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AP Macroeconomics

AP Macroeconomics. How Banks Create of Money. Banks can create money!. When you deposit money in a checking account at the bank, does the bank have to keep all your money in the bank vault?

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AP Macroeconomics

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  1. AP Macroeconomics How Banks Create of Money

  2. Banks can create money! • When you deposit money in a checking account at the bank, does the bank have to keep all your money in the bank vault? • The FED requires that banks keep only a certain percentage of your money in the bank vault or on deposit at the FED.

  3. Reserve Ratio (Requirement) • The percent that must be kept in the bank vault or on deposit at the FED is the required reserveratio or reserve requirement. • For example, if the RR is 20%, the bank must keep $200 of your $1000 deposit in the bank vault. • What can the bank do with the other $800 (excess reserves)?

  4. So – how do banks create $? Total Amount of $ created by banking system: $4000

  5. Money Creation Formula • A single bank can create $ by the amount of its excess reserves. • The banking system as a whole can create $ by a multiple of the excess reserves. • MM X ER = Expansion of money • Money Multiplier = 1/RR • Ex. If RR = 20% MM = 1/.20 = 5 • If $1000 is deposited in bank, required reserves are $200; excess reserves are $800. • The banking system as a whole can create: • 5 X $800 = $4000.

  6. New vs Existing $ • If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation (buried treasure), the deposit immediately increases the money supply. • The deposit then leads to further expansion of the money supply through the money creation process. • Total change in MS if initial deposit is new $ = Deposit + $ created by banking system.

  7. New vs. Existing $ • If a deposit in a bank is existing $ (already counted in M1; ex. Currency or checks), depositing the amount does NOT change the MS immediately because it is already counted. • Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposits. • Total change in the MS if deposit is existing $ = banking system created money only.

  8. Factors that weaken the effectiveness of the deposit multiplier: • If bank customers take their loans in cash rather than in new checking account deposits. (cash or currency drains) • If banks fail to loan out all their excess reserves.

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