Chapter 10 How Banks Create Money - WordPress.com

Chapter 10 How Banks Create Money - WordPress.com

How banks create money 10-1 Learning objectives Describe the simplified balance sheets of a single bank and the banking system Explain the money-creating abilities of a single bank that is part of a multibank system Explain the money-creating abilities of the banking system as a whole through multiple-deposit expansion, and compare this with the moneycreating abilities of the single bank 10-2 Learning objectives (cont.) Define the monetary (or credit) multiplier Discuss some of the limitations on the banking

systems ability to create deposits and expand the money supply Describe how the banks lending activities may contribute to financial instability and to increased fluctuations in the level of economic activity 10-3 Balance sheet A statement of assets and claims that summarises the financial position of a firm at a point in time Each side balances: Assets are items of economic and financial value Assets = Liabilities + Net worth 10-4

Formation of a bank Transaction (1): The birth of a bank New owners sell $250 000 worth of shares in the bank Assets $ Cash 250 000 Liabilities & Net worth $ Capital stock 250 000 10-5 Formation of a bank (cont.)

Transaction (2): Becoming a going concern Acquisition of property and equipment Assets $ Liabilities & Net worth $ Cash 10 000 Capital stock Property 240 000 250 000 10-6

Formation of a bank (cont.) Transaction (3): Accepting deposits Citizens and businesses deposit $100 000 Change in composition not total supply of money Assets Liabilities & Net worth $ $ Cash 110 000 Deposits 100 000 Property 240 000 Capital stock 250 000 10-7

Formation of a bank (cont.) Required reserve ratio The ratio of reserves to deposits to meet official liquidity requirements Transaction (4): Setting aside required reserves Assume reserve ratio is 20% Bank must keep $20 000 (required reserves) Reserve ratio = banks required reserve banks deposit liabilities 10-8 Formation of a bank (cont.) Bank decides to keep $110 000 (actual reserves), which is $90 000 more than required (excess

reserves) Banks required reserves are 20% of $100 000 Assets $ Liabilities & Net worth $ Cash 0 Deposits 100 000 Reserves 110 000 Capital stock 250 000 Property 240 000 10-9

Formation of a bank (cont.) Transaction (5): Drawing a cheque A citizen who has substantial deposits in the bank draws a cheque for $50 000 to buy goods The seller of the goods deposits the cheque in another bank The banking system as a whole has not lost or gained 10-10 Formation of a bank (cont.) Transaction (5): Drawing a cheque (cont.) Assets $ Reserves 60 000

Property 240 000 Liabilities & Net worth $ Deposits 50 000 Capital stock 250 000 10-11 Creating money Transaction (6): Granting a loan A company borrows $50 000 from the bank Money is created Balance sheet after loan is negotiated:

Assets Liabilities & Net worth $ $ Reserves 60 000 Deposits 100 000 Loans 50 000 Capital stock 250 000 Property 240 000 10-12 Creating money (cont.) Balance sheet after cheque drawn on loan has been cancelled: Assets

Liabilities & Net worth $ $ Reserves 10 000 Deposits 50 000 Loans 50 000 Capital stock 250 000 Property 240 000 Now, bank has no excess reserves 10-13 Creating money (cont.) Transaction (7): Buying government bonds Bank buys $50 000 of government bonds instead

of lending $50 000 Money is created Assets Liabilities & Net worth $ $ Reserves 60 000 Deposits 100 000 Bonds 50 000 Capital stock 250 000 Property 240 000 10-14 The banking system

Multiple banks: multiple-deposit expansion Money is created by a multiple of the banking systems excess reserves 10-15 Multiple-deposit expansion Assume initially: 20% reserve requirement Bank A Accepts a deposit for $100 Does not alter money supply Excess reserves of $80 A loan of $80 is negotiated 10-16

Multiple-deposit expansion (cont.) Balance sheet: Bank A Assets $ Reserves +100 80 Loans +80 Liabilities & Net worth $ Current deposits +100 +80 80

10-17 Multiple-deposit expansion (cont.) Loan cheque of $80 is drawn on Bank A and deposited in Bank B Bank B Gains $80 in reserves and deposits Excess reserves of $64 Loans $64 10-18 Multiple-deposit expansion (cont.) Bank B Assets

$ Reserves 80 64 Loans +80 Liabilities & Net worth $ Current deposits +80 +64 64 Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on

10-19 Multiple deposit expansion process Bank Acquired reserves and deposits 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 26.22 20.98 16.78 13.42

10.74 8.59 6.87 5.50 21.97 Required reserves $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 Excess reserves $80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42

10.74 8.59 6.87 5.50 4.40 17.57 Total amount of money created by the banking system New money created $80.00 64.00 51.20 40.96 32.77 26.22

20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 $400.00 10-20 Multiple-deposit expansion (cont.) Total banking system has created $400 How?

Via the monetary multiplier monetary multiplier = 1 m R = 1 reserve ratio Where m is the monetary multiplier 10-21 Multiple-deposit contraction The multiple credit expansion process is reversible and leads to a multiple reduction in the level

of deposits and hence the supply of money if reserves are withdrawn 10-22 Possible leakages Currency drains Loan may be paid in cash and remain in circulation Transfer of deposits to non-bank financial institutions Excess reserves Individual banks may choose to have larger reserves than required (say 25% instead of 20%) 10-23 Willingness to borrow

For the full multiplier effect to take place: Borrowers must be willing and able to utilise the loans Borrowing is likely to be low during a recession 10-24 Banks and financial instability Banks may contribute to business fluctuations Can exacerbate recession, by holding back on credit expansion May amplify inflationary pressures, by increasing lending and credit creation, during recovery and business cycle peaks 10-25

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