Pump Primer

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Pump Primer

• How do you believe banks create money?

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Module Banking and Money Creation
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• KRUGMAN'S
• MACROECONOMICS for AP

Margaret Ray and David Anderson
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What you will learnin this Module

• The role of banks in the economy
• The reasons for and types of banking regulation
• How banks create money

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Biblical Integration

• What are the priorities in your life? Do you
  desire what the Lord wishes for you, or are they
  caught up in the desire for possessions, status,
  and wealth? (1 Cor 41-2 Eph 515-17)

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The Monetary Role of Banks

• Recall the definition of M1 currency coin
  travelers checks checking deposits
• This last component of M1 is where the role of
  banks comes into focus. If a large part (about
  half) of the money supply is accounted for by
  checking deposits into banks, the banks must play
  a crucial role in the supply of money in the
  economy.

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What Banks Do
Ask a typical bank teller, Do you make money
here? and you will get a most peculiar
look.   Banks are financial intermediaries in
business to earn profit, but in the process they
do make more money. Banks offer a safe place for
depositors to put money and they offer lending
services to borrowers who need money. A saver is
paid interest on his or her savings, and a
borrower is charged interest on his or her
borrowing. Another way of thinking about it is
that banks take liquid assets (savings) to
finance the investment of illiquid assets (homes
and capital equipment).
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What Banks Do
Banks only hold a fraction of their deposits in
reserve. These reserves are there for customers
who wish to withdraw money from their checking
and saving accounts. Banks know that on any given
day, only a small fraction of reserves will be
withdrawn, so the bank can lend the rest and
profit from making those loans. Once loans are
made, there is now more money in circulation, and
the money supply increases.   (Note A simple
tool for analyzing a banks financial position a
T-account.)  
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What Banks Do
A businesss T-account summarizes its financial
position by showing, in a single table, the
businesss assets and liabilities, with assets on
the left and liabilities on the right. Suppose a
small business, Jims Jerseys, produces athletic
uniforms. Jim owns 50,000 in equipment and
10,000 in cloth. These are his assets because he
owns them. Jim has also borrowed 25,000 from the
bank and this is his liability, because he owes
it to someone else, the bank.
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What Banks Do
Jims Jerseys Assets Liabilities Equipment
50,000 Outstanding Loan 25,000 Cloth
10,000 But, this module is focused on
banks, so lets look at a hypothetical banks
T-account.
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What Banks Do
Main Street Bank has 2 million in deposits.
These are liabilities to the bank because they
are simply holding that money for customers who
could withdraw the money at any time. The bank
has 1 million in cash reserves and has made 3
million in loans to borrowers. The cash reserves
and the loans are assets for the bank
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What Banks Do
Main Street Bank Assets Liabilities
Loans 2,000,000 Deposits 2,000,000
Cash Reserves 200,000 In this example, Main
Street Bank is holding 10 (200,000 of 2
million) of deposits in reserve at the bank.
The ratio of (reserves/deposits) is called the
reserve ratio.   The Federal Reserve specifies
how low this ratio may go.   Banks must hold some
deposits in reserve because there is always the
small risk of a bank run.
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The Problem of Bank Runs
Depositors put their money in banks to earn
interest and to keep it safe. But, when the
public begins to fear that the bank itself might
fold, or if they fear for the stability of the
entire financial system, they may want to
withdraw their money. If everyone goes to the
bank to withdraw their deposits, it creates a
bank run. The bank keeps only a small percentage
of the total deposits on reserve, so a bank run
can lead to a self-fulfilling prophesy of the
banks failure. This can be very damaging to
communities and it can spread across the economy.
This is one of the primary reasons for regulating
banks.
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Bank Regulation
Learning from the disastrous bank runs of the
1930s, the U.S. has put in place several
important regulations to insure the public trust
in banks and to lessen the probability of rampant
failures.   1. Deposit Insurance The U.S.
government created the Federal Deposit Insurance
Corporation. The FDIC provides deposit insurance,
a guarantee that depositors will be paid even if
the bank cant come up with the funds, up to a
maximum amount per depositor. Currently, the FDIC
guarantees 250,000 of each depositor (due to
return to 100,000 in 2013).
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Bank Regulation
2. Capital Requirements To reduce the incentive
for excessive risk-taking, regulators require
that the owners of banks hold substantially more
assets than the value of bank deposits. That way,
the bank will still have assets larger than its
deposits even if some of its loans go bad, and
losses will accrue against the bank owners
assets, not the government.   Banks capital
assets - liabilities   For example, Main Street
Bank has capital of 200,000, equal to 9 of the
total value of its assets. In practice, banks
capital is required to equal at least 7 of the
value of their assets.
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Bank Regulation
3. Reserve Requirements The Federal Reserve
establishes the required reserve ratio for banks.
This policy insures that the banks will have a
certain fraction of all deposits on hand in the
event that customers wish to withdraw money.   In
the United States, the required reserve ratio for
most checkable bank deposits is 10.
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Bank Regulation
4. The Discount Window The Federal Reserve
stands ready to lend money to banks via an
arrangement known as the discount window. We will
see later that the interest rate that the Fed
charges on these loans, the discount rate, is one
of the Feds tools of monetary policy.   This
helps a bank that finds itself in a short-term
pinch because many depositors might be
withdrawing their cash in a short period of time.
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Determining the Money Supply
(Remember, the most basic definition of the money
supply (M1) is currency in circulation plus
checking deposits.) When you make a deposit into
your checking account, the bank can make a loan
to a borrower and he/she has part of your money
in his/her checking account. So, by making a
loan, the checking deposits have increased, thus
increasing M1 the money supply.
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How Banks Create Money
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How Banks Create Money
Example Step 1 Eli has 5000 in cash and decides
that he needs to open a checking account at Main
Street Bank.   The t-account shows how the assets
and liabilities change at the bank.
Main Street Bank Assets Liabilities
Loans Nochange Checking deposits
5000 Cash Reserves 5000 Money has
not been created Eli has just moved his money
from cash to checking, so M1 is unaffected.  
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How Banks Create Money
Step 2 Main Street Bank must keep 10 (500) of
Elis deposit in reserve, and makes a 4500 loan
to Max so he can buy some furniture at Melanies
Mega Mart.   The loan to Max has the following
affect on the T-account at Main Street Bank. Main
Street Bank Assets Liabilities Loans
4500 Checking deposits No
change Cash Reserves - 4500  
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How Banks Create Money
Step 3 Melanie banks at the First Bank of
Sherman, so when Melanie receives 4500 from Max
for the furniture, she deposits the money at the
FBS. The affect on the T-account at FBS is shown
below. First Bank of Sherman Assets
Liabilities Loans No change
Checking deposits 4500 Cash Reserves
4500  
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How Banks Create Money
Step 4 The FBS must also keep 10 (450) of
Melanies deposit in reserve, and can then make a
4050 loan to Fekru.   Summary of these four
steps 1. Eli deposits 5000 2. Max borrows 4500
to buy furniture. 3. Melanie receives the payment
for her furniture, and Melanie deposits
4500 at the FBS. 4. The FBS lends 4050 to
Fekru.   So, an initial deposit of 5000 created
new M1 of 4500 4050 8550 after only two
loans.  
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Reserves, Bank Deposits, and the Money
Multiplier
The key to this multiplication of money is that
the bank holds 10 of cash in reserve and lends
the remaining 90. This 90 refers to excess
reserves.   Excess reserves total reserves
required reserves   In the previous example, the
creation of new M1 began with the 4500 loan to
Max. The textbook shows that the money multiplier
is given as   MM 1/rr   Where rr is the
reserve ratio.
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Reserves, Bank Deposits, and the Money
Multiplier
MM tells us how much money will be created if a
bank has 1 of excess reserves.   Back to our
example MM 1/.10 10, so the initial 4500 of
excess reserves would theoretically multiply by a
factor of 10 to 45,000 of newly created M1.   As
noted before, the initial 5000 deposit does not
count as new money.
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The Money Multiplier in Reality
What if Max had not spent his entire 4500 at
Melanies Mega Mart? Or, what if Main Street Bank
had decided to keep 20 of Elis deposit in
reserve and only lend 4100 to Max?   These would
have slowed down the money multiplier process and
something less than 45,000 of new M1 would have
been ultimately created.   Note The text notes
that the actual money multiplier is closer to 1.9
than it is to 10.