The document discusses how banks create money through fractional reserve banking. It begins by explaining how goldsmiths in the early days would lend out receipts for gold they held, even though they did not hold all the gold in reserve. This created the fractional reserve system. It then provides examples of how a commercial bank's balance sheet changes as it accepts deposits, makes loans from excess reserves, and purchases assets like government securities. The document also discusses the monetary multiplier effect, where one bank's loans become another bank's deposits, expanding the money supply. It concludes by noting that monetary policy will be covered in the next chapter.

1. How Banks and Thrifts Create Money 14 C H A P T E R

2. How Banks Create Money [ MS ] M1=Currency+DD of Public Banks [thru loans] C reate M ore DD Give me a loan so there will be more DD in the system.

3. “ Wow, you mean we can create money out of thin air.?” Once upon a time there was a gold-smithy who offered to store people’s gold in his vault. He issued paper receipts for the gold, and it was not long before the townsfolk used the paper to purchase eggs and beer. The smithy’s paper receipts 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 gold I 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 gold each week. I think I’ll do it.” “ The smithy has invented the Fractional Reserve Banking System.” Advantages of Lending [One disadvantage was the possibility of “bank runs”] 1. Depositors haven’t lost money [ Goldsmiths paid them instead of other way ] 2. With the interest you earned you could give some to depositors. 3. The loans benefited the economy The Very Early Days Of Banking The fractional banking system began when someone issued claims for gold that already belonged to someone else. Greatest invention since sliced bread

4. BALANCE SHEET OF A COMMERCIAL BANK ASSETS = LIABILITIES + NET WORTH The Goldsmiths Fractional Reserve Banking System

5. FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES (OWN) (OWE)

6. FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock

7. Cash $250,000 Capital Stock $250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH Deposit Added to Vault Cash

8. Property 250,000 Capital Stock $250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH

9. History of Deposit Insurance In 1934, federal deposit insurance made its debut at $2,500 to protect the average family’s savings and end the bank runs that had shut down businesses and contributed to the Great Depression . Through the years the coverage rose in $5,000 increments until the 70s when it jumped to $40,000 . In 1980 , it was raised to $100,000 .

10. Property 250,000 Capital Stock $250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 2 Accepting Deposits $100,000 Cash

11. Cash $100,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH

12. Cash $110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH NOTES: Bank deposits are subject to a reserve requirement. Reserve ratio

13. Cash $100,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH Actual Reserves $ 100,000 Required Reserves - $ 20,000 Excess Reserves $ 80,000

14. Cash $100,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH Important Issue... 1 - Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $100,000 - 20,000 = $80,000

15. Cash $100,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 3 Deposits at the FED $100,000 Cash

16. Cash $ 0 Reserves 100,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH

17. Cash $ 0 Reserves 110,000 Property 240,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 4 A check is drawn against the bank $50,000

18. Cash $ 0 Reserves 50,000 Property 250,000 Checkable Deposits $ 50,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH

19. And What Happens If A Turtle Doesn’t Keep Up with His Mortgage Payments

20. Cash $ 0 Reserves 50,000 Property 240,000 Checkable Deposits $ 50,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH NOTES: Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money.

21. Reserves $ 50,000 Property 250,000 Checkable Deposits $ 50,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 5 Make a loan from excess reserves $40,000

22. Reserves $ 50,000 Loans 40,000 Property 250,000 Checkable Deposits $90,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH Making the loan created money!

23. Reserves $ 10,000 Loans 40,000 Property 250,000 Checkable Deposits $ 50,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH After a check for the $40,000 is drawn against the bank

24. Reserves $ 50,000 Securities 50,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH TRANSACTION 6 (Assume previous balance sheet) Buy Government Securities $50,000

25. Reserves $ 50,000 Securities 50,000 Property 250,000 Checkable Deposits $100,000 Capital Stock 250,000 FORMATION OF A COMMERCIAL BANK ASSETS LIABILITIES AND NET WORTH

26. MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system Bank Acquired reserves and deposits Required reserves Excess reserves Amount bank can lend - New money created 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 26.21 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

27. RR Excess Reserves Total(Actual) Reserves Dennis Rodman deposits $1 with A 10% RR . 10 cents 90 cents One Dollar One bank’s loan becomes another bank’s DD. Rodman’s

28. MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system Bank Acquired reserves and deposits Required reserves Excess reserves Amount bank can lend - New money created 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 26.21 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 Money destruction works in exactly the same multiple way!

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

30. $20 Required reserves $100 New reserves $100 Initial Deposit $400 Bank system lending Money Created $80 Excess reserves OUTCOME OF MONEY EXPANSION

31. $20 Required reserves $100 New reserves $100 Initial Deposit $400 Bank system lending Money Created $80 Excess reserves OUTCOME OF MONEY EXPANSION Leakages exist... Currency Drains Excess Reserves

32. Coming Soon... Monetary Policy Chapter 15

33. THE END