How Banks & Thrifts Create Money

How Banks & Thrifts Create Money Chapter 14

Introduction • Most transaction accounts are created as a result of loans from banks or thrifts • This chapter demonstrates the money creating ability of a single bank and the system as a whole

Goldsmiths • 16th century goldsmiths created safes for holding gold and other precious metals. Receipts were issued for their deposit. • The receipts came to be used as currency as goldsmiths also discovered that not all gold was redeemed • The idea of loaning money also was established with an accompanying interest charge

Fractional Reserve Banking • The idea that there is only a fraction or percentage of gold on hand in relation to the number of receipts issued • The significance is that you had banks that were creating money • Policies regarding this creation must be careful and well thought out to avoid “panics” or “runs” on banks

Bank Reserves • Reserves are kept either with the district Federal Reserve Bank or as cash in a vault • Cash kept on hand as well to meet needs of customers • Required reserves are again, a fraction of deposits • Actual Reserves = Excess + Required • Banks may not loan required reserves

Balance Sheets • All balance sheets must balance • Assets = Liabilities (Claims) • Bank owner claims are referred to as net worth • Items such as reserves, property, loans are assets to the bank • Checkable deposits, capital stock, etc. would be considered liabilities

Bank Transactions • Currency held by the bank is not part of the money supply • Reserve ratio – Ratio of required reserves the bank is obligated to keep in its vault. • The reserve ratio is calculated by dividing the required reserves by the bank’s total checkable deposits

Bank Transactions • Once lending requirements have been set, a bank will “create” money in the form of loans. • Conversely, money is destroyed once the loan has been repaid. • Banks also may buy Government securities from the pubic which also creates money

Profits, Liquidity, & Federal Funds • Profits: Bank profits come primarily from interest on securities they hold and off the interest they earn off of loans they grant • Liquidity: Banks must seek safety by having liquidity to meet cash demands of depositors and check clearing transactions

Profits, Liquidity, & Federal Funds • Federal Funds Rate: Banks borrow from one another in the Federal Funds Market. Rate at which they borrow is the Federal Funds Rate

Multiple Deposit Expansion • Reserves lost by a single bank are not lost by the banking system as a whole. • The result is a system that allows for “the banking system” to lend by a multiple of its reserves. (Monetary Multiplier) • This is calculated by dividing one by the reserve ratio or M=1/R

Multiple Deposit Expansion An individual bank may loan only what they have in their “excess reserves” on a dollar for dollar basis. We use the monetary multiplier to illustrate how much money is created throughout the system w/ a single deposit

How Banks & Thrifts Create Money