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Discover the process of money creation in commercial banks through various transactions and the formation of assets and liabilities. Understand the importance of reserves, loans, deposits, and the impact on the money supply.
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Principles of Macroeconomics Supplement to Chapter 9 How Banks Create Money
TRANSACTION 1 Creating a bank $250,000 Cash for Capital Stock FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000 Deposit Added to Vault Cash
TRANSACTION 2 Acquiring Property and Equipment $240,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $250,000 Capital Stock $250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property240,000 Capital Stock $250,000
TRANSACTION 3 Accepting Deposits $100,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 10,000 Property240,000 Capital Stock $250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
NOTES: Bank deposits are subject to a reserve requirement. Commercial bank’s required reserves Reserve ratio = Commercial bank’s checkable-deposit liabilities FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000 Three Important Issues... 1 - Excess Reserves = Actual Reserves - Required Reserves (assume 20% reserve requirement) $110,000 - 20,000 = $90,000 2 – Control of Lending Ability 3 - Asset or Liability to Which Bank?
TRANSACTION 4 Deposits at the FED $110,000 Cash FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
TRANSACTION 5 A check is drawn against the bank $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 110,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000
NOTES: Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money. FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Cash $ 0 Reserves 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000
TRANSACTION 6 Make a loan from excess reserves $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000
Making the loan created money! FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $60,000 Loans 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
After a check for the $50,000 is drawn against the bank FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000
TRANSACTION 7 Repaying a loan with cash $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 10,000 Loans 50,000 Property240,000 Checkable Deposits $ 50,000 Capital Stock 250,000
$50,000 in money supply is destroyed! FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $10,000 Loans 0 Property240,000 Checkable Deposits $ 0 Capital Stock 250,000
TRANSACTION 8 (Assume previous balance sheet) Buy Government Securities $50,000 FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000
FORMATION OF A COMMERCIAL BANK LIABILITIES AND NET WORTH ASSETS Reserves $ 60,000 Securities 50,000 Property240,000 Checkable Deposits $100,000 Capital Stock 250,000 Bankers pursue two conflicting goals: Profits and Liquidity Use of Federal Funds Market Federal Funds Rate
Amount bank can lend - New money created Acquired reserves and deposits Required reserves Excess reserves Bank $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 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 MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system
Amount bank can lend - New money created Acquired reserves and deposits Required reserves Excess reserves Bank $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 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 Money destruction works in exactly the same multiple way! MULTIPLE DEPOSIT EXPANSION PROCESS $400.00 Total amount of money created by the banking system
1 = Deposit Multiplier Required reserve ratio Maximum checkable- deposit creation x = Excess reserves Deposit Multiplier THE DEPOSIT MULTIPLIER
OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created
Leakages exist... Currency Drains Excess Reserves OUTCOME OF MONEY EXPANSION $100 New reserves $20 Required reserves $80 Excess reserves $400 Bank system lending $100 Initial Deposit Money Created