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Chapter 32 - Money creation. In this chapter, you will learn to: “Fractional Reserve” system, actual reserves vs. required reserves, how banks create money through granting loans, multiple expansion of loans and money by the banking system, the monetary multiplier.
Chapter 32 Money Creation McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.Allrightsreserved Chapter Objectives Fractional Reserve” system • Actual reserves vs required reserves • How banks create money through granting loans • Multiple expansion of loans and money by the banking system • The monetary multiplier 32-2 Fractional Reserve Banking • The Goldsmiths – Stored gold and gave a receipt – Receipts used as money by public – Made loans by issuing receipts • Characteristics – Banks create money through lending – Banks are subject to “panics” 32-3 Fractional Reserve System • Balance sheet – Assets = Liabilities + Net Worth – Both sides balance • Necessary transactions – Create a bank – Accept deposits – Lend excess reserves 32-4 Creating a Bank • Transaction #1 • Vault cash: cash held by the bank Creating a Bank Balance Sheet 1: Wahoo Bank Assets Cash Liabilities and Net Worth $250,000 Stock Shares $250,000 32-5 Creating a Bank • Transaction #2 • Acquiring property and equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Assets Cash Property Liabilities and Net Worth $10,000 Stock Shares 240,000 $250,000 32-6 Creating a Bank • Transaction #3 • Commercial bank functions – Accepting deposits – Making loans Accepting Deposits Assets Cash Property Balance Sheet 3: Wahoo Bank Liabilities and Net Worth $110,000 240,000 Checkable Deposits Stock Shares $100,000 250,000 32-7 Creating a Bank • Transaction #4 • Depositing reserves in a Federal Reserve bank – Required reserves – Reserve ratio Reserve ratio = Commercial bank’s Required reserves Commercial bank’s Checkable-deposit liabilities 32-8 Reserve Requirements Type of Deposit Current Requirement Statutory Limits Checkable deposits: $0-$9.8 Million $9.3-$43.9 Million Over $43.9 Million Noncheckable nonpersonal savings and time deposits 0% 10 3% 8-14 0-9 • Fed can establish and vary reserve ratio within limits set by Congress • Required reserves help Fed control lending abilities of commercial banks 32-9 Creating a Bank • Transaction #4 • Assume the bank deposits all cash on reserve at the Fed Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Assets Liabilities and Net Worth Cash Reserves $0 Checkable 110,000 Deposits Property 240,000 Stock Shares $100,000 250,000 32-10 Reserve Requirements • Excess reserves – Actual reserves - required reserves • Required reserves – Checkable deposits x reserve ratio • Example: – Checkable deposits $100,000 – Reserve ratio 20% 32-11 Creating a Bank • Transaction #5 • Clearing a check – $50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Assets Reserves Property Liabilities and Net Worth Checkable $60,000 Deposits 240,000 Stock Shares $50,000 250,000 32-12 Money Creating Transactions • Transaction #6a • Granting a loan – $50,000 loan deposited to checking When a Loan is Negotiated Balance Sheet 6a: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $60,000 Checkable Deposits 50,000 240,000 Stock Shares $100,000 250,000 32-13 Money Creating Transactions • Transaction #6b • Using the loan – $50,000 loan cashed After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank Assets Reserves Loans Property Liabilities and Net Worth $10,000 Checkable Deposits 50,000 $50,000 240,000 Stock Shares 250,000 A single bank can only lend an amount equal to their preloan excess reserves 32-14 Money Creating Transactions • Transaction #7 • Bank buys government securities from dealer – Deposits payment into checking Buying Government Securities Balance Sheet 7: Wahoo Bank Assets Reserves Securities Property Liabilities and Net Worth $60,000 Checkable Deposits 50,000 240,000 Stock Shares New money is created $100,000 250,000 32-15 Commercial Banks • Conflicting goals • Earn profit – Make loans to earn interest – Buy securities to earn interest • Maintain liquidity • Alternative? – Overnight bank loans – Federal funds rate 32-16 The Banking System • Multiple-deposit expansion • Assumptions: – 20% required reserves – All banks “loaned up” – Banks lend all of excess reserves • A $100 bill is found and deposited • Multiple deposits can be created 32-17 The Banking System (3) (4) (2) Excess Amount Bank Can Required Reserves Lend; New Money Reserves (1)-(2) Created = (3) Bank (1) Acquired Reserves and Deposits 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… 32-18 The Banking System Bank (1) Acquired Reserves and Deposits Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99 (2) Required Reserves (Reserve Ratio = 2) (3) Excess Reserves (1)-(2) $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 32-19 The Monetary Multiplier Monetary multiplier = Graphic Example required reserve ratio = R New Reserves $100 $80 Excess Reserves $400 Bank System Lending Money Created $20 Required Reserves $100 Initial Deposit 32-20 The Monetary Multiplier • Maximum amount of new money created by single dollar of excess reserves • Higher R, lower m • Reversibility – Making loans creates money – Loan repayment destroys money 32-21 Bank Panics of 1930-1933 • • • • • Before deposit insurance Bank failure led to mass withdrawals Forced loan reduction 25-33% decline in money supply 1933 national bank holiday to evaluate all banks • Contributed to the Great Depression • Regulation protects the system today 32-22 Key Terms • • • • • • • • • fractional reserve banking system balance sheet vault cash required reserves reserve ratio excess reserves actual reserves Federal funds rate monetary multiplier 32-23 Next Chapter Preview… Interest Rates and Monetary Policy 32-24 ... Commercial bank’s Checkable-deposit liabilities 3 2- 8 Reserve Requirements Type of Deposit Current Requirement Statutory Limits Checkable deposits: $ 0-$ 9.8 Million $9. 3-$ 43.9 Million Over $43.9... reserves actual reserves Federal funds rate monetary multiplier 3 2- 23 Next Chapter Preview… Interest Rates and Monetary Policy 3 2- 24 ... deposits 0% 10 3% 8-1 4 0-9 • Fed can establish and vary reserve ratio within limits set by Congress • Required reserves help Fed control lending abilities of commercial banks 3 2- 9 Creating a Bank