1. Banks create money through the fractional reserve banking system by accepting deposits and making loans. When a bank makes a loan, it credits the borrower's account, increasing the overall money supply. 2. A single commercial bank can multiply the amount of money it creates through the process of accepting deposits and making loans. As more people deposit money and banks continue to loan out deposits, the money supply expands. 3. The money creation process occurs as banks build on one another's actions. When one bank makes a loan, those funds may be deposited in another bank, allowing the second bank to make additional loans and further increasing the money supply through the banking system.

1. CHAPTER 35
Money Creation

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The Fractional Reserve System
A Single Commercial Bank
Money-Creating Transactions of a Commercial Bank
The Banking System: Multiple-Deposit Expansion
The Money Multiplier
35-2
Chapter Contents

3. Money Creation by Banks
• The goldsmiths:
• Stored gold and gave a receipt
• Receipts used as money by public
• Made loans by issuing receipts
• Characteristics:
• Banks create money by accepting deposits and
making loans.
LO35.1
35-3

4. 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?
• Assets = Liabilities + Net Worth
• Both sides balance
13-4

5. 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
13-5

6. 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
• Bank’s owners’ equity is called “capital” or “net worth”
• Owners’ equity is the difference between total assets and total
liabilities.
13-6

7. Reserves
• Reserves: Sum of Vault cash and deposits at the Fed
Reserves = Vault cash + 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.
Excess Reserves = Actual reserves – Required Reserves 13-7
Required
Reserves
=
Required
reserve ratio
Checkable
Deposits
X

8. Example: Required and Excess 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).
13-8

9. Reserve Requirements
LO35.2
Type of Deposit
Current
Requirement
Statutory
Limits
Checkable deposits:
$0 to $16.3 million 0% 3%
$16.3 to $124.2 million 3 3
Over $124.2 million 10 8-14
Noncheckable nonpersonal savings and
time deposits
0 0-9
Reserve Requirements (Reserve Ratios) for Banks and Thrifts, 2019• The Fed can establish
and vary the reserve
ratio within limits set
by Congress.
• Required reserves
help the Fed control
lending abilities of
commercial banks.
35-9

10. Global Perspective 35.1
Source: Reserve Requirements. Board of Governors of the Federal Reserve System, 2018.
LO35.2
35-10

11. A Single Commercial Bank: Transaction 1
• Investors raised $250,000 cash by selling stocks.
• Cash received are recorded as assets (Reserves), while stocks are
counted as owner’s equity (Capital).
LO35.2
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets Liabilities and net worth
Cash
(Reserves)
$250,000
Stock shares
(Capital)
$250,000
35-11

12. A Single Commercial Bank: Transaction 2
• Bank purchases equipment, worth $240,000 and paid by cash.
• Cash decreases from $250,000 to $10,000 by $240,000.
• Property (Fixed assets) is recorded as assets.
LO35.2
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets Liabilities and net worth
Cash (Reserves)
Property (Fixed assets)
$ 10,000
240,000
Stock shares (capital) $250,000
35-12

13. A Single Commercial Bank: Transaction 3
• Bank accepts $100,000 cash as checkable deposits.
• Cash increases from $10,000 to $110,000 by $100,000.
• Checkable deposits are recorded as liabilities (Bank owes to
depositor).
LO35.2
Accepting Deposits
Balance Sheet 3: Wahoo Bank
Assets Liabilities and net worth
Cash (Reserves)
Property (Fixed assets)
$110,000
240,000
Checkable deposits
Stock shares (Capital)
$100,000
$250,000
35-13

14. A Single Commercial Bank: Transaction 4
• Bank deposits all cash to the Federal Reserve bank.
• Cash in vault decreases from $110,000 to $0 by $110,000.
• Deposits at the Fed increases from $0 to $110,000.
LO35.2
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets Liabilities and net worth
Cash (Reserves)
Deposits at Fed (Reserves)
Property (Fixed assets)
$ 0
110,000
240,000
Checkable deposits
Stock shares (Capital)
$100,000
250,000
35-14

15. A Single Commercial Bank: Transaction 5
• Depositor spent $50,000 and wrote a check. The check is cleared at the Fed,
which take $50,00 deposits of bank at the Fed.
• Deposits at the Fed decrease from $110,000 to $60,000 by $50,000.
• Checkable deposits decrease from $100,000 to $50,000 by $50,000.
• At 20% required reserve ratio, with $50,000 of checkable deposits the
required reserves are $10,000 and the excess reserves are $50,000.
LO35.2
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets Liabilities and net worth
Deposits at Fed (Reserves)
Property (Fixed assets)
$ 60,000
240,000
Checkable deposits
Stock shares (Capital)
$ 50,000
250,000 35-15

16. Money Creating Transactions: Transaction 6a
• Bank made $50,000 loan to a customer. It is deposited to the customer’s
checking account.
• Loans are recorded as assets (Note receivable for bank).
• Checkable deposits increase from $50,000 to $100,000 by $50,000.
• Bank can loan up to the amount of its excess reserves ($50,000).
LO35.3
When a Loan Is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets Liabilities and net worth
Reserves
Loans
Property (Fixed assets)
$ 60,000
50,000
240,000
Checkable deposits
Stock shares (capital)
$100,000
250,000
35-16

17. Money Creating Transactions: Transaction 6b
• Borrower wrote $50,000 check and the check is cleared.
• The Fed debit Bank’s account at the Fed, so Reserves decrease from
$60,000 to $10,000 by $50,000.
• Bank debit borrower’s checking account, so checkable deposits decrease
from $100,000 to $50,000 by $50,000.
• Bank’s required reserves are $10,000 (20% of $50,000 checkable deposits)
and bank’s excess reserves are zero. (10,000 - $10,000 = $0).
LO35.3
After a Check Is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets Liabilities and net worth
Reserves
Loans
Property (Fixed assets)
$ 10,000
50,000
240,000
Checkable deposits
Stock shares (capital)
$ 50,000
250,000
35-17

18. Money Creating Transactions: Transaction 7
• Staring from Transaction 5, instead of transaction 6 (Making loan), Bank
buys $50,000 worth of government securities from a dealer.
• Purchased government securities are recorded as assets.
• Bank credits $50,000 to seller’s checking account as payment, so checkbale
deposits increase from $50,000 to $100,000 by $50,000.
LO35.3
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Assets Liabilities and net worth
Reserves
Securities
Property (Fixed assets)
$ 60,000
50,000
240,000
Checkable deposits
Stock shares (capital)
$100,000
250,000
35-18

19. Fractional Reserve Banking
• Banks make profits by charging high interest rates on loans
and giving low interest rates on checkable deposits.
• To make more profits, banks should loan out as much as
possible.
• Banks must maintain required reserves, so they cannot loan
out all checkable deposits.
• Fractional reserve banking: a system under which banks
keep as reserves only a fraction of the funds they hold on
deposit.
13-19

20. Profits, Liquidity, and the Federal Funds Market
• Bank may not loan out all excess reserves to maintain its
liquidity.
• Bank may need some excess reserves (vault cash) just in
case that depositors come back to withdraw.
• If bank does not have enough reserves to meet its
requirement, it can borrow from other banks.
• Federal funds: overnight interbank loans (loans made by
one bank to another bank).
• Federal funds rate: Interest rate on federal funds.
LO35.3
35-20

21. Money Creation Process
• When one bank receives deposits, it initiates a process of creating loans and
deposits among banks.
• When Bank A receives $100 deposits, it loans $80 after keeping $20 of required
reserves (assuming 20% required reserve ratio).
• Borrower from Bank A spends $80 and a seller deposits $80 at Bank B.
• Bank B, with $80 deposits, loans $64 after keeping $16 of required reserves ($80 x
20%).
• Borrower from Bank B spends $64 and a seller deposits $64 at Bank C.
• Bank C, with $64 deposits, loans $51.20 after keeping $12.80 of required reserves
($64 x 20%).
• Borrower from Bank C spends $51.20 and a seller deposits $51.20 at Bank D.
• Bank D ….
• The process continues until an additional loan reaches to $0.
LO35.4
35-21

22. LO35.4
Expansion of the Money Supply by the Commercial
Banking System
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)
Bank A $100.00 (a1) $20.00 $80.00 $ 80.00 (a2)
Bank B 80.00 (a3, b1) 16.00 64.00 64.00 (b2)
Bank C 64.00 (b3, c1) 12.80 51.20 51.20 (c2)
Bank D 51.20 10.24 40.96 40.96
Bank E 40.96 8.19 32.77 32.77
Bank F 32.77 6.55 26.21 26.21
Bank G 26.21 5.24 20.97 20.97
Bank H 20.97 4.20 16.78 16.78
Bank I 16.78 3.36 13.42 13.42
Bank J 13.42 2.68 10.74 10.74
Bank K 10.74 2.15 8.59 8.59
Bank L 8.59 1.72 6.87 6.87
Bank M 6.87 1.37 5.50 5.50
Bank N 5.50 1.10 4.40 4.40
Other banks 21.99 4.40 17.59 17.59
Total amount of money created (sum of the amounts in column 4) $400.00
35-22

23. Money Creation Process
• The diagram below summarizes the multiple deposit
creation process example.
13-23
Fed
Banking System
Public
D +$100M
Loan + $80
+ $64
+ $51
+ ...
Deposit + $80
+ $64
+ $51
+ ...
1. Initially, the Fed
injects $100M,
creating excess
reserves.
2. Any excess reserves
are loaned out. 3. Eventually, they
are deposited back
to banks.
Money Supply

24. Money Creation Process
• When banks make loans and accept deposits, they create money in
economy.
• Federal Reserve’s $100 injection initiated the process and created
deposits in many banks along the process.
• ∆ 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.
13-24

25. Money Multiplier
• Money multiplier: m = 1/R
• R: required reserve ratio
• If R = 20%, m = 5.
• ∆ Money supply = m x ∆ 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.
13-25

26. 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.
LO35.5
35-26
Monetary
multiplier
=
1
required reserve ratio
=
1
R

27. Last Word: 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.
• Insolvency: Liabilities exceed assets
35-27