Module 25 banking and money creation practice


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Module 25 banking and money creation practice

  2. 2. *COMMERCIAL BANKS CREATE AND DESTROY MONEY*How can a commercial bank createmoney? If it can create money, it candestroy money, too.*We’ll begin with the organization of alocal commercial bank.
  3. 3. *COMMERCIAL BANKS CREATE AND DESTROY MONEY*TRANSACTION 1: Creating a Bank*Suppose the citizens of Nebaj, Quichedecide their town needs a new commercialbank to provide banking services for thatgrowing community. Once they obtain thepermit for their bank, they turn to the task ofselling Q250,000 worth of capital stock(equity shares) to buyers, both in and out ofthe community. The Bank of Nebaj comesinto existence. What does its balance sheetlook like at this stage?
  4. 4. * FORMATION OF A COMMERCIAL BANKThe bank now has Q250,000 worth of capital stockoutstanding. This cash is an asset to the bank.Cash held by a bank is called vault cash. Theseshares of stock outstanding constitute an equalamount of claims that owners have against thebank’s assets. These shares of stock constitutethe net worth of the bank. CREATING A BANK Balance Sheet 1: Nebaj Bank ASSETS LIABILITIES Cash Q250,000 Capital Stock Q250,000
  5. 5. * BUYING PROPERTY AND EQUIPMENTTRANSACTION 2: Acquiring Property andEquipmentThe directors of the bank purchase a building forQ220,000 and pay Q20,000 for office equipment.Now the balance sheet looks like this: ACQUIRING PROPERTY AND EQUIPMENT Balance Sheet 2: Nebaj Bank ASSETS LIABILITIES Cash Q10,000 Capital Stock Q250,000 Property Q240,000
  6. 6. * DEPOSITS AT A COMMERCIAL BANKTRANSACTION 3: Accepting DepositsNow the bank is operating, suppose the citizensand businesses of Nebaj decide to depositQ100,000 in the Nebaj bank. What happens tothe balance sheet? ACQUIRING PROPERTY AND EQUIPMENT Balance Sheet 2: Nebaj Bank ASSETS LIABILITIES Cash Q110,000 Checkable Property Q240,000 Deposits Q100.000 Capital Stock Q250,000
  7. 7. * CHANGE IN COMPOSITION OF THE MONEY SUPPLYNow the there has been no change in theeconomy’s total supply of money as a result ofthis transaction, but a change has occurred in thecomposition of the money supply. Bank money, orcheckable deposits, has increased by Q100,000,and currency held by the public has decreased byQ100,000. Currency held by a bank, is not part ofthe economy’s money supply.A withdrawal of cash will reduce the bank’scheckable deposit liabilities and its holdings ofcash by the amount of the withdrawal, whichwould change the composition, but not the totalsupply, of the money in the economy.
  8. 8. * REQUIRED RESERVESAll commercial banks that provide checkabledeposits must by law keep required reserves.Required reserves are an amount of funds equalto a specified percentage of the bank’s owndeposit liabilities. A bank must keep thesereserve’s on deposit with the Federal ReserveBank in its district or as cash in the bank’s vault.To simplify, we’ll the Bank of Nebaj keeps itsrequired reserves entirely as deposits in the Fed.But remember: the vault cash is counted asreserves, and real-world banks keep a significantportion of their own reserves in their vaults.
  10. 10. * DEPOSITING RESERVES AT THE FEDTRANSACTION 4: Depositing Reserves in aFederal Reserve BankSuppose the required reserve ratio for checkabledeposits in commercial banks is 1/5 or 20percent. By depositing Q20,000 in the FederalReserve Bank, the Nebaj bank will just bemeeting the required reserve ratio between itsreserves and its own deposit liabilities.But suppose that the Nebaj Bank anticipates thatits holdings of the checkable deposits will grow inthe future.
  11. 11. * DEPOSITING RESERVES AT THE FED(2) Vault cash can be counted as reserves, we canassume that all the bank’s cash is deposited inthe Fed and therefore constitutes the commercialbank’s actual reserves. This way, we don’t needto bother adding two assets – “cash” and“deposits at the Fed” – to determine “reserves”.After the Nebaj Bank deposits Q110,000 orreserves, its balance sheet becomes: Depositing Reserves at the Fed Balance Sheet 4: Nebaj Bank ASSETS LIABILITIES Cash Q0.00 Checkable Reserves Q110,000 Deposits Q100,000 Property Q240,000 Capital Stock Q250,000
  12. 12. * EXCESS RESERVESA bank’s excess reserves are found by subtractingits required reserves from its actual reserves: Excess Reserves = actual reserves – required reserves In this case: Actual reserves Q110,000 Required reserves - 20,000 Excess reserves Q 90,000
  13. 13. * EXCESS RESERVESThe only reliable way to compute the excessreserves is to multiply the banks checkable-deposits by the reserve ratio to obtain therequired reserves (Q100,000 X .20 = Q20,000) andthen to subtract the required reserves from theactual reserves listed on the asset side of thebank’s balance sheet.Test your understanding by computing the bank’sexcess reserves from balance sheet 4, assumingthat the required reserve ratio is: (1) 10 percent,(2) 33⅓ percent, and (3) 50 percent.
  14. 14. * CHECK CLEARING PROCESSThe reserves created in transaction 4 are an assetto the depositing commercial bank because theyare a claim this bank has against the assets ofanother institution – the Federal Reserve Bank.The checkable deposit you get by depositingmoney in a commercial bank is an asset to youand a liability to the bank.In the same way, the reserves that a commercialbank establishes by depositing money in abanker’s bank are an asset to that bank and aliability to the Federal Reserve Bank.
  15. 15. * CLEARING A CHECK DRAWN AGAINST THE BANKAssume that Juan Perez, a Nebaj farmer,deposited a substantial portion of the Q100,000 incheckable deposits that the Nebaj bank receivedin Transaction 3. Now suppose that Juan buysQ50,000 of farm machinery from the CaterpillarCompany of Guatemala City. Juan pays for hismachinery by writing a check for Q50,000, againsthis account in the Nebaj Bank, to the CaterpillarCo. How is this check collected or cleared, andwhat effect does the collection of the check haveon the balance sheet of the banks involved in thetransaction?