Banking and Money Creation

Module 25May 2015

Financial intermediary – uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers.

They cannot lend everything they have, they have to keep some in reserve

Bank reserves – the currency banks hold in their vault plus their deposits at the Federal Reserve

Bank reserves are not part of currency in circulation

What banks do

T-account – a tool for analyzing a business’s financial position by showing, in a single table, the business’s assets and liabilities

What banks do

Figure 25.1 A T-Account for Samantha’s SmoothiesRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Assets are always on the left and liabilities are always on the right

Reserve ratio – is the fraction of bank deposits that a bank holds as reserves

Required reserve ration – the smallest fraction of deposits that the Federal Reserve allows banks to hold

See example next slide

What banks do

Figure 25.2 Assets and Liabilities of First Street BankRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Don’t feed ‘em chili! J/K Only a small fraction of its depositors want to

withdraw their funds on any given day, but if a large fraction of its depositors did want to withdraw their funds during a short period of time, that would be a bank run.

If depositors had $100,000 in the bank, and a car wash has that $100,000 in a loan…if the depositors all wanted their money back and the loan was not due, then it would take time for the bank to sell the loan in order to pay back depositors.

Bank Runs

Pepto Bismal! Sometimes when selling a loan to reimburse

depositors, banks must sell at a loss – say $50,000. Inevitably, this will lead to bank failure because the bank would be unable to pay back its depositors in full.

If trouble starts a-brewing, and people get wind of it, a great many of the depositors will be rushing to the bank to get their deposits back, creating a bank run.

Bank Runs

Deposit insurance – guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account

Reserve requirement – rules set by the Federal Reserve that determine the required reserve ratio for banks

Discount window – an arrangement in which the Federal Reserve stands ready to lend money to banks

Bank Regulation

When Silas deposits $1,000 in a checkable bank account, there is initially no effect on the money supply, currency in circulation falls by $1,000, but checkable bank deposits rise by $1,000. The corresponding entries on the bank’s T-account, depicted in panel a, show deposits initially rising by $1,000 and the bank’s reserves riding by $1,000.

Effects on the Money Supply of Turning Cash into Checkable Deposit at First Street Bank

Figure 25.3 Effect on the Money Supply of Turning Cash into a Checkable Deposit at First Street BankRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

In the second stage, depicted in panel b, the bank holds 10% of Silas’s deposit as reserves and lends out the rest ($900) and its loans increase by $900. Its liabilities, including Silas’s $1,000 deposit are unchanged. The money supply, the sum of checkable bank deposits and currency in circulation has now increased by $900 – the $900 now held by Mary.

Table 25.1 How Banks Create MoneyRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Excess reserves – a bank’s reserves over and above its required reserves

We’ll assume that reserve requirements are 10%The money (in circulation) multiplier would look like this 1000 + 900 + 810 + 729…. = reserve requirement1000+1000x(1-rr) +1000x1000x

An infinite series of this form can be written:

Reserves, Bank Deposits, and the Money Multiplier

Given a reserve of 10% or 0.1, a $1,000 increase in excess reserves will increase the total value of checkable bank deposits by $1000/0.1 = $10,000

If the reserve ratio is 10% then for each $1 held in reserve supports $10 of checkable bank deposits

Monetary base – sum of currency in circulation and bank reserves

Money multiplier - the ratio of the money supply to the monetary base. It indicates the total number of dollars created in the banking system by each $1 addition to the monetary base

The Money Multiplier in Reality

Figure 25.4 The Monetary Base and the Money SupplyRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers