 for office equipment. This simple transaction changes the composition of the bank's assets. The bank now has $240,000 less in cash and $240,000 of new property assets. Balance sheet: Assets: -Cash - $10,000 -Property - 240,00 Liabilities and Networth: -stock shares - $250,000

What do the asset items on a commerical bank's balance sheet reflect?

Reflect the banker's pursuit of two conflicting goals: -Profit: Commercial banks, like any other business, seek profit. This is why banks make loans and buy securities -- the two major earning assets of commercial banks. -Liquidity: The other goal is safety, which lies in liquidity, specifically liquid assets as cash and excess reserves. A bank must be on guard for a depositor who wants to transform their checkable deposits into cash or it must guard against more checks clearing against it than are cleared in its favor, causing a net outflow of reserves. Bankers thus seek a balance between prudence and profit. The compromise is between assets that earn higher returns and highly liquid assets that earn no returns.

Transaction 5: Clearing a Check Drawn against the Bank

Suppose Fred deposits $100,000 in the Wahoo bank. Then he buys $50,000 of machinery from Ajax Farm Company of Surprise, Nebraska. He pays for the machinery by writing a $50,000 check and gives it to the Ajax company. Ajax deposits the check in its account at the Surprise Bank. The Surprise bank increases Ajax's checkable deposits by $50,000. Now the Surprise bank has Fred's check. This check is simply a cleaim against the assts of the Wahoo bank. The Surprise bank will collect this claim by sending the check to the regional Fed bank. Here, a bank employee will clear, or collect, the check for the Surprise bank by increasing Surprise's reserves in the Federal Reserve Bank by $50,000 and decreasing the Wahoo's bank reserves by that same amount. Finally, the Fed send the cleared check back to the Wahoo bank, and for the first time the Wahoo bank discovers one of its depositors has drawn a check. Accordingly, the Wahoo bank reduces Fred's checkable deposit by $50,000 and notes that the collection of this check has caused a $50,000 decline in its reserves at the Fed. The Wahoo bank has decreased it assets and liabilites by $50,000 and the Surprise bank has $50,000 more in assets and (reserves) and in checkible deposits. Balance Sheet: Assets: -Reserves - $60,000 -Property - 240,000 Liabilites and Net worth: -Checkable deposits - $50,000 -Stock shares - 250,000

Transaction 6: Granting a Loan (when a loan is negotiated)

Suppose Gristly Company decides to expand its facilties. They need exactyl $50,000-- which just happens to be equal to Wahoo bank's excess reserves-- to finance their project. Gristly goes to Wahoo bank and requests a loan for this amount. The Wahoo bank knows the Gristly company's fine reputation and financial soundness and is convinced if its ability to pay back the loan. So the loan is granted. In return, the president of Gristly hands a promissionary note to the Wahoo Bank. Gristly wants the convenience of paying back by check so Gristly gets a $50,000 increase in its checkable-deposit acount. The Wahoo bank has acquired an interest-earning asset and has created checkable deposits to "pay" for this asset. Gristly has swapped an IOU for the right to draw an additional $50,000 worth of checks against its checkable deposit in the Wahoo bank. Balance sheet: Assets: -Reserves - $60,000 -Loans - 50,000 -Property - 240,000 Liabilities and Net worth; -Checkable deposits - $100,000 -stock shares - 250,000

Transaction 1: Creating a Bank

Suppose someone decides they want to start a bank for a growing community in Wahoo, Nebraska. Once they have secured a state or national charterr for their bank, they turn to the task of selling, say, $250,000 worth of stock (equity shares) to buyers, both in and out of the community. Their efforts meet success, and the Bank of Wahoo comes into existence (astlest on paper). What does their balance sheet look like? The founders of the bank have sold $250,000 worth of shares of stock in the bank-- some to themselves, some to other ppl. As a result, the bank now has $250,000 in cash on hand and $250,000 worth of stock shares outstanding. The cash is the asset to the bank. The share of stocks outstanding constitute an equal amount of claims that the owners have against the bank's assets. Those shares of stocks constitute the net worth of the bank. Balance sheet: Assets: -cash - $250,000 Liabilities and Networth: -stock shares - $250,000

reserve ratio

The "specified percentage" of checkable-deposit liabilites that a commercial bank must keep as reserves is known as the reserve ratio-- the ratio of the required reserves the commercial bank must keep to the bank's own outstanding checkable-deposit liabilities reserve ratio = commercial bank's required reserves / commercial bank's checkable-deposit liabilites The Fed has the authority to establish and vary the reserve ratio within limits legislated by congress.

balance sheet

The balance sheet of a commercial bank (or thrift) is a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time. Every balance sheet must balance; this means that the value of ASSETS must equal the amount of claims against those assets. The claims shown on balance sheets are divided into two groups: the claims of nonowners againsts the firm's assets called LIABILITIES, and the claims of the owners of the firm against the firm's assets, called NET WORTH. assets = liabilities + net worth

the monetary multiplier

The banking system magnifies any original excess reserves into a larger amount of newly created checkable-deposit money. The checkable-deposit multiplier, or the monetary multiplier results. The monetary multiplier exists bc the reserves and deposits lost by one bank becomes reserves of another bank. It magnifies excess reserves into a larger creation of checkable-deposit money. Monetary multiplier = 1 / required reserve ratio also maxium checkable-deposit creation = excess reserves x monetary multiplier.

What is multiple lending?

The commercial banking system can lend (create money) by a multiple of its excess reserves. There is an entire example of lending, the conclusion is: On the basis of only $80 in excess reserves, the entire commercial banking system is able lend $400, the sum of the ammounts in column 4. The banking system can lend excess reserves by a multiplier of 5 when the reserve ratio is 20%. This happens bc the reserves lost by a single bank are not lost to the banking system as a whole. The reserves lost by bank A are acquired by bank B. Those lost by B are gained by C. C loses to D, D to E, E to F, and so forth. Although reserves can be, and are, lost by individual banks in the banking system, there is no loss of reserves for the banking system as a whole.

Reversibility: the multiple destruction of money

The process we have described is reversible. Just as checkable-deposit money is created when banks make loans, checkable-deposit money is destroyed when loans are paid off. Loan repayment, in effect, sets off a process of multiple destruction of money the opposite of the multiple creation process. Because loans are both made and paid off in any period, the direction of the loans, checkable deposits, and money supply in a given period will depend on the net effect of the two processes. If the dollar amount ofloans made in some period exceeds the dollar amount of loans paid off, checkable deposits will expand and the money supply will increase. But if the dollar amount of loans is less than the dollar amount of loans paid off, checkable deposits will contract and the money supply will decline.

What do reserves do to ASSET AND LIABILITY?

The reserves created in transaction 4 are an asset to the depositing commercial bank because they are a claim this bank has against assets of another institution-- the Federal Reserve Bank. The checkable deposits you get by deposting money into a bank is an asset to you and a liability to the bank. In the same way, the reserves that a commerical bank has by depositing money in a bankers' bank are an asset to the bank and a liability to the Fed.

The Fractional Reserve System

US has a fractional reserve banking system in which only a portion (fraction) of checkable deposits are backed up by cash in bank vault or deposits at the central bank.

Transaction 7: Buying Government Securities

When a commercial bank buys government bonds from the public, the effect is substancially the same as lending. New money is created. Assume Wahoo's balance sheet was as it was at the end of Transaction 5. Now suppose, instead of making the loan, the bank buys $50,000 of government securities from a securities dealer. Gets "securities," and gives the dealer an increase in its checkable-deposit account. Balance Sheet: Assets: -Reserves - $60,000 -Securities - 50,000 -Property - 240,000 Liabilities and Net worth -Checkable deposits - $100,000 -Stock shares - 250,000 Creates money bc the bank accepts government bonds (which are not money) and gives the securities dealer an increase in it checkable deposits (which are money). Finally, the selling of government bonds to the public by a commerical bank-- like the repayment of a loan-- reduces the supply of money.

What is the history behind the fractional reserve system?

When early traders began to use gold in making transaction, they soon realized that it was both unsafe and inconvenient to carry gold to have it weighed and assayed every time they negotiated a transaction. So they began to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a reciept to the depositor. Soon ppl began paying for goods with goldsmith reciepts, which served as the 1st kind of paper money. At this point goldsmiths used a 100 percent reserve system; they backed the money reciepts with the gold they held "in reserve" in their vaults. But bc ppl accepted the reciepts as money, the goldsmiths realized that owners rarely redeemed the gold they had in storage. Then a clever goldsmith hit on the idea that "reciepts" could be issued in excess of the amount of gold held. Goldsmiths would put these reciepts in circulation by making interest-earning loans to others. Borrowers were willing to accept loans in the form of gold reciepts bc the reciepts were accepted as a medium of exchange in the marketplace. This was the beginning of the fractional reserve system. If the goldsmith issued $1 million in reciepts for the actual gold in storage and $1 million in reciepts as loan, then the total value of paper money in circulation would be $2 million-- twice the value of gold.

Why is there a reserve requirement?

You might think the basic purpose of reserves is to enhance the liquidity of a bank and protect commercial bank depositors from losses. Reserves would constitute a ready source of funds from which commercial banks could meet large, unexpected cash withdrawals by depositors. If it is not the purpose of reserves to provide for commercial bank liquidity, then what is their function? Control. Required reserves help the Fed control the lending ability of commerical banks. The Fed can take certain actions that either increase or decrease commercial bank reserves and affect the ability of banks to grant credit. The objective is to prevent banks from overextending or underextending bank credit.