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Econ789 chapter033
- 1. Money Creation Chapter 33 Copyright Š 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
- 2. 33-2 Balance Sheet ⢠Balance sheet: A list of the assets and liabilities. ⢠Assets: What owned. ⢠Liabilities: What owed. ⢠What do you own? Cash, textbooks, car, etc. What do you owe? Credit card loan, student loan, utility bill?
- 3. 33-3 Bank Assets ⢠Bank assets are what a bank owns or its claims for future payments. ⢠Cash in vault ⢠Deposits at the Federal Reserve Bank ⢠Securities (e.g. Treasury bonds, municipal bonds) ⢠Loans (e.g. Consumer loans, mortgage loans, student loans, commercial loans) ⢠Fixed assets ⢠e.g. Buildings, ATM machines
- 4. 33-4 Bank Liabilities and Capital ⢠Bank liabilities are what a bank owes. ⢠Deposits ⢠Checkable deposits, non-transaction deposits (CDs) ⢠Borrowings include ⢠Loans from other banks: Federal funds ⢠Loans from the Fed: Discount loans ⢠Long-term bonds that a bank issued ⢠Bankâs ownersâ equity is called âcapitalâ or ânet worthâ ⢠Ownersâ equity is the difference between total assets and total liabilities.
- 5. 33-5 Reserves ⢠Reserves: Sum of Vault cash and deposits at the Fed ⢠Required Reserves: The Fed requires banks to keep a certain fraction (required reserve ratio) of deposits at banks. ⢠Excess Reserves: Any extra reserves held by a bank beyond the required reserves.
- 6. 33-6 Required Reserves ⢠Bank of America has $100 million of deposits and holds $25 million of reserves. A required reserve ratio is 20%. ⢠Required reserves are 20% of $100 million deposits, that is $20 million. ⢠Excess reserves are any reserves held by Bank of America over its required reserves, that is $5 million (= $25 million - $20 million).
- 7. 33-7 Bank Balance Sheet ⢠The balance sheet of commercial bank includes various assets and liabilities items. However, for simplicity of analysis, we only focus on the following items in this course. Reserves Securities Loans Deposits Borrowings Capital Assets Liabilities &Ownersâ Equity
- 8. 33-8 Banking Operations ⢠What does a bank do? It does not produce or sell anything. ⢠Basic business of banking is ⢠To borrow funds from depositors ⢠To loan funds to borrowers ⢠Banks make profits by ⢠Charging interests on loans (Revenue) ⢠Paying interests on deposits (Cost)
- 9. 33-9 Banking Operation Example ⢠Bank of American receives $100 deposits (liabilities). ⢠Bank of America is required to keep $20 as required reserves (assets), and the rest ($80) is excess reserve. ⢠Bank of America loans out $80 (assets). ⢠Federal Reserve pays 0.5% on required reserves. ⢠If Bank of America pays 1% on deposits and 1% on loans, will it make profits?
- 10. 33-10 How Bank Make Profits ⢠Banks charge high interest rates on loans and give low interest rates on deposits to make profits. ⢠This difference in interest rates is considered as fee charged on services that the bank provides to its customers.
- 11. 33-11 Fractional Reserve Banking Should banks loan all deposits out or keep them? ⢠Banks need cash at vault (excess reserves) to pay off as depositors request withdrawals of their deposits. ⢠Banks are also required to maintain required reserves. ⢠To make profits, banks loan out the rest. ⢠Fractional reserve banking: a system under which bankers keep as reserves only a fraction of the funds they hold on deposit.
- 12. 33-12 Money Creation Process ⢠What will happen to the funds once loaned out to borrowers? ⢠Borrowers will spend the borrowed funds ($80). ⢠Sellers receive funds, then deposit to his bank, Wells Fargo Bank. ⢠What will Wells Fargo Bank do with deposits ($80)? ⢠Do just like Bank of America, but its deposits are little less â Keeps $16 as required reserves and loans out $64. ⢠The process continues until funds become $0.
- 13. 33-13 Money Creation Process ⢠Where did this process start? ⢠Where did the first depositor get funds to deposit at Bank of America? ⢠Funds are injected by the Federal Reserves . ⢠Federal Reserve purchased a stuff from Mr. Rich and paid $100 to him. ⢠In reality, Federal Reserve may not purchase many stuffs, but securities such U.S. Government bonds (Open Market Operation).
- 14. 33-14 Bank (1) Acquired Reserves and Deposits (2) Required Reserves (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) Bank A $100 $20 $80 $80 Bank B $80 $16 $64 $64 Bank C $64 $12.80 $51.20 $51.20 Bank D $51.20 $10.24 $40.96 $40.96 The process will continue⌠The Banking System LO4
- 15. 33-15 Money Creation Process LO1 ⢠The diagram below summarizes the multiple deposit creation process example. Fed Banking System Public D +$100M L + $80M + $64M + $51M + ... D + $80M + $64M + $51M + ... 1. Initially, the Fed injects $100M, creating excess reserves. 2. Any excess reserves are loaned out. 3. Eventually, they are deposited back to banks.
- 16. 33-16 The Banking System Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks Bank (1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $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 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00LO4
- 17. 33-17 Money Creation Process ⢠Federal Reserveâs $100 injection initiated the process and created deposits in many banks along the process. ⢠â Deposits in process = $80 + $64 + ⌠= $80/0.2 = $400 ⢠Because deposits are parts of money supply (M1), any increase in deposits leads to the same increase in money supply.
- 18. 33-18 Money Multiplier ⢠Money multiplier: m = 1/R ⢠R: required reserve ratio ⢠If R = 20%, m = 5. ⢠â Money supply = m x â Excess Reserves ⢠If m = 5 and an initial change in excess reserve is $80, then 5 x $80 = $400 ⢠Initial $80 excess reserves creates additional $400 of money supply in economy.
- 19. 33-19 The Monetary Multiplier Monetary multiplier = 1 required reserve ratio = 1 R LO5
- 20. 33-20 The Monetary Multiplier ⢠Maximum amount of new money created by a single dollar of excess reserves ⢠Higher R, lower m ⢠Reversibility ⢠Making loans creates money ⢠Loan repayment destroys money
- 21. 33-21 Profits, Liquidity, and the Fed Funds Market ⢠Bank can make more profits by lending as much as possible. ⢠What will bank do if depositors come to withdraw deposits? It must comply. ⢠Banks may maintain liquidity by holding excess reserves and avoid short of cash. ⢠Alternatively, bank may borrow from the Federal Reserves (discount loan) or other banks (Federal funds: Overnight bank loans) LO3
- 22. 33-22 Banking, Leverage, and Financial Instability ⢠Leverage is the use of borrowed money to magnify profits and losses ⢠Modern banks use lots of leverage ⢠Thus small losses can drive banks into insolvency and bankruptcy ⢠Insolvency: Liabilities exceed assets ⢠Bankruptcy: It cannot meet its obligation (deposit withdrawal request for bank).
Editor's Notes
- This chapter explains how the banking system creates money and increases the money supply. The balance sheets of the banks are used to show how different transactions impact the banks and the money supply. You will learn the difference between excess and required reserves. You will learn how the money multiplier impacts the money supply. Lastly, we will discuss the bank panics of the 1930s.
- This table illustrates the creation of new money based on a single $100 deposit made into one bank. Each subsequent bank can lend a smaller portion of $100 after factoring in their reserve requirement, but overall total deposits in all banks will increase.
- The development of a functioning banking system is key to the economic development of any system. Banking developed as early traders recognized that carrying gold around to use in transactions was both unsafe and inconvenient. Goldsmiths would take the gold, store it in a safe place, and give the trader a receipt which could then be used in place of the gold. The trader could give the receipt to another party who could then go to the goldsmith and retrieve the gold. As the system developed, the goldsmiths discovered that owners rarely actually came back for the gold, so some goldsmiths began issuing excess paper receipts as loans to merchants, producers, and really just about anyone whom they felt would pay back the loan. This was the beginning of the fractional reserve system still in use today. The only way that the system can fail is if every depositor demands their funds back at the same time, causing a run on the bank. Todayâs banking system has many safeguards in place to secure deposits and prevent panics from occurring.
- This shows that, in total, the original $100 deposit will end up adding $400 in new money into the system.
- The money multiplier is a key measure in banking that helps to predict the money supply that will be available to drive economic growth. As you can see from the formula, if the reserve requirement is 20%, the money multiplier will be 1 divided by 0.2, which is 5. We can then use the money multiplier multiplied by the excess reserves to determine the maximum checkable-deposit creation that will be provided by the new money entering the system.
- Ironically, one of the items that is slowing current economic growth is people paying down credit card balances and other loans; this is, in effect, removing money from the system.
- Obviously, the events of the past couple of years illustrate the fact that even with the restrictions in place, it is a difficult balancing act for a bank to earn a profit while maintaining sufficient liquidity to handle those periods of lows that naturally occur in the business cycle.
- By using leverage, a bank can use borrowed money to invest which leads to greater profits for investors if things go well but increased losses if things go bad. The government in the past has stepped in to bail out banks who made bad investment decisions leading to a moral hazard. If banks do not have to assume the risk of bad decisions, there is no incentive for them to make more conservative decisions in the future. Bankers have lobbied the government against any attempt to require lower leverage levels so the current regulatory system relies on bank supervisors who attempt to prevent the banks from making bad loans. That system was unable to prevent the 2007-2008 financial crisis.