Money Creation

1. Money Creation When it comes to money, everybody is of the same religion - Voltaire Chapter 12: Money and the Banking System © 2002 Claudia Garcia-Szekely

2. Checking Deposits Coins and Paper Money What is money? What does the Federal Reserve Bank consider money? © 2002 Claudia Garcia-Szekely

3. Liquid Assets Assets in the form of cash (or easily convertible into cash) © 2002 Claudia Garcia-Szekely

4. M1 1,383Billion M2 7,211 Billion M3 10,336 Billion Credit extended to (debt owed by) Currency (754b) Travelers checks (6.6b) Demand deposits at banks(310b) Other demand deposits (312b) M1 Savings deposits Money market deposit accounts Small time deposits Retail-type money market mutual fund balances Overnight repurchase agreements (RPs) Overnight Eurodollars M2 Large time deposits Wholesale-type money market mutual fund balances Term (beyond overnight) RPsTerm Eurodollars Federal government State and local governments Households Non-financial businesses Monetary and Credit Aggregates M3 10,336 (2006 Discontinued) Velocity = Nominal GDP/M1 V = 13,926/1,383= 10 Each dollar was used 10 times during the year M2 7,211 Billion M1 1,383 Billion Velocity of money: Number of times a dollar is used GDP ~ 13,926 Billion

5. First National Bank Currency held outside banks Demand Deposits at banks The Money Supply is + (1,350b) (760b) (590b) Ms = Currency held outside banks + Demand Deposits The amount of money in circulation is the Money Supply © 2002 Claudia Garcia-Szekely

6. The First Banks Goldsmiths © 2002 Claudia Garcia-Szekely

7. Withdrawals Deposits Loans Reserves 20% Reserves 10% Reserves The FED imposes a reserve requirement: r 80% 90% If r = 20% If r = 10% © 2002 Claudia Garcia-Szekely

8. Withdrawals Deposits Loans Reserves 10% The FED imposes a 10% reserve requirement © 2002 Claudia Garcia-Szekely

9. L=D-R D R = D x r The FED imposes a 10% reserve requirement These loans become deposits at another bank © 2002 Claudia Garcia-Szekely

10. Banks are Fully Loaned Up r = 10% R = D x r Deposits 590 Reserves 59 New loans are made. Loans 531 Holding loans outstanding at 531 As loans are paid back, L=D-R 59 in reserves allow banks up to 531 in loans © 2002 Claudia Garcia-Szekely

11. The Supply of Money and the Federal Reserve System How Banks Create Money © 2002 Claudia Garcia-Szekely

12. The bank does not keep all your money in its vault. loans $5,000 First National Bank Your deposit $20,000 $5,000 $8,000 The bank makes loans and holds a portion as reserve in vault. Reserve 2,000 © 2002 Claudia Garcia-Szekely

13. By lending Banks allow several individuals to write checks on the same amount of money… Create Money out of thin air… Lending © 2002 Claudia Garcia-Szekely

14. 20,000 5,000 5,000 8,000 38,000 The Bank has created Money Now you and other three individuals can write checks up to: Only 2,000 “support” 38,000 in spending! The bank holds only 2,000 If all these payments must be made at the same time, the bank does not have enough in reserves. © 2002 Claudia Garcia-Szekely

15. Why is secrecy necessary in banking? © 2002 Claudia Garcia-Szekely

16. Withdrawals Deposits =590 B Loans Reserves =59B In a business based on confidence, when that confidence evaporates, so does the business. 531B There are only $59B in banks’ reserves supporting $590B in deposits…if everyone tries to cash $590 at the same time there is NOT enough money for everyone… © 2002 Claudia Garcia-Szekely

17. Monday, March 10/08 "There is absolutely no truth to the rumors of liquidity problems that circulated today in the market." Bear Stearns Press Release © 2002 Claudia Garcia-Szekely

18. True? On Monday, the firm had about $17 billion in cash. © 2002 Claudia Garcia-Szekely

19. Tuesday, March 11: • In previous weeks, banks such as Goldman Sachs had agreed to stand in for institutions nervous that Bear wouldn't be able to cough up its obligations on deal. • In the morning, Goldman Sachs's sent its clients an e-mail announcing that it would no longer step in for them on Bear deals. © 2002 Claudia Garcia-Szekely

20. TUESDAY, MARCH 11: Bear again tried to reassure investors: “The rumors are false, there is no liquidity crisis. No margin calls. It's nonsense." CFO Molinaro on CNBC. © 2002 Claudia Garcia-Szekely

21. WEDNESDAY, MARCH 12: • When word of the Goldman e-mail leaked out, the floodgates opened. Hedge funds and other clients, eventually running into the hundreds, began yanking their funds. • Bear continued to maintain publicly that all was well. "We don't see any pressure on our liquidity, let alone a liquidity crisis." CEO Alan Schwartz © 2002 Claudia Garcia-Szekely

22. THURSDAY, MARCH 13 • The gravity of the situation finally registered at Bear. Liquidity was plummeting: $2 billion at week's end (from 17 billion on Monday) • Even as the firm frantically negotiated a rescue package with J.P. Morgan, Bear executives continued to try to convince the world that everything was under control. That evening Schwartz contacted a well-known New York hedge fund manager to plead with him to appear on CNBC the next morning and express his confidence in Bear. The hedge fund manager declined politely but wondered why Bear needed a client to convince the world of its health. He wouldn't wonder long.

23. FRIDAY, MARCH 14: IT'S ALL GONE NOW • AT 9 A.M., Bear announced $30 billion in funding provided by J.P. Morgan and backstopped by the government. • Schwartz still fighting reality: "Bear Stearns has been subject to a significant amount of rumor. Customer requests to cash out "accelerated yesterday ... there could be continued liquidity demands that would outstrip liquidity resources." The new loan facility, he said, would restore calm. • Of course, that didn't happen: Bear's stock dropped nearly 40% in the first half-hour of trading. Within days, Bear's 85 years as an independent entity were at an end.

24. 2008 • 200 billion dollar government bail-out of US mortgage lenders Fannie Mae and Freddie Mac • 85 billion dollar loan to US insurance giant AIG • 29 billion dollars to support the bail-out of investment bank Bear Stearns. © 2002 Claudia Garcia-Szekely

25. 700 B Financial Bail Out • US Treasury Secretary Hank Paulson given unlimited authority to buy the "troubled assets“ so banks can "resume the flow of credit to American families and businesses“ • The US government would appoint agents, likely to be Wall Street firms, to manage the purchases. • The Treasury would have "full discretion over the management of assets" which it could "sell at its discretion or may hold assets to maturity". Any cash received "will be returned to the Treasury's general fund for the benefit of US taxpayers". • The price of the assets will be determined "by market mechanisms where possible" but no real market exists for many of these complex financial instruments © 2002 Claudia Garcia-Szekely

26. 700 B Financial Bail Out • Finding a true value will be challenging: • If the government prices them too low, some banks will significantly revalue their assets, increasing the credit crunch and making the situation worse. • Too high, and it will hand a windfall profit to Wall Street firms that speculated on a bail-out - leaving the government open to accusations that it is taking money from tax-payers to bail out rich banks which caused the problem in the first place. © 2002 Claudia Garcia-Szekely

27. When the bank gets that loan… A “Money Multiplier” process should be set in motion… © 2002 Claudia Garcia-Szekely

28. Loan/Deposit $510 New Loan /Deposit $630 Loan/Deposit $567 63 70 Bank B Reserves Bank A Reserves $700 Deposit r=10% 10% 90% 90% 10% 90% 10% Each round a portion(r) of the $700 goes into the vault as reserves…. 57 Bank C Reserves

29. The Change in Deposits = New Loans + Original Deposit Deposits Reserves 700 700(0.1)=70 700(0.9)=630 630(0.1)=63 630(0.9)=567 567(0.1)=57 567(0.9)=510 510(0.1)=51 . . . . . . Loans SUM of New Reserves = 700 the original deposit. SUM of New Deposits = ? © 2002 Claudia Garcia-Szekely

30. The entire 700 deposit becomes reserves All Banks Reserves 700 Deposit=700 All Banks Deposits Each bank holds a portion of the new deposit as reserves and makes loans that become New deposits… ? © 2002 Claudia Garcia-Szekely

31. The Money Multiplier The stream of deposits generated by the original 700 can be written as: 700 + 700 (0.9)+ 700 (0.9)(0.9)+ 700(0.9)(0.9)(0.9)+ … or 700+ 700 (0.9)+ 700 (0.9)2+ 700 (0.9)3+ 700 (0.9)4+… or 700[1+ (0.9) + (0.9)2+ (0.9)3+ (0.9)4+…] © 2002 Claudia Garcia-Szekely

32. 1 1 1 1-0.9 0.1 r Since 0.1= r We can write: Since 1 – 0.9 = 0.1 We can write: The Multiplier Formula This sum of terms can be written: DD = 700 [1+ (0.9) + (0.9)2+ (0.9)3 + (0.9)4 +…] If we keep adding terms…the limit of this sum is: © 2002 Claudia Garcia-Szekely

33. 1 r 1 x D Deposits = 700 0.1 Original Deposit D D = x The Change in Deposits is D Deposits = 10 x 700 = 7,000 © 2002 Claudia Garcia-Szekely

34. 1 1 1 Becomes reserves r r r New Reserves D D = x Original Deposit D D = x The Money Multiplier Money Multiplier Multiple by which deposits increase for every one dollar increase in reserves D R D D = x © 2002 Claudia Garcia-Szekely

35. 1 0.1 D D = x 700 The Money Multiplier Increase in Deposits = 7,000 Of these 7,000 in newly created deposits, only 700 is “really” in reserves and the rest 6,300 are loans: money that does not exist. How many loans were created? D L = D D - D R D L = 7,000- 700 = 6,300 © 2002 Claudia Garcia-Szekely

36. D=7,000 When you deposit $700 the banks create $6,300 out of thin air… All Banks Reserves R=700 Deposit=700 R = r(D) All Banks Deposits Each bank holds a portion of the new deposit as reserves and makes loans that become deposits of 6,300… © 2002 Claudia Garcia-Szekely

37. When a 700 deposit generates loans The increase in deposits +increase in the amount of cash held by the public. And loans generate additional bank deposits… The increase in the money supply (DMs) is: DMs = D deposits + D currency outside banks © 2002 Claudia Garcia-Szekely

38. Money in circulation Money in circulation Deposits D = 590 New Loan New Deposit New Deposit New Loan R = r D 59 = 0.1 D D =590 R = r D 759 = 0.1 D D =7,590 Federal Reserve Bank r = 10% Bank Reserves increase to R = 59+700 R=759 Bank Reserves at Fed R = 59 Or: DD= DR (1/r) DD= 700 (1/0.1) DD= 7,000 New Money 700 D = 590+7,000

39. All Banks Deposits D=590b All Banks Reserves d1= 100b d2= 80b d3=120b R=59b d4= 125b d5= 165b Ms = Currency held outside banks + Demand Deposits (1,350b) (760b) (590b) Ms = 1,376b until “new” money is injected into the system… Only new money is multiplied! When checks are used to make a payment, the money simply changes “owner”

40. All Banks Deposits D=590b d1= 100b d2= 80b d3=120b d4= 125b d5= 165b Where does new Money come from? • The FED : Buying bonds from the public or the Government (Monetizing the Debt). • The FED :lending to banks • The public: money under the matress • Bank’s excessreserves: money that was not circulating as loans before. New Money D= 7,590 700 d6= 7,000 © 2002 Claudia Garcia-Szekely

41. The following is the “T-Account” for the entire banking system. Banks are fully loaned up r= 10% • Reserves for the entire banking system are _____ • Loans for the entire banking system are ________ • If the amount of currency held outside banks by the public is 700b, the Money Supply is __________

42. R=10% Questions for test 1b previously held as currency by public is deposited into the banking system. R=10% R=70 D = 700 DR=1 DD = DR x (10)=10 R = 71 D = 710 L= 630 DL= DD – DR = 9 Currency = 800 Ms = 800 + 700 =1,500 L = 639 Ms = 799 + 710 1509 Ms = 800-1 + 700+10 DMs = +10 + -1 +9 DMs = DD + DCurrency

43. Three Kinds of Reserves • Required Reserves (RR). The amount that must be held by law, the required reserve ratio times deposits: RR = r(D) • Actual Reserves (AR). The amount of reserves actually held by the bank. This could be higher or lower than RR. • Excess Reserves(ER). Any amount held above required reserves. © 2002 Claudia Garcia-Szekely

44. R=10% DR=0 DD = 1 x (10)=10 DL= DD – DR = 10 Questions for test 1b held as excess reserves by banks is used to make loans R=10% AR=71 RR=70 ER=1 R=71 D = 700 AR = 71 D = 710 L= 629 10 – 0 Currency = 800 L = 639 Ms = 800 +700 =1,500 Ms = 800 + 710 1510 Ms = 800+700+10 DMs = +10 + 0 +10 D Ms = DD + D Currency

45. What if some money “leaks” into currency? In our story, the original 20,000 deposit set in motion a chain of loans and deposits at several banks… What if part of the loan is kept as “cash” and only part of it becomes a deposit at a bank? The deposit expansion will be smaller than previously calculated when we assumed that the entire amount of the loans became bank deposits.

46. What if some banks decide to hold more reserves than required? In our story, banks kept ONLY required amount of reserves What if one or more banks in the chain hold more reserves than required? The deposit expansion will be smaller than previously calculated when we assumed that banks only hold the amount of reserves they are required. © 2002 Claudia Garcia-Szekely

47. The deposit expansion depends on: • The amount of Excess Reserves. • Currency leak. Gives the largest change in deposits that can occur if there is no currency leak no excess reserves. The Money Multiplier © 2002 Claudia Garcia-Szekely

48. The following is the “T-Account” for the entire banking system. Banks are fully loaned up r= 7% • The money multiplier is 1/0.07 = 14.28 • Reserves for the entire banking system are 0.07*1,000,000 • Loans for the entire banking system are D-R =1,000,000-70,000=930,000 • If the amount of currency held outside banks by the public is 600,000, the money supply is=D + currency = 1,000,000+600,000=1,600,000

49. The following is the “T-Account” for the entire banking system. Banks are fully loaned up. Currency held outside banks = 500,000. r = 8 % • Suppose that the public deposits in the banking system 100,000 previously held as currency outside banks. • Reserves in the banking system (Increase/decrease/remain the same)__________ by ____________ • Loans in the banking system (Increase/decrease/remain the same)__________ by ____________ • Deposits in the banking system (Increase/decrease/remain the same)__________ by ____________ • The money supply (Increase/decrease/remain the same)__________ by ____________

50. Currency held outside banks = 500,000. r = 8%. • The public deposits in the banking system 100,000 previously held as currency outside banks. • Reserves in the banking system increase by 100,000 • Deposits in the banking system increase by 1,250,000 • Loans in the banking system increase by 1,150,000 • The money supply increase by 1,150,000