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AP Economics. Mr. Bernstein Module 25: Banking and Money Creation March 7, 2014. AP Economics Mr. Bernstein. Banking and Money Creation Objectives - Understand each of the following: The role of banks in the economy The reasons for and types of banking regulation

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ap economics

AP Economics

Mr. Bernstein

Module 25:

Banking and Money Creation

March 7, 2014

ap economics mr bernstein
AP EconomicsMr. Bernstein

Banking and Money Creation

  • Objectives - Understand each of the following:
    • The role of banks in the economy
    • The reasons for and types of banking regulation
    • How banks create money
ap economics mr bernstein1
AP EconomicsMr. Bernstein

How Banks Create Money

  • Banks receive deposits
  • Banks make loans
  • Banks hold reserves against those loans
    • If reserves are 10%, loans can be 10x deposits
    • This effectively creates money
  • Demonstrated by T-Account:
  • Fed sets reserve requirements
ap economics mr bernstein2
AP EconomicsMr. Bernstein

How Banks Create Money: An Example

  • Similar to the Spending Multiplier
ap economics mr bernstein3
AP EconomicsMr. Bernstein

Problem of Bank Runs

  • If public fears a bank may fold and be unable to pay back depositors, they rush to the bank to make withdrawals before others can
  • Since deposits are several times reserves, a bank with solid loans but the subject of rumours may be unable to meet demand for withdrawals
  • Can become a self-fulfilling prophecy
  • Preventing bank runs is a primary reason for bank regulation
ap economics mr bernstein4
AP EconomicsMr. Bernstein

Bank Regulation

  • Deposit Insurance
    • Current FDIC insurance is $250,000 per account
  • Capital Requirements (= Assets – Liabilities)
    • Capital Requirements have been rising since 2008 crisis
  • Reserve Requirements
    • Currently 10% in the USA
  • Discount Window
    • Fed stands as short-term lender to banks in need of capital
ap economics mr bernstein5
AP EconomicsMr. Bernstein

Reserves, Bank Deposits and the Money Multiplier

  • Money Multiplier = 1 / reserve ratio…MM = 1/rr
  • Excess Reserves = Total Reserves - rr
  • MM tells us how

much money can be

created from each $

of Excess Reserves

  • In reality, MM is not

10 – its now < 1.

  • Why?