Chapter Fifteen: Money Creation

Suppose that the required reserve ratio is 25 percent for commercial banks and there are currently no excess reserves. Then, one bank in the bank system receives a cash deposit of $100,000 for a checking account. What is the maximum amount of money that will be created in the banking system as a result of that that deposit?

$300,000. Maximum deposit expansion equals excess reserves times the monetary multiplier. The $100,000 deposit creates excess reserves of $75,000 because $25,000 are required reserves. The monetary multiplier is 1/.25 or 4. So $75,000 x 4 = $300,000.

Required Reserves

% of checkable deposits banks are required by law to keep at FED

A commercial bank has required reserves of $1 million and checkable-deposit liabilities of $10 million. The reserve ratio is:

10%. If the bank must keep $1 million of their $10 million of checkable deposits the reserve requirement must be 10% (Reserve ratio = Commercial Bank's Required Reserves / Commercial Bank's Checkable-Deposit Liabilities)

A single bank in a multibank system can lend by an amount:

Equal to its excess reserves

New money created by banking system from a loan equals

Monetary Multiplier times Excess Reserves

Actual Reserves

all reserves that the banks keep at the FED

Fed can be

countercyclical

Liquidity is a goal of a banking institution because

depositors may want to withdraw currency from their checkable deposits. Bankers have two conflicting goals: Profit, like any business banks want to earn a profit, and liquidity, banks must be on guard for depositors who want to transform their checkable deposits to currency.

Excess Reserves at the FED

extra reserves at FED that are not required Actual= Required + Excess

David deposits $200,000 in a commercial bank that is subject to a 20 percent legal reserve requirement. The deposit increases the lending capacity of the bank by

$160,000, The bank must retain $40,000 (20% of the deposit) in reserves. The remaining $160,000 is available for lending. The bank must retain $40,000 (20% of the deposit) in reserves. The remaining $160,000 is available for lending.

A commercial bank has actual reserves of $5 million and checkable-deposit liabilities of $20 million. The required reserve ratio is 15 percent. The excess reserves of the bank are

$2,000,000. The bank must keep 15% of its $20 million in deposits as required reserves, or $3,000,000. It has $5,000,000 in actual reserves, so that means it has $2,000,000 in excess reserves ($5,000,000 minus $3,000,000).

Suppose the commercial banking system has $100,000 of checkable deposits and actual reserves of $35,000. If the reserve ratio is 10 percent, the banking system can expand the supply of money by a maximum of

$250,000. If checkable deposits are $100,000 and the reserve ratio is 10%, the required reserves are $10,000. Actual reserves are $35,000 so there is $25,000 of excess reserves. The monetary multiplier is 1/.1 or 10. So the commercial banking system can create $250,000 in new money ($25,000 of excess reserves times 10).

Suppose a bank has checkable deposits of $1,000,000 and the legal reserve ratio is 5 percent. If the institution has excess reserves of $5,000, then its actual reserves are

$55,000, The bank's required reserves are 5% of $1,000,000, or $50,000. Its actual reserves are its required reserves plus its excess reserves, for a total of $55,000.

Bank Balance Sheets

1. Create a bank 2. Acquire property and equipment 3. Accept deposits 4. Deposit reserves at the Fed 5. Clear a check 6a. Negotiate a loan 6b. Draw check on a loan 7. Buy government securities

Money Multiplier equals

1/required reserve ratio If required reserve ratio = 20% Express % in hundredths = .20 Monetary multiplier = 5

The Monetary Multiplier

1/required reserve ratio= 1/R

What is one significant consequence of fractional reserve banking?

Banks are vulunerable to "panics" or "bank runs." If a bank only keeps a fraction of their depositors' money in reserve, then in a panic or a bank run the bank may not have enough money to meet depositor demands.

Federal Funds Rate

Banks hold reserves at the Fed If banks have excess reserves at Fed they can lend them overnight to other banks Federal funds rate is interest rate paid on overnight loans of excess bank reserves

FED-Quantitative Easing (2008-2014)

FED buys bonds or other assets from financial institutions (banks) and pays for them with money The buying of bonds increases bank reserves which allows banks to increase their lending FED bought $3.9 trillion in asset (2008-2014) Quantitative easing is now ended.

10% reserve ratio and $100 deposit

Monetary multiplier 1/.10 = 10 Excess reserves = $90 Maximum checkable deposit expansion = $900 10 x $90 = $900 (money created)

20% Reserve ratio and $100 deposit

Monetary multiplier 1/.20 = 5 Excess reserves = $80 Maximum checkable deposit expansion = $400 5 x $80 = $400 (money created)

25% Reserve Ratio and 100$ Deposit

Monetary multiplier 1/.25 = 4 Excess reserves = $75 Maximum checkable deposit expansion = $300 4 x $75 = $300 (money created)

Excess Reserves

Money is deposited at a bank some is required to be held at the Fed (required reserves) the remainder (excess reserves) is loaned. Example: 20% reserve ratio $100 deposited at bank $20 in required reserves $80 in excess reserves for loan

Required Reserves give FED control

Required Reserves FED are a fraction of checkable deposits. FED purpose is not to protect depositors. It is limited! FED purpose is to control bank lending.

Liquidity

Total bank reserves held at the FED were greater than total checkable deposits The reserve that the banks held at the Fed were no long a fraction of checkable deposits. It was 100 percent or more of checkable deposits. The interest rate in the Federal funds markets fell to zero. LO6 No demand and ample supply

Assume the banking system has no excess reserves with a reserve requirement of 20%. The reserve requirement is then decreased to 10%. As a result of this decrease

banks lending will likely increase. The decrease in the required reserve ratio will provide banks with more reserves that they use to increase loans or acquire other financial assets. Banks will decrease reserves through increased lending.

A bank's assets are are equal to its

networth plus liabilities

Composition

of the money supply changes, but not money supply $100,000 in cash deposited becomes $100,000 in checkable deposits

The goldsmith's ability to create money was based on the fact that:

paper money in the form of gold receipts was rarely redeemed for gold. Most people did not redeem their gold so the paper receipts could be used as money.

Bank lending is

procyclical Increase lending in good times But may be too much Decrease lending in bad times But may be too little

Banks sometimes loan other banks money to meet their required reserves. The interest rate paid on these loans is known as

the Federal funds rate. The Federal funds rate is the rate banks charge each other on overnight loans to meet reserve requirements

When a business owner goes to a commercial bank to deposit cash in a checking account

the composition of the money supply changes. Depositing cash in a checking account changes the composition of money from cash to a checkable deposit. There is no change in the supply of money, only its composition (more checkable deposits and less cash)

When commercial banks sell government securities to the public

the money supply deceases. When a bank sells government securities to the public, it decreases checkable deposits, thus decreases the money supply.