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Money Creation

Money Creation. The Very Early Days of Banking. Greatest invention since sliced bread. “Wow, you mean we can create money out of thin air.?”. There were more claims to gold than there were ounces of gold. The fractional banking system began when someone issued

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Money Creation

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  1. Money Creation

  2. The Very Early Days of Banking Greatest invention since sliced bread “Wow, you mean we can create money out of thin air.?” There were more claims to gold than there were ounces of gold. The fractional banking system began when someone issued claims for gold that already belonged to someone else. Once upon a time there was a gold-smithy who offered to store people’s gold in his vault. He issued paper receiptsfor the gold, and it was not long before the townsfolk used the paper to purchase eggs and beer. The smithy’s paper receipts[first checks] became as “good as gold.” Our Smithy was not stupid. He said to himself. “I have 2000 ounces of gold stored in my vault, but in the last year I was never called upon to pay out more than 100 ounces in a single day. What harm could it do if I lent out say,half the goldI now have? I’ll still have more than enough to pay off any depositors that come in for a withdrawal. No one will know the difference. I could earn 30 additional ounces of goldeach week. I think I’ll do it.” “The smithy has invented the Fractional Reserve Banking System.” Advantages of Lending[One disadvantagewas the possibility of “bank runs”] 1. Depositors haven’t lostmoney [Goldsmiths paid theminstead of other way] 2. With the interest you earned you could give some to depositors. 3. The loans benefited the communitythru loans.

  3. Give me a loan so there will be more DD in the system. How Banks CreateMoney[MS] MS=Currency + DD of Public Banks [thru loans] Create More DD

  4. How Banks Create Money [Objectives & Vocabulary] 1. Fractional Reserve Banking System – a fraction of DD are kept in reserve (say, 10%) at either the bank’s vault or at the Fed. 2. Vault cash – cash held by a bank (banks rarely keep more than 2% of their RR in cash). 3. Required Reserve(RR) – specified % of DD that banks must keep as RR. 4. Excess Reserves(ER) – amount of money over the RR, which can be loaned out. 5. Total(Actual) Reserves(TR) – RR + ER. 6. Money(Deposit) Multiplier – reciprocal of the RR; or 1/RR = MM. RR = 1/RR 5% = 20 12.5% = 8 16.67%= 6 33.33%= 3 RR = 1/RR 10% 10 20% = 5 25% = 4 40% = 2.5 50% = 2 You could also use these! 7. Balance Sheet – statement of assets & liabilities [assets = liabilities] 8. Discount Rate – when banks borrow from the Fed. [symbolic] (for emergencies) “wholesale price of money” 9. Federal Funds Target Rate – banks borrow from other banks for overnight loans. 10. Prime Rate – when a bank’s prime customers [good credit] get loans. “Retail price of money” 11. Buying Bonds – “buying” bonds means “bigger” MS & “lower interest rates”. 12. Selling Bonds – “selling” bonds means “smaller” MS & “higher interest rates”.

  5. Money Creation with Fractional-Reserve Banking • When a bank makes a loan from its reserves, the money supply increases. (not literally) • The money supply is affected by the amount deposited in banks and the amount that banks loan. • Deposits into a bank are recorded as both assets and liabilities. • The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. • Loans become an asset to the bank.

  6. How does a loan create money? • Remember it doesn’t literally create money. There are the same amount of dollars in the economy. So how does this work. When I say they create money they really create transactions. Let me show you what I mean.

  7. Money Creation • So lets say that you put $100 dollars in a Wellsfargo bank account. The bank when then lend out most of that money. Lets say the reserve requirement is 10%. So the bank can lend out $90 dollars. Someone comes in and wants a loan for $90 dollars to buy an ipod. The bank lends them the money. They then buy the ipod and the person who sold the ipod takes the 90 dollars they just made and puts it in their bank at Bank of America. Bank of America must keep 9 dollars in their vault but they lend out the other 81 dollars. So you can see your $100 dollars creates transactions. This is said to be creating money.

  8. Money Creation with Fractional-Reserve Banking • When one bank loans money, that money is generally deposited into another bank. • This creates more deposits and more reserves to be lent out. • When a bank makes a loan from its reserves, the money supply increases. (not literally)

  9. How Banks and Thrifts CreateMoney

  10. Dennis Rodman deposits $1 with a 10% RR Rodman’s .10 90 cents Excess Reserves RR Total (Actual) Reserves One bank’s loan becomes another bank’s DD. One Dollar PMC = M x ER, so 10 x 90¢ = $9 TMS = PMC[$9] + DD[$1] = $10 [MS= Currency+ DD of Public]

  11. Eva LongoriaDeposits$1 with a 20% RR Eva Longoria’s .20 80 cents Excess Reserves RR Total(Actual) Reserves One Dollar PMC = M x ER, so 5 x 80¢ =$4 TMS = PMC[$4] + DD[$1] = $5 [MS = Currency + DD of Public]

  12. BANKS AND THE MONEY SUPPLY • Reserves are deposits that banks have received but have not loaned out. • In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

  13. BANKS AND THE MONEY SUPPLY • The reserve ratio is the fraction of deposits that banks hold as reserves.

  14. First National Bank Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 Banking Money Creation with Fractional-Reserve • This T-Account shows a bank that… • accepts deposits, • keeps a portion as reserves, • and lends out the rest. • It assumes a reserve ratio of 10%.

  15. Money Creation with Fractional-Reserve Banking • When one bank loans money, that money is generally deposited into another bank. • This creates more deposits and more reserves to be lent out. • When a bank makes a loan from its reserves, the money supply increases. (not literally)

  16. The Money Multiplier • How much money is eventually created by the new deposit in this economy?

  17. The Money Multiplier • The money multiplier is the amount of money the banking system generates with each dollar of reserves.

  18. First National Bank Second National Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier Increase in the Money Supply = $190.00!

  19. The Money Multiplier Original deposit = $100.00 • 1st Natl. Lending = 90.00 (=.9 x $100.00) • 2nd Natl. Lending = 81.00 (=.9 x $ 90.00) • 3rd Natl. Lending = 72.90 (=.9 x $ 81.00) • … and on until there are just pennies left to lend! • Total money created by this $100.00 deposit is $1000.00. (= 1/.1 x $100.00)

  20. The Money Multiplier • The money multiplier is the reciprocal of the reserve ratio: M = 1/R • Example: • With a reserve requirement, R = 20% or .2: • The money multiplier is 1/.2 = 5.

  21. 1 = MM RR Maximum checkable- deposit expansion x = ER THE Money [Deposit] MULTIPLIER The MM is the reciprocal of the RR. Potential money Creation in the Banking System [PMC] MM

  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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 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. 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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $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 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 MULTIPLE DEPOSIT EXPANSION PROCESS RR= 20% Paris Hilton 1st 10 $357 of the $400 Susie RahRah I’m doing the econ rap. Ronald McDonald $400.00 PMC in the banking system [MxER] Reese Witherspoon TMS = $500.00

  25. $1,000DDby Morgan[MS=Currency+DDofPublic] New Deposits [New Reserves] DD New Required Reserves RR=10% DDCreated By New Loans [equal to new ER] Bank Dog that can YoYo $1,000.00 A $100.00 900.00 900.00 One year “all u can eat” hot wings at Hooters B $90.00 900.00 810.00 C $81.00 810.00 729.00 $729.00 for a “cat bodyguard” $72.90 729.00 D 656.10 PMC = $9,000.00 PMC = ER[$900] x M[10] Smoking cat Morgan’s DD + PMC = TMS $1,000.00 +$9,000.00 =$10,000.00 MSgrows by multiple of10

  26. $1,000DDby Rachel[MS=Currency+DDofPublic] Hair care for 1 year New Deposits [New Reserves] DD New Required Reserves RR=20% DD Created By New Loans [equal to new ER] Bank Purchase of a donkey $1,000.00 A $200.00 800.00 800.00 B $160.00 800.00 640.00 C $128.00 640.00 512.00 TwoMonkeys $102.40 512.00 D 409.60 PMC = $4,000.00 PMC = ER[$800 x M[5] A chauffeur dog Rachel’s DD + PMC = TMS $1,000.00 + $4,000.00 = $5,000.00 MSgrows by multiple of5

  27. $1,000DDby Jordan[MS=Currency+DDofPublic] Shark to keep in bathtub New Deposits [New Reserves] DD New Required Reserves RR=25% DD Created By New Loans [equal to new ER] Bank $1,000.00 Prom date w. Linda Blair A $250.00 750.00 750.00 B $188.00 750.00 562.00 Frog with teeth C $140.00 562.00 422.00 Teach Stuart Little how to brush his teeth $105.00 422.00 D 317.00 E $80.00 237.00 317.00 Cat with human teeth PMC = ER[$750] x M[4] PMC = $3,000.00 Jordan’s DD + PMC = TMS $1,000.00 + $3,000.00 = $4,000.00 MSgrows by multiple of4

  28. 1 = Monetary Multiplier Required reserve ratio Maximum checkable- deposit expansion x = Excess reserves Monetary Multiplier THE MONETARY MULTIPLIER

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

  30. 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

  31. Kristen StewartDeposits$1,000In HerBank [RR is 20%] Kristen’s New reserves $800 Excess Reserves $200 RR Kristen [member of the public] $1,000 Initial Deposit $4,000 PMC thru Bank Lending TMS is $5,000

  32. Ashley Olsen Deposits$1,000 in her bank RR = 25% $1,000 New reserves $750 Excess reserves Ashley Olsen’s $250 RR Ashley Olsen deposits$1,000 $3,000 PMCthru bank lending $1,000 Initial Deposit TMS = $4,000

  33. Fedbuys a $1,000Bond fromKristen’sBank New reserves 20% RR Fed $1,000 Excess Reserves Kristen’s $5,000 PMC thru Bank System Lending TMSis $5000

  34. FedBuys A $1,000 Bond From Ashley’s Bank New reserves Ashley Olsen’s $1,000 Excess Reserves 25% RR $4,000 PMCthru Bank Lending TMS is $4,000

  35. Eva’s Bank Borrows $1 From The Fed [20% RR] Fed Eva Longoria’s 0 One Dollar RR Excess Reserves Total(Actual) Reserves One Dollar PMC = M x ER, so 5 x $1 = $5 TMS [$5] = PMC [$5] [MS = currency + DD of Public]

  36. Rodman’s Bank borrows $1 from the Fed [10% RR] Rodman’s Bank Fed One Dollar 0 Excess Reserves RR Total(Actual) Reserves One Dollar PMC = M x ER, so 10 x $1 = $10 TMS [$10] = PMC[$10] [MS=Currency+DDofPublic]

  37. Type 1: Calculate the initial change in Excess Reserves once a bank obtains money. a.k.a. the amount a single Bank can loan from the initial deposit is the ER [DD-RR(Public)] or [All if from Fed] Type 2: Calculate the Potential change in loans [MoneyCreation] in the banking system[PMC][ERxMM] Type 3: Calculate the potential Total change in the Money Supply [TMS] [DD or loan x MM] Type 2 [PMC] and type 3 [TMS] will have the same result if a Bank gets their money from the Fed and not the Public. The 3 Types of Multiple Deposit Expansion Questions

  38. Money Supply=DD +Currencyof thePublic • “PMC”“PMC” “TMS” • ER Loans Crea. In “Potential” • $100[10%RR][1st Bank][1st Bank]SystemTotal MS • Banks/PublicDD [$100] $90$90 $900 $1,000 • Fed /Public/BanksDD[$100] $90$90 $900 $1,000 • [*Fedbuys bonds frompublicwho put the money in theirDD] • Banks/FedFedLoan[$100] $100$100 $1,000 $1,000 • [or sells bonds toFed] • “PMC” “PMC” “TMS” • ER Loans Crea. In “Potential” • $100 [20%RR] [1st Bank][1st Bank]SystemTotal MS • Banks/PublicDD [$100] $80 $80 $400 $500 • Fed/Public/BanksDD[$100]$80$80 $400 $500 • [*Fed buys bonds frompublicwho put the money in theirDD] • Banks/FedFedLoan[$100] $100$100 $500 $500 • [or sells bonds toFed] Long Run Short Run

  39. [No Cash Leakages And Zero Excess Reserves] Assumptions: All monies are deposited in bank checking accounts and become demand deposits [DD]. Every bank lent all its excess reserves, leaving every bank with zero excess reserves. Because we assumed no cash leakages and zero excess reserves, the change in checkable deposits is the maximum possible change. Why Potential [Maximum] Money Creation [PMC]?

  40. 2 Big Exceptions I have seen on AP Test If The FED Buys or Sells bonds it literally affect money supply. The banks don’t have to keep a reserve like if it was a deposit from someone else. So if the fed does it the whole thing gets multiplied out. Also if they ask about demand deposits. You do the whole thing. Because a demand deposit is part of what is put in reserve so you add that to the potential money creation.

  41. Money Creation FRQ - 2009

  42. 3.  [6 pts] Assume that the reserve requirement is 20% & banks hold no excess reserves. (a)  [3 pts] Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following.             (i)  The maximum dollar amount the commercial bank can initially lend             (ii)  The maximum total change in demand deposits in the banking system             (iii)  The maximum change in the money supply. (b) [1 pts] With the 20% RR, assume that the Fed buys $5 million in government bonds on the open market from the public.  As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system. (c) [2 pts] Given the increase in the money supply in part b, what happens to real wages in the short run?  Explain. Answer to 3. (a) [1 pt each for (i) $80, (ii) $500, and (iii) $400] (i) The $100 in DD will result in $80 new ER that the banks can initially lend. (ii) Maximum total DD could be as high as $500. This includes $100 DD in the first bank and a PMC of $400. MM [5] x ER [$80] = PMC of $400. Total DD of $500. (iii) The MS was already $100 as the $100 in cash was part of MS, so this results in an increase in money supply of $400. Answer to 3. (b) Once this $5 million is deposited by the public, $1 million has to be kept in RR and $4 million becomes ER. MM [5] x ER [$4 M] = $20 million increase in the MS in the banking system. The Total MS is now $25 million [DD of $5 & PMC of $20] Answer to 3. (c) The increase in MS results in a decrease in the nominal interest rate, resulting in an increase in QID, and an increase in AD, which pushes prices up [1 pt], therefore a decreasein real wages [1 pt].

  43. NS 31-35 AP Econ[MS = Currrency+ DD of Public] RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS Excess Reserves prior to new currency deposit (DD) = $0 Britney Spears deposits in the banking system = $40million Legal Reserve Requirement[RR] = 20% 31. The $40 million depositof Currencyinto DDwould result in MS staying at ($8/$40/$160) million. [MS composition changed from currency to DD] 32. The $40 million deposit of currency into checking accounts will create ER of ($20/$32/$40) million. 33. The Potential Money Creation of the banking system through loans is ($40/$160/$$200) mil. The Potential TMS [all DDof the public] could be as much as ($40/$160/$200) mil. 34. The RR applies to checkable deposits at (banks/S&Ls/ credit unions/ all depository institutions). 35. If the Duck National Bank has ER of $6,000 & DDof $100,000 what is the size of the bank’s TR if the RR is 25%? ($25,000/$75,000/$31,000) [RR($____)+ER($___)=TR($____) 25,000 31,000 6,000

  44. NS 36-45 [MS = Currrency+DD of Public] 36. A stranger deposits$1,000 in a bank that has a RR of 10%. The maximum possible change in the dollar value of the local bank’s loans would be $______. PMC[MXER] in the banking system is $_____. Potential TMS could become as high as $_______. 37. Suppose a commercial bank hasDD of $100,000 and the RR is 10%. If the bank’s RR & ER are equal, then its TR are ($10,000/$20,000/$30,000). 38. Total Reserves (minus/plus) RR = ER. 39. Suppose the Thunderduck Bank has DDof $500,000& theRR is 10%. If the institution has ER of $4,000 then its TR are ($46,000/$54,000/$4,000). 40. If ER in a bank are $4,000, DDare$40,000, & the RR is 10%, then TR are ($4,000/$8,000). 41. The main purpose of the RR is to (have funds for emergency withdrawals/ influence the lending ability of commercial banks). 42. If I write you a check for $1 & we both have our checking accts at the Poorman Bank, the bank’s balance sheet will (increase/decrease/be unchanged). 43. Banks (create/destroy) money when they make loans and repaying bank loans (create/destroy) money. 44. When a bank loan is repaid the MS is (increased/decreased). 45. The Fed Funds rate is a loan by one bank (to another bank/from the Fed). RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS 900 9,000 10,000

  45. NS 46-47 [MS = Currrency+DD of Public] RR+ER=TR; TR-RR=ER;TR-ER=RR; MXER=PMC; PMC(Public)+DD=TMS; PMC(Fed)=TMS 46. If the RR was lowered [say, from 50% to 10%], the size of the monetary multiplier [MM] would (increase/decrease). Leakages (limitations) of the Money Creating Process 1. Cash leakages [taking part of loan in cash] 2. ER (banks don’t loan it or we don’t borrow] 47. If borrowers take a portion of their loans as cash, the maximum amount by which the banking system increases the MS by lending will (increase/decrease).

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