How Banks and Thrifts Create

Money

14C H A P T E R

How Banks CreateHow Banks Create MoneyMoney[[MSMS]]M1=Currency+DD of PublicM1=Currency+DD of Public

Banks Banks [thru loans][thru loans] C Create reate MMoreore DDDD

Give me a loan so Give me a loan so there will be more there will be more DD in the system.DD in the system.

“Wow, you mean we can create money out of thin air.?”

Once upon a time there was a gold-smithygold-smithy who offered to store people’s gold in his vault. He issued paper receipts for the gold, and it was not long before the townsfolk used the paper to purchase eggs and beer. The smithy’s paper receipts became as “good as gold.”“good as gold.” Our Smithy was not stupidnot stupid. He said to himself. “I have 2000 ounces of gold“I have 2000 ounces of goldstored in my vault, but in the last year I was never called upon to pay outmore than 100 ounces100 ounces in a single day. What harm could it do if I lent out say,half the goldhalf the gold I now have? I’ll still have more than enough to pay off any depositors that come in for a withdrawal. No one will know the difference. Icould earn 30 additional ounces ofearn 30 additional ounces of goldgold each week. I think I’ll do it.”““The smithy has invented the Fractional Reserve Banking System.”The smithy has invented the Fractional Reserve Banking System.”Advantages of LendingAdvantages of Lending [One disadvantage was the possibility of “bank runs”]1. Depositors haven’t lost money [Goldsmiths paid them instead of other way]2. With the interest you earned you could give some to depositors.3. The loans benefited the economy

The Very Early Days Of BankingThe Very Early Days Of Banking

The fractional banking system began when someone issuedclaims for gold that alreadybelonged to someone else.

GreatestGreatestinventioninventionsincesincesliced breadsliced bread

BALANCE SHEET OF ACOMMERCIAL BANK

ASSETS = LIABILITIES + NET WORTH

The Goldsmiths

Fractional Reserve Banking

System

FORMATION OF ACOMMERCIAL BANK

ASSETS LIABILITIES(OWN) (OWE)

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 1

Creating a bank$250,000 Cash

forCapital Stock

Cash $250,000 Capital Stock $250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

Deposit Added to Vault Cash

Property 250,000 Capital Stock $250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

History of Deposit InsuranceHistory of Deposit Insurance

In 1934, federaldeposit insurance made its debut at$2,500$2,500 to protect the average family’s savings and end thebank runsbank runs that hadshut down businessesand contributed to the Great DepressionGreat Depression.Through the yearsthe coverage rosein $5,000 increments$5,000 incrementsuntil the 70suntil the 70s when itjumped to $40,000.In 19801980, it was raisedto $100,000$100,000.

Property 250,000 Capital Stock $250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 2

AcceptingDeposits

$100,000 Cash

Cash $100,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

Cash $110,000Property 240,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTHNOTES:Bank deposits aresubject to a reserverequirement.

Reserveratio

Cash $100,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

• Actual Reserves $ 100,000• Required Reserves - $ 20,000• Excess Reserves $ 80,000

Cash $100,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

Important Issue...

1 - Excess Reserves = Actual Reserves - Required Reserves

(assume 20% reserve requirement) $100,000 - 20,000 = $80,000

Cash $100,000Property 240,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 3

Depositsat the FED

$100,000 Cash

Cash $ 0Reserves 100,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

Cash $ 0Reserves 110,000Property 240,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 4

A check is drawn against

the bank$50,000

Cash $ 0Reserves 50,000Property 250,000

Checkable Deposits $ 50,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

And What Happens If A Turtle Doesn’t And What Happens If A Turtle Doesn’t Keep Up with His Mortgage PaymentsKeep Up with His Mortgage Payments

Cash $ 0Reserves 50,000Property 240,000

Checkable Deposits $ 50,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

NOTES:Banks create moneyby lending excessreserves and destroyit by loan repayment.Purchasing bondsfrom the public alsocreates money.

Reserves $ 50,000Property 250,000

Checkable Deposits $ 50,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 5

Make a loan from excess

reserves$40,000

Reserves $ 50,000Loans 40,000Property 250,000

Checkable Deposits $90,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

Making the loancreated money!

Reserves $ 10,000Loans 40,000Property 250,000

Checkable Deposits $ 50,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

After a check for the $40,000is drawn against the bank

Reserves $ 50,000Securities 50,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTHTRANSACTION 6

(Assume previous balance sheet)

Buy GovernmentSecurities$50,000

Reserves $ 50,000Securities 50,000Property 250,000

Checkable Deposits $100,000Capital Stock 250,000

FORMATION OF ACOMMERCIAL BANK

ASSETSLIABILITIES AND

NET WORTH

MULTIPLE DEPOSIT EXPANSION PROCESS

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

Amount bankcan lend - Newmoney created

ABCDEFGHIJKLMNOther 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

$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

$400.00Total amount of money created by the banking system

RRRR Excess ReservesExcess Reserves

Total(Actual) ReservesTotal(Actual) Reserves

Dennis Rodman deposits $1 with A 10% RRDennis Rodman deposits $1 with A 10% RR

.1010 cents cents 90 cents90 cents

One DollarOne Dollar

One bank’s loan becomesOne bank’s loan becomesanother bank’s DD.another bank’s DD.

Rodman’sRodman’s

MULTIPLE DEPOSIT EXPANSION PROCESS

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

Amount bankcan lend - Newmoney created

ABCDEFGHIJKLMNOther 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

$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

$400.00Total amount of money created by the banking system

Moneydestruction worksin exactly the same

multiple way!

Maximumcheckable-

depositcreation

= Excessreserves x Monetary

Multiplier

MonetaryMultiplier Required reserve ratio

1

=

THE MONETARY MULTIPLIER

$20Requiredreserves

$100New reserves

$100Initial

Deposit

$400Bank system lending

Money Created

$80Excess

reserves

OUTCOME OF MONEY EXPANSION

$20Requiredreserves

$100New reserves

$100Initial

Deposit

$400Bank system lending

Money Created

$80Excess

reserves

OUTCOME OF MONEY EXPANSION

Leakages exist...

Currency Drains Excess Reserves

Coming Soon...

Monetary Policy

Chapter 15

THE END