Pump Primer How do you believe banks create money?

Pump PrimerPump Primer

• How do you believe banks create money?

KRUGMAN'SMACROECONOMICS for AP*

25

Margaret Ray and David Anderson

ModuleBanking andMoney Creation

What you will learnWhat you will learn

in thisin this ModuleModule::

• The role of banks in the economy

• The reasons for and types of banking regulation

• How banks create money

Biblical IntegrationBiblical Integration

• What are the priorities in your life? Do you desire what the Lord wishes for you, or are they caught up in the desire for possessions, status, and wealth? (1 Cor 4:1-2; Eph 5:15-17)

•Recall the definition of M1 = currency + coin + traveler’s checks + checking deposits

•This last component of M1 is where the role of banks comes into focus. If a large part (about half) of the money supply is accounted for by checking deposits into banks, the banks must play a crucial role in the supply of money in the economy.

The Monetary Role of BanksThe Monetary Role of Banks

What Banks DoWhat Banks Do

Ask a typical bank teller, “Do you make money here?” and you will get a most peculiar look. Banks are financial intermediaries in business to earn profit, but in the process they do make more money.

Banks offer a safe place for depositors to put money and they offer lending services to borrowers who need money. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing. Another way of thinking about it is that banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment).


Banks only hold a fraction of their deposits in reserve. These reserves are there for customers who wish to withdraw money from their checking and saving accounts. Banks know that on any given day, only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. Once loans are made, there is now more money in circulation, and the money supply increases. (Note: A simple tool for analyzing a bank’s financial position: a T-account.)


A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right.

Suppose a small business, Jim’s Jerseys, produces athletic uniforms. Jim owns $50,000 in equipment and $10,000 in cloth. These are his assets because he owns them. Jim has also borrowed $25,000 from the bank and this is his liability, because he owes it to someone else, the bank.


Jim’s JerseysAssets Liabilities

Equipment $50,000 Outstanding Loan $25,000

Cloth $10,000

But, this module is focused on banks, so let’s look at a hypothetical bank’s T-account.


Main Street Bank has $2 million in deposits. These are liabilities to the bank because they are simply holding that money for customers who could withdraw the money at any time. The bank has $1 million in cash reserves and has made $3 million in loans to borrowers. The cash reserves and the loans are assets for the bank


Main Street BankAssets Liabilities

Loans $2,000,000 Deposits $2,000,000 Cash Reserves $200,000

In this example, Main Street Bank is holding 10% ($200,000 of $2 million) of deposits in reserve at the bank.

The ratio of (reserves/deposits) is called the reserve ratio. The Federal Reserve specifies how low this ratio may go. Banks must hold some deposits in reserve because there is always the small risk of a bank run.

The Problem of Bank RunsThe Problem of Bank Runs

Depositors put their money in banks to earn interest and to keep it safe. But, when the public begins to fear that the bank itself might fold, or if they fear for the stability of the entire financial system, they may want to withdraw their money. If everyone goes to the bank to withdraw their deposits, it creates a bank run.

The bank keeps only a small percentage of the total deposits on reserve, so a bank run can lead to a self-fulfilling prophesy of the bank’s failure. This can be very damaging to communities and it can spread across the economy. This is one of the primary reasons for regulating banks.

Bank RegulationBank Regulation

Learning from the disastrous bank runs of the 1930s, the U.S. has put in place several important regulations to insure the public trust in banks and to lessen the probability of rampant failures. 1. Deposit InsuranceThe U.S. government created the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per depositor. Currently, the FDIC guarantees $250,000 of each depositor (due to return to $100,000 in 2013).


2. Capital RequirementsTo reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. Bank’s capital = assets - liabilities For example, Main Street Bank has capital of $200,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets.


3. Reserve RequirementsThe Federal Reserve establishes the required reserve ratio for banks. This policy insures that the banks will have a certain fraction of all deposits on hand in the event that customers wish to withdraw money. In the United States, the required reserve ratio for most checkable bank deposits is 10%.


4. The Discount WindowThe Federal Reserve stands ready to lend money to banks via an arrangement known as the discount window. We will see later that the interest rate that the Fed charges on these loans, the discount rate, is one of the Fed’s tools of monetary policy. This helps a bank that finds itself in a short-term pinch because many depositors might be withdrawing their cash in a short period of time.

Determining the Money SupplyDetermining the Money Supply

(Remember, the most basic definition of the money supply (M1) is currency in circulation plus checking deposits.)

When you make a deposit into your checking account, the bank can make a loan to a borrower and he/she has part of your money in his/her checking account. So, by making a loan, the checking deposits have increased, thus increasing M1; the money supply.

How Banks Create MoneyHow Banks Create Money


Example: Step 1Eli has $5000 in cash and decides that he needs to open a checking account at Main Street Bank. The t-account shows how the assets and liabilities change at the bank. Main Street Bank

Assets Liabilities Loans Nochange Checking deposits + $5000 Cash Reserves + $5000

Money has not been created; Eli has just moved his money from cash to checking, so M1 is unaffected.


Step 2Main Street Bank must keep 10% ($500) of Eli’s deposit in reserve, and makes a $4500 loan to Max so he can buy some furniture at Melanie’s Mega Mart. The loan to Max has the following affect on the T-account at Main Street Bank.

Main Street Bank Assets Liabilities

Loans + $4500 Checking deposits No change Cash Reserves - $4500


Step 3Melanie banks at the First Bank of Sherman, so when Melanie receives $4500 from Max for the furniture, she deposits the money at the FBS. The affect on the T-account at FBS is shown below.

First Bank of ShermanAssets Liabilities

Loans No change Checking deposits + $4500Cash Reserves + $4500


Step 4The FBS must also keep 10% ($450) of Melanie’s deposit in reserve, and can then make a $4050 loan to Fekru. Summary of these four steps:1. Eli deposits $50002. Max borrows $4500 to buy furniture.3. Melanie receives the payment for her furniture, and Melanie deposits $4500 at the FBS.4. The FBS lends $4050 to Fekru. So, an initial deposit of $5000 created new M1 of $4500 + $4050 = $8550 after only two loans.

Reserves, Bank Deposits, andReserves, Bank Deposits, and the Money Multiplier the Money Multiplier

The key to this multiplication of money is that the bank holds 10% of cash in reserve and lends the remaining 90%. This 90% refers to excess reserves. Excess reserves = total reserves – required reserves In the previous example, the creation of new M1 began with the $4500 loan to Max. The textbook shows that the money multiplier is given as: MM = 1/rr Where rr is the reserve ratio.

Reserves, Bank Deposits, andReserves, Bank Deposits, and the Money Multiplier the Money Multiplier

MM tells us how much money will be created if a bank has $1 of excess reserves. Back to our example:MM = 1/.10 = 10, so the initial $4500 of excess reserves would theoretically multiply by a factor of 10 to $45,000 of newly created M1. As noted before, the initial $5000 deposit does not count as new money.

The Money Multiplier in RealityThe Money Multiplier in Reality

What if Max had not spent his entire $4500 at Melanie’s Mega Mart? Or, what if Main Street Bank had decided to keep 20% of Eli’s deposit in reserve and only lend $4100 to Max? These would have slowed down the money multiplier process and something less than $45,000 of new M1 would have been ultimately created. Note: The text notes that the actual money multiplier is closer to 1.9 than it is to 10.

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Pump Primer How do you believe banks create money?