3-10-16

Banks and the Creation of Money

How do banks “create” money?

By lending out deposits.

Where do the loans come from?

From depositors who get cash and place it in their banks.

How are the amounts of potential loans calculated?
By using the balance sheet or the T-account which consists of liabilities and assets

Bank Liabilities
1.Demand Deposits(DD) and Check able Deposits(CD)- Cash deposits from the public. They are a liability because they belong to the depositors and can be withdrawn by the depositors.
2.Owners Equity- These are the values of stocks held by the public ownership of bank shares.
Key Concept for AP concerning Liabilities
1. If the DD comes in from someone's cash holdings then that DD is already part of the money supply.
2. If the DD comes in from the purchase of bonds (by the fed) then this creates new cash and therefore creates new money supply.

Bank Assets
1.Required Reserves (RR)- the percentage of demand deposits that must be held in the vault so that some depositors may have access to their money. Usually 5%, 10%, or 20%. The Fed usually sets it at 10% not 0%.
2. Excess Reserves(ER)- this is the source of new loans. DD=RR+ER
3. Property
4. Securities (bonds) - Bonds that are purchased by the banks or new bonds sold to the banks by the federal reserve. These Bonds can be purchased from the bank, turned into cash that immediately becomes available as excess reserves.
5. Loans Customer's Loans

Reserve Requirement

The Fed requires banks to always have some money readily available to meet consumers’ demand for cash.

The amount , set by the Fed, is the Required Reserve Ratio.

The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out.

Typically the Required  Reserve Ration = 10%

The Three Types of Multiple Deposit Expansion Question

Type 1: Calculate the initial change in excess reserves

• a.k.a. The amount a single bank can loan from the initial deposit

Type 2: Calculate the change in loans in the banking system

Type 3: Calculate the change in the money supply

• Sometimes type 2 and type 3 will have the same result( i.e. no Fed Involvement)

1. Assume that Kim deposits $100 cash from her pocket into her checking account.

Assets	Liabilities
RR= $100*.20=$20	DD= $100
ER= $100-$20=$80	(New Loans)

There's only one person making a deposit so it’s a single bank.

Ai. The maximum dollar amount the bank can initially lend is $80.

Aii. The maximum total change in demand deposits in the banks. (ER*MM)($80*1/0.20)= (new + original) $400+$100 = $500

Aiii. The Maximum change in the money supply ($80*5) = $400

B. Assume that the Federal Reserve buys $5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system.

Assets	Liabilities
RR= $5 million * .20= $1 million	DD= $5 million
ER= $5 million - $1 million = $4 million	(New Loans)

Maximum Increase in the money supply = $25 million

$4 million*(1/0.20)= $20 million + $5 million = $25 million

Add initial if it is more than one bank