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C hapter 26 Money Creation and the Banking System

C hapter 26 Money Creation and the Banking System. Outline. The fractional reserve system The legal reserve requirement A bank’s balance sheet, its assets and liabilities Demand deposits and bank loans. Outline. The potential money multiplier Bank failure

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C hapter 26 Money Creation and the Banking System

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  1. Chapter 26Money Creation and the Banking System

  2. Outline • The fractional reserve system • The legal reserve requirement • A bank’s balance sheet, its assets and liabilities • Demand deposits and bank loans Gottheil - Principles of Economics, 4e

  3. Outline • The potential money multiplier • Bank failure • The Federal Deposit Insurance Corporation (FDIC) Gottheil - Principles of Economics, 4e

  4. How Banks Create Money Fractional reserve system • A banking system that provides people immediate access to their deposits but allows banks to hold only a fraction of those deposits in reserve. Gottheil - Principles of Economics, 4e

  5. How Banks Create Money The fractional reserve system serves as the basis of all modern banking. Gottheil - Principles of Economics, 4e

  6. How Banks Create Money If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands. Gottheil - Principles of Economics, 4e

  7. How Banks Create Money Balance sheet • The bank’s statement of liabilities (what it owes) and assets (what it owns). Gottheil - Principles of Economics, 4e

  8. How Banks Create Money Banks make a profit on the loans they provide, not on their deposits. Gottheil - Principles of Economics, 4e

  9. How Banks Create Money Legal reserve requirement • The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves. • In the example from the textbook, it is assumed 20%. Gottheil - Principles of Economics, 4e

  10. Balance Sheet Gottheil - Principles of Economics, 4e

  11. Balance Sheet • Bank makes loans for profit. • Example: Matt want to borrow money from PFN for an investment project. PFN lends him $800 (max amount PFN can make under 20% reserve requirement. The bank then opens demand deposit account for him. Gottheil - Principles of Economics, 4e

  12. Balance Sheet after Loans made Gottheil - Principles of Economics, 4e

  13. The Interaction of Deposits and Loans • Suppose Matt hires Charlie to work for him. This service will cost Matt $800. When the job is done, Matt writes out the check to Charlie for $800. Thus, the balance sheet of PFN becomes: Gottheil - Principles of Economics, 4e

  14. The Interaction of Deposits and Loans • Suppose Charlie deposits the check in his bank, PSN. • Below is the balance sheet of PSN. Gottheil - Principles of Economics, 4e

  15. The Interaction of Deposits and Loans • Now PSN makes loans to Betty for its max allowed amount $800*0.8=$640. • Balance sheet of PSN is: Gottheil - Principles of Economics, 4e

  16. The Interaction of Deposits and Loans • Betty then pays her loan $640 to Forrest for his consulting service. • Forrest deposits the check in the bank, PTN. Thus, the balance sheet of PSN is as below. Gottheil - Principles of Economics, 4e

  17. The Interaction of Deposits and Loans • In the meantime, the balance sheet of PTN becomes: • This process can keep going on… Gottheil - Principles of Economics, 4e

  18. How Banks Create Money Banks create money by repeating processes we discuss above. That is , we say bank serve as: • Financial intermediaries • Firms that accept deposits from savers and use those deposits to make loans to borrowers. Gottheil - Principles of Economics, 4e

  19. How Banks Create Money What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. Gottheil - Principles of Economics, 4e

  20. How Banks Create Money What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. • People willing to make demand deposits. Gottheil - Principles of Economics, 4e

  21. How Banks Create Money What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. • People willing to make demand deposits. • Borrows prepared to take out loans. Gottheil - Principles of Economics, 4e

  22. How Banks Create Money Potential money multiplier • The increase in the money supply that is potentially generated by a change in demand deposits. Gottheil - Principles of Economics, 4e

  23. How Banks Create Money Gottheil - Principles of Economics, 4e

  24. How Banks Create Money If the legal reserve requirement is 10 percent, what is the potential money multiplier? • The potential money multiplier “m” = 1/(legal reserve requirement) = 1/0.1 = 10. Gottheil - Principles of Economics, 4e

  25. How Banks Create Money If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $1,000, then what is the maximum potential increase in the money supply (M)? • M = ID/LRR. Gottheil - Principles of Economics, 4e

  26. How Banks Create Money If the legal reserve requirement (LRR) is 20 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)? • M = $1,000/.20 = $5,000. Gottheil - Principles of Economics, 4e

  27. How Banks Create Money Why might the actual increase in the money supply be less than the maximum potential increase in the money supply? • Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system. Gottheil - Principles of Economics, 4e

  28. How Banks Create Money Excess reserves • The quantity of reserves held by a bank in excess of the legally required amount. Gottheil - Principles of Economics, 4e

  29. Excess reserves • Suppose now PFN only makes loans amounted to $400, then its balance sheet eventually will be just: Gottheil - Principles of Economics, 4e

  30. How Banks Create Money If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves. Gottheil - Principles of Economics, 4e

  31. How Banks Create Money Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Required reserves are 0.2 × ($100,000) = $20,000. Gottheil - Principles of Economics, 4e

  32. How Banks Create Money Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Excess reserves = (total reserves) - (required reserves). Gottheil - Principles of Economics, 4e

  33. How Banks Create Money Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Excess reserves = $35,000 - $20,000 = $15,000. Gottheil - Principles of Economics, 4e

  34. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves. Gottheil - Principles of Economics, 4e

  35. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made. Gottheil - Principles of Economics, 4e

  36. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply. Gottheil - Principles of Economics, 4e

  37. Why Banks Sometimes Fail 1. What will happen if too many borrowers are unable to repay their loans? • A bank may fail. Gottheil - Principles of Economics, 4e

  38. Why Banks Sometimes Fail 2. If a bank fails, what will happen to the depositors? • If deposits are not insured by the federal government, then depositors may lose their money. Gottheil - Principles of Economics, 4e

  39. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits. Gottheil - Principles of Economics, 4e

  40. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result. Gottheil - Principles of Economics, 4e

  41. Why Banks Sometimes Fail • To prevent the spreading of panics, the government should step in. • On way is to pay depositors up to the maximum insurable amount. Gottheil - Principles of Economics, 4e

  42. Safeguarding the System Federal Deposit Insurance Corporation (FDIC) • A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $250,000 of deposits. Gottheil - Principles of Economics, 4e

  43. FDIC Historical insurance limits • 1934 - $2,500 • 1935 - $5,000 • 1950 - $10,000 • 1966 - $15,000 • 1969 - $20,000 • 1974 - $40,000 • 1980 - $100,000 • 2008 - $250,000 Gottheil - Principles of Economics, 4e

  44. Safeguarding the System Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection. Gottheil - Principles of Economics, 4e

  45. Federal Deposit Insurance and Moral Hazard Fully insuring deposits leads to a costly side effect known as moral hazard. Gottheil - Principles of Economics, 4e

  46. Federal Deposit Insurance and Moral Hazard Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured. Gottheil - Principles of Economics, 4e

  47. Safeguarding the System In addition to deposit insurance, the FDIC also audits banks to make sure that they use sound banking practices. Gottheil - Principles of Economics, 4e

  48. Safeguarding the System Despite these safeguards, banks still fail each year. Gottheil - Principles of Economics, 4e

  49. EXHIBIT 1 BANK FAILURES: 1930–2000 Gottheil - Principles of Economics, 4e

  50. EXHIBIT 2 BANK FAILURES, SELECTED STATES: 1987–89 Source: Federal Deposit Insurance Corporation, Annual Report, 1989 (Washington, D.C., 1989), p. 11. Gottheil - Principles of Economics, 4e

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