Banks Creating Money Notes

Banks and the Creation of Money

Bank Balance Sheets

Key Concept Notes for an AP Macro Class

How do banks “create” money?

By lending out deposits that are used multiple times, just like the Consumption Multiplier Effect (1/1-MPC or 1/MPS)

Where do the loans come from?

From depositors who take cash and place it in accounts at banks

How are the amounts of potential loans calculated?

By understanding and applying the bank balance sheet system, also known as a “T-Account” that consists of “assets” and “liabilities” for banks

Bank Liabilities (the right side of the T Account Sheet):

#1 = Demand Deposits (also known as “Checkable Deposits”)(DD)         These are cash deposits from the public.         These are a liability because they belong to the depositors and can be           withdrawn by the depositors.

#2 = Owners Equity (also known as “Stock  Shares”)         These are the values of stocks held by the public ownership of bank           shares.

Key concept for AP concerning Liabilities:   If the demand deposit comes in from someone’s “cash” holdings, then   that demand deposit is already part of the Money Supply (M-1).  The cash   is simply being placed into a bank account.   If the demand deposit comes in from the purchase of bonds (by the Fed)   then this creates new cash and therefore creates new Money Supply (M-1).

Bank Assets (the left side of the T Account Sheet):

#1= Required Reserves (RR)        These are the percentages of demand deposits that must be held in the        vault so that some depositors have access to their money.  Textbooks        show that actual demand deposits can be as low as 3%, but they vary        based on the bank and the amount of the demand deposit.        AP will use 5%, 10%, or 20% for reserves….

#2 = Excess Reserves (ER)        These are the source of new loans.  These amounts will be applied to the        Monetary Multiplier/Reserve Multiplier        NOTE:  DD = RR plus ER

#3 = Bank Property Holdings (Buildings and Fixtures)        These are usually stated as a money value of the bank’s property…

#4 = Securities (Federal Bonds)         These are the bonds previously purchased by the bank, or new bonds         sold to the bank by the Federal Reserve.  These bonds can be         purchased from the bank, turned into cash that immediately becomes         available as “excess reserves”.

#5 = Customer Loans         This can be amounts held by banks from previous transactions, owed to          the bank by prior customers.

Money Creation (Using Excess Reserves)

Banks want to create profit.  They can generate profit by lending the excess reserves and collecting interest payments.  Since each loan will go out into customer’s and business’ accounts, more loans are created in decreasing amounts.  Each successive bank must pull some of the money out for required reserves.  A rough estimate of the number of loan amounts created by any first loan is the “monetary multiplier”.

The Monetary Multiplier (also known as):

Checkable Deposits Multiplier

Reserve Multiplier

Loan Multiplier

The formula is simple:  1divided by the reserve requirement (ratio)   An example = RR = 10% = 1/.1 = Monetary Multiplier of 10.

Excess Reserves are multiplied by the Multiplier to create new loans for the entire banking system and this creates new Money Supply.

Summary of Items to Know

Bank Balance Sheet =

Assets and Liabilities in a T Account

Liabilities =

Demand Deposits

Owner’s Equity (Stock Shares)

Assets =

Required Reserves

Excess Reserves

Bank Property (Buildings and Fixtures)

Securities (Bonds)

Loans

Assets must Equal Liabilities

DD = RR + ER

Money is Created through the Monetary Multiplier

ER x 1/RR (Multiplier)= New Loans throughout the banking system

The Money Supply is affected

Cash from a citizen becomes a DD, but does NOT change the Money Supply The ER from this cash becomes an “immediate” loan amount.

ER x Multiplier become New Loans and DO change the Money Supply

The Fed Buying bonds creates new loans and changes the Money Supply

IF the Fed buys the bonds on the open market, this also becomes a new   Demand Deposit amount. (2009 FRQ) IF the Fed buys bonds from accounts already held by a particular bank,   then the amount only becomes new Excess Reserves (2011 FRQ)

Supplemental Note about Bonds

Bond “prices” move opposite to the changes in interest rates. (2011 FRQ) Higher interest rates will push bond prices downward. (Less Money Supply) Lower interest rates will push bond prices upward. (More Money Supply)