Principles of Macroeconomics Supplement to Chapter 9

1. Principles of Macroeconomics Supplement to Chapter 9 How Banks Create Money

2. TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS

3. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000 Deposit Added to Vault Cash

4. TRANSACTION 2 Acquiring Property and Equipment $240,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000

5. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property240,000 Capital Stock $250,000

6. TRANSACTION 3 Accepting Deposits $100,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property240,000 Capital Stock $250,000

7. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

8. NOTES: Bank deposits are subject to a reserve requirement. Commercial bank’s required reserves Reserve ratio = Commercial bank’s checkable-deposit liabilities FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

9. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000 Three Important Issues... 1 - Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $110,000 - 20,000 = $90,000 2 – Control of Lending Ability 3 - Asset or Liability to Which Bank?

10. TRANSACTION 4 Deposits at the FED $110,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

11. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

12. TRANSACTION 5 A check is drawn against the bank $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

13. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

14. NOTES: Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

15. TRANSACTION 6 Make a loan from excess reserves $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

16. Making the loan created money! FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $60,000 Loans 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

17. After a check for the $50,000 is drawn against the bank FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

18. TRANSACTION 7 Repaying a loan with cash $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000

19. $50,000 in money supply is destroyed! FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $10,000 Loans 0 Property240,000 Checkable Deposits $ 0 Capital Stock 250,000

20. TRANSACTION 8 (Assume previous balance sheet) Buy Government Securities $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000

21. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000 Bankers pursue two conflicting goals: Profits and Liquidity Use of Federal Funds Market Federal Funds Rate

22. Amount bank can lend - New money created Acquired reserves and deposits Required reserves Excess reserves Bank $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 A B C D E F G H I J K L M N Other banks $100.00 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 21.99 $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 MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system

23. Amount bank can lend - New money created Acquired reserves and deposits Required reserves Excess reserves Bank $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 A B C D E F G H I J K L M N Other banks $100.00 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 21.99 $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 Money destruction works in exactly the same multiple way! MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system

24. 1 = Deposit Multiplier Required reserve ratio Maximum checkable- deposit creation x = Excess reserves Deposit Multiplier THE DEPOSIT MULTIPLIER

25. OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created

26. Leakages exist... Currency Drains Excess Reserves OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created