This document discusses how banks create money through fractional reserve banking and lending. It explains that banks keep only a portion of deposits as reserves, allowing them to lend out the excess and thereby create new money through the money multiplier effect. As more banks participate in lending, the initial deposit is multiplied across the banking system, with each new deposit creating still more loans and money. A monetary multiplier formula is provided to calculate the maximum increase in money from a given increase in reserves. The system is subject to risks of bank panics if depositors lose confidence and demand withdrawals.

1. Money
Creation
Chapter 32
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives
• “Fractional Reserve” system
• Actual reserves vs. required
reserves
• How banks create money through
granting loans
• Multiple expansion of loans and
money by the banking system
• The monetary multiplier
32-2

3. Fractional Reserve Banking
• The Goldsmiths
–Stored gold and gave a receipt
–Receipts used as money by public
–Made loans by issuing receipts
• Characteristics
–Banks create money through
lending
–Banks are subject to “panics”
32-3

4. Fractional Reserve System
• Balance sheet
–Assets = Liabilities + Net Worth
–Both sides balance
• Necessary transactions
–Create a bank
–Accept deposits
–Lend excess reserves
32-4

5. Assets Liabilities and Net Worth
Creating a Bank
• Transaction #1
• Vault cash: cash held by the
bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Cash $250,000 Stock Shares $250,000
32-5

6. Assets Liabilities and Net Worth
Creating a Bank
• Transaction #2
• Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Cash $10,000 Stock Shares $250,000
Property 240,000
32-6

7. Assets Liabilities and Net Worth
Creating a Bank
• Transaction #3
• Commercial bank functions
–Accepting deposits
–Making loans
Accepting Deposits
Balance Sheet 3: Wahoo Bank
Cash $110,000 Checkable
Deposits $100,000
Property 240,000
Stock Shares 250,000
32-7

8. Creating a Bank
• Transaction #4
• Depositing reserves in a Federal
Reserve bank
–Required reserves
–Reserve ratio
Reserve
ratio =
Commercial bank’s
Required reserves
Commercial bank’s
Checkable-deposit liabilities
32-8

9. Reserve Requirements
Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0-$9.8 Million
$9.3-$43.9 Million
Over $43.9 Million
Noncheckable nonpersonal
savings and time deposits
0%
3
10
3%
3
8-14
0 0-9
• Fed can establish and vary reserve
ratio within limits set by Congress
• Required reserves help Fed control
lending abilities of commercial banks
32-9

10. Assets Liabilities and Net Worth
Creating a Bank
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Cash $0 Checkable
Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves 110,000
• Transaction #4
• Assume the bank deposits all
cash on reserve at the Fed
32-10

11. Reserve Requirements
• Excess reserves
–Actual reserves - required reserves
• Required reserves
–Checkable deposits x reserve ratio
• Example:
–Checkable deposits $100,000
–Reserve ratio 20%
32-11

12. Assets Liabilities and Net Worth
Creating a Bank
• Transaction #5
• Clearing a check
–$50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Checkable
Deposits $50,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
32-12

13. Assets Liabilities and Net Worth
Money Creating Transactions
• Transaction #6a
• Granting a loan
–$50,000 loan deposited to checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Checkable
Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
Loans 50,000
32-13

14. Assets Liabilities and Net Worth
Money Creating Transactions
• Transaction #6b
• Using the loan
–$50,000 loan cashed
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Checkable
Deposits $50,000
Property 240,000 Stock Shares 250,000
Reserves $10,000
Loans 50,000
A single bank can only lend an amount
equal to their preloan excess reserves 32-14

15. Assets Liabilities and Net Worth
Money Creating Transactions
• Transaction #7
• Bank buys government securities
from dealer
–Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Checkable
Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
Securities 50,000
New money is created 32-15

16. Commercial Banks
• Conflicting goals
• Earn profit
–Make loans to earn interest
–Buy securities to earn interest
• Maintain liquidity
• Alternative?
–Overnight bank loans
–Federal funds rate
32-16

17. The Banking System
• Multiple-deposit expansion
• Assumptions:
–20% required reserves
–All banks “loaned up”
–Banks lend all of excess reserves
• A $100 bill is found and deposited
• Multiple deposits can be created
32-17

18. 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
32-18

19. 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
$400.00
The Banking System
32-19

20. The Monetary Multiplier
Monetary
multiplier =
1
required reserve ratio
New Reserves
$100
$20
Required
Reserves
$80
Excess
Reserves
$100
Initial
Deposit
$400
Bank System Lending
Money Created
Graphic
Example
=
1
R
32-20

21. The Monetary Multiplier
• Maximum amount of new money
created by single dollar of excess
reserves
• Higher R, lower m
• Reversibility
–Making loans creates money
–Loan repayment destroys money
32-21

22. Bank Panics of 1930-1933
• Before deposit insurance
• Bank failure led to mass withdrawals
• Forced loan reduction
• 25-33% decline in money supply
• 1933 national bank holiday to
evaluate all banks
• Contributed to the Great Depression
• Regulation protects the system today
32-22

23. Key Terms
• fractional reserve banking system
• balance sheet
• vault cash
• required reserves
• reserve ratio
• excess reserves
• actual reserves
• Federal funds rate
• monetary multiplier
32-23

24. Next Chapter Preview…
Interest Rates
and Monetary
Policy
32-24