Banks create money!!

Remember that bank deposits are money. Banks create bank

deposits when they make loans.

Creating a BankTo create a bank, you will need to go through

the following 8 steps:

1. Obtain a charter to operate a commercial bank.

2. Raise some financial capital.

3. Buy some equipment and computer programs.

4. Accept deposits

5. Establish a reserve account at a Federal Reserve Bank

6. Clear checks

7. But government securities

8. Make loans

Assets Liabilities

Cash $200,000 Owners' Equity $200,000

Virtual College Bank’s Balance Sheet #1

A bank charter has been obtained, and Virtual College Bank has been able to raise $200,000 from private individuals.

Assets Liabilities

Cash $0  

Equipment $200,000 Owners' Equity $200,000

Virtual College Bank’s Balance Sheet #2

Virtual College Bank uses its financial resources to purchase servers, database, software, etc.

Assets Liabilities

Cash $120,000 Checkable deposits $120,000

Equipment $200,000 Owners' Equity $200,000

Virtual College Bank’s Balance Sheet #3

Virtual College Bank accepts $120,000 in new deposits.

Assets Liabilities

Cash $0  

Reserves at the Dallas FED $120,000 Checkable deposits $120,000

Equipment $200,000 Owners' Equity $200,000

We assume the required reserve ratio is 25 percent. Thus, Virtual College Bank initially has required reserves of $30,000 ($120,000 × .25) excess reserves of $90,000

Virtual College Bank’s Balance Sheet #4

•Virtual College depositor Jay writes a check for $20,000 to buy some computers from Hal’s PCs.

•Hal’s PCs has a checking account with first American Bank.

•Virtual College and First American Banks are both located in the Dallas Federal Reserve district.

•The Dallas FED facilitates the check clearing process.

Assets Liabilities

Reserves at the Dallas FED +$20,000 Checkable deposits +$20,000

Assets Liabilities

  First American Reserves +$20,000

  Virtual College Reserves -$20,000

Assets Liabilities

Reserves at the Dallas FED -$20,000 Checkable deposits -$20,000

(C) Change in Virtual College Bank’s balance sheet

Virtual College Bank

First American Bank

(b) Change in First American Bank’s balance sheet

(a) Change in Dallas Fed’s balance sheet

Federal Reserve Bank of Dallas

•Virtual college Banks wishes to purchase $60,000 in government securities.

•First American Bank wishes to sell $60,000 in government securities.

•Virtual College pays for the securities with a check.

Assets Liabilities

  First American Reserves +$60,000

  Virtual College Reserves -$60,000

(C) Change in Virtual College Bank’s balance sheet

Virtual College Bank

First American Bank

(b) Change in First American Bank’s balance sheet

(a) Change in Dallas Fed’s balance sheet

Federal Reserve Bank of Dallas

Assets Liabilities

Reserves at the Dallas FED +$60,000  

Government securities -$60,000

Assets Liabilities

Reserves at the Dallas FED -$60,000  

Government securities +$60,000

Banks may make in loans amounts up to,

but not exceeding, their holding of excess

reserves.

Assets Liabilities

Reserves at the Dallas FED $40,000 Checkable deposits $100,000

Gov. securities $60,000 Owners' Equity $200,000

Equipment $200,000  

Total assets $300,000 Total liabilities $300,000

Virtual College Bank’s Balance Sheet #5

With a .25 required reserve ratio and $100,000 in checkable deposits, this bank has required reserves of $25,000.

Excess Reserves = Total Reserves – Required Reserves.

Thus for this bank:

Excess Reserves = $40,000 - $25,000 = $15,000

Now Virtual College Bank makes $15,000

in loans. The bank credits the accounts of

loan recipients by $15,000. Keep in the mind that the loans are an asset for the

bank.

Assets Liabilities

Reserves at the Dallas FED $40,000 Checkable deposits $115,000

Gov. securities $60,000 Owners' Equity $200,000

Loans $15,000  

Equipment $200,000  

Total assets $315,000 Total liabilities $315,000

Virtual College Bank’s Balance Sheet #6

After the loans are made and the new deposits (money) are created, required reserves are $28,750 ($115,000 × .25).

The bank now has excess reserves = $11, 250. Why not make more loans?

Virtual College Bank can anticipate that borrowers will quickly spend their

loans by drawing checks on accounts at the bank.

The bank must be prepared for these

withdrawals.

Assets Liabilities

Reserves at the Dallas FED $25,000 Checkable deposits $100,000

Gov. securities $60,000 Owners' Equity $200,000

Loans $15,000  

Equipment $200,000  

Total assets $300,000 Total liabilities $300,000

Virtual College Bank’s Balance Sheet #7

Once borrowers have spent their loans, and checks have cleared, checkable deposits have decreased by $15,000 to $100,000.

Virtual College Bank “made good” on the checks by drawing on its reserve account at the FED.

Excess reserves are now equal to zero.

Virtual College Bank still has loans outstanding of $15,000

Multiple Creation of Bank Deposits

The following illustration of the mechanics of multiple deposit creation is based on the following assumptions:

•Initially, all banks are “loaned up”—that is, have zero excess reserves.

•The required reserve ratio is 25 percent (or .25).

•Proceeds of all checks written are re-deposited in the banking system

Steps in the process1. Tony Soprano deposits $100,000 in cash

into a checking account at Virtual College Bank. The transaction creates a $75,000 excess reserve for Virtual College Bank.

2. Virtual College Bank makes a $75,000 loan to Amy.

3. Amy writes a check for $75,000 to purchase a copy-shop franchise from Barb.

4. Barb deposits a $75,000 check into her account at First American Bank. This transaction creates a $56,250 excess reserve for First American.

5. First American makes a $56,250 loan to Bob.

6. Bob writes a check for $56,250 to Carl to pay off a business loan.

7. Carl deposits the check for $56,250 into his account at Fleet PC. This transaction creates a $42,187 excess reserve for Fleet PC.

8. Fleet PC makes a loan for $42,187 to Emelda.

9. Emelda writes a check for $42,187 to Acme Inc. for restaurant equipment.

10.Acme Inc. deposits the check for $42, 187 into its account at First e-bank. This transaction creates a $31,640 excess reserve for First e-bank.

11.And so on and so on . . .

Round The sequenceThe running tally

Deposit$100,000

Loan$75,000

Reserve$25,000

Deposit$75,000

Loan$56,250

Reserve$18,750

Deposit$56,250

Loan$42,187

Reserve$14,063

1. Virtual College

2. First American

3. Fleet PC

Reserves Loans Deposits

$25,000

$43,750

$57,813

$75,000

$131,250

$173,437

$100,000

$175,000

$231,250

Round The sequenceThe running tally

Reserve$10,547

Deposit$42,187

Loan$31,640

4. First e-bank

Reserves Loans Deposits

$68,360 $273,437

$400,000

$205,077

andso on . . .

$100,000

$300,000

The process summarized

...1 432 LLL

Notice that at each stage of the process the loan is 75 percent (0.75) of the previous loan and the deposit is 75 percent (0.75) of the previous deposit. Let L denote this proportion. Thus the sequence is described by:

The total change in deposits when the process is complete is given by:

L1

1Initial change in reserves

Do the math

000,400$4000,100$25.0

1000,100$

)75.01(

1000,100$

...)75.075.075.01(000,100$

...)42187.05625.075.01(000,100$

...187,42250,56000,75000,100$

32

The Deposit Multiplier The deposit multiplier is the number by which an increase in bank reserves is multiplied to find the resulting increase in bank deposits. That is:

Change in deposits = Deposit multiplier × Change in reserves

The deposit multiplier is linked to the required reserve ratio by the following equation

Deposit Multiplier =1

Required reserve ratio

Open Market Operations

Now we will illustrate how FED open

market operations impact the reserve

positions of commercial banks—

and hence their ability to make loans and

create money.

When the FED buys securities on the open

market, it pays for them with newly created bank

reserves. We will illustrate how it works.

FED Buys Securities

Suppose the FED buys $100 million is securities from Manhattan Commercial Bank. What happens then?

1. The Manhattan commercial bank has $100 million less in securities, and the FED has $100 million more in securities.

2. To pay for the securities, the FED increases Manhattan Commercial Bank’s reserve account at the New York FED by $100 million.

Assets Liabilities

Securities +$100 million  Reserves of Manhattan

Commercial Bank +$100 million  

Manhattan Commercial Bank

Federal Reserve Bank of New York

Assets Liabilities

Securities -$100 million  

Reserves +$100 million

The FED buys securitiesfrom a commercial bank . . .

. . .and pays for the securities by increasing the reserves of the commercial bank .

The FED Buys Securities From a Commercial Bank

The Multiplier Effect of an Open

Market Operation •An open market purchase creates excess reserves.

•Banks lend excess reserves.

•Bank deposits increase.

•The quantity of money increases.

•New money is used to make payments.

•Some of the new money is held as currency.

•Some of the new money remains in deposits at the bank.

•Banks’ required reserves increase

•Excess reserves decrease but remain positive.

Banks lend excess reserves

Excess reserves Banks

deposits increase

Quantity of money increases

New money used to make payments

Open market purchase

Money that remains in deposits

Currency drain

Excess reserves

Required reserves increase

A Round in the Multiplier Process Following an Open Market Operation

Note: Required reserve ratio is 10 percent

The Money Multiplier

basemonetary in Change multiplierMoney money ofquantity in the Change

000,250$000,100$ 5.2money ofquantity in the Change

This version of the multiplier takes into account cash drains:

The total amount of new money created by as a result of an open market operation is described by

purchasemarket Open L-1

1 createdmoney ofQuantity

The monetary base consists of bank reserves and currency in circulation. Thus we have:

Money multiplier

What is L?

)1()1( RCL

Where C is the proportion of new money that is held as currency and R is the required reserve ratio.

In our example, C = 0.33 and R = .10. Thus:

6.0)1.01()33.01( L

Notice that, the value of L is inversely related to the values of C and R

Do the math

000,250$

5.2000,10$4.0

1000,100$

0.6)-(1

1$100,000 createdmoney ofQuantity