Money Creation

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• Money Creation

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Overview
In order to see how monetary policy can be used
to influence economic performance (we saw fiscal
policy before) we first have to look at the
banking system. We will look at some basic
operations of banks. Plus we will see how the
actions of people (the public), Federal Reserve
action, combined with bank operations, leads to
changes in the money supply. Remember we say
that money is basically 1 - currency, and 2 -
checkable deposits.
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Bank Balance sheet
To understand the banking system we will look at
banks from a balance sheet perspective. On a
balance sheet you will find bank 1) assets 2)
liabilities and net worth. Using a mechanism
called a t-account, we have assets on the left
and liabilities and net worth on the right.
assets liabilities NW
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examples of assets and liabilities

• Some assets we will talk about are
• 1) reserves of the bank(BR)
• loans the bank has made(L)
• For now we will mention the liability called
• 1) checkable deposits or demand deposits(D)
• Note remember we said money or M1currency (CU)
  
• checkable deposits (D). By currency, we mean the
  funds in the hands of the nonbank public.
• Lets look at some examples of bank operations.

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currency deposits
A LNW
Say you have 100 in currency and you put it into
your checking account. The bank now has a
liability -gt it owes you 100. But it also has
what are called reserves, in this case the
currency you brought in is put in the bank vault.
D100
BR 100
Note the currency in the vault is not in the
hands of the nonbank public, so is not money, but
now reserves of the bank. In this example the
money supply was not changed, but transformed
from currency to checkable deposits.
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Lets ponder some more what we just had on the
last screen.
When people hold these bills the bills are called
money. When people put the bills into their
checking account the people still have money, but
now in the form of checking account balances.
The bank then has the bills and the bills are
then called reserves!
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currency withdrawal
A LNW
Say you want 100 in currency from your checking
account. The bank no longer has a liability and
it loses an equal amount of reserves, in this
case from the bank vault.
D -100
BR -100
In this example the money supply was not changed,
but transformed from checkable deposits to
currency.
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Imagine the economy is just starting its use of
money. Say the Federal Reserve (FED), the
central bank in the US, has some guys fly around
in a helicopter and they drop 100 single dollar
bills over the land where people live. At this
point the money supply would be 100 and made up
of only currency. If people just used these bills
and never put money in a bank, then the money
supply would stay at 100 unless the FED put more
money in or took money out of the system. A few
potential problems of holding money only in the
form of currency is that it may be lost, or it
could be stolen. Because of this (and a few
other things we do not need to worry about here )
folks put their money into a bank. For now lets
assume people do not want to hold any currency.
So, they put all 100 into a checking account.
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All currency is deposited into banks
A LNW
At this point the money supply is still only 100
but is now made up of checking account balances.
D 100
BR 100
Banks customers as a group usually do not want
all of their deposits back on a certain day. As
an example, maybe on every dollar customers have
in a bank they only want to withdraw 5 cents on a
given day. What I am trying to express here is
that banks have noticed that customers as a group
only take out a fraction of their deposits on a
given day.
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Lets note a few ideas. Bank reserves are held
because the bank has to be able to give you these
bills if you so desire (and you have balances in
your account otherwise they try to put you in
jail). Bank reserves do not earn the bank any
interest or other gain other than keeping
customers happy by being able to give out bills
when desired. Banks have noticed that at any
point in time depositors do not want all their
money to be transformed back from checking
account balances to currency. With these three
things in mind banks have discovered that they
can lend out some of the bank reserves and then
interest can be charged.
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By remembering what I have here you can score
some points on the next few exams. If banks
always kept all the reserves in the bank, we
would have a 100 reserve banking systems. When
banks lend some of the reserves and thus only
keep a fraction of its reserves the banking
system becomes a fractional reserve banking
system. Lets assume banks desire to keep in
reserve .20 of the deposits obtained. This
means the banks will lend out the rest. Also
remember we said the public does not want to hold
currency at this time. Lets next see what
happens in the banking system when bank loans are
made.
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Bank loan
I have plus signs and minus signs to denote
changes in these amounts.
A LNW
At the top you see what the banking system looks
like when the public deposits the 100. Next you
see how the loan is made. Since the bank wants
to hold 20 of deposits as reserves it loans 80
by creating an asset called loans and adds to
checkable deposits for the person who gets the
loan. The third point is the person with the loan
spends the money and the bank loses an equal
amount of reserves. At the bottom here you see
the final position for the bank. The 100 in new
deposits will support 80 in loans.
D 100
BR 100
A LNW
L 80
D 80
A L NW BR -80 D -80
A LNW
BR 20 L 80
D 100
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Bank loan is money creation
At any point in time the bank can only lend out
what it has in excess reserve. The bank notes
what is excess over a period of time. The bank
we saw before had excess reserves of 80 and lent
out 80. Once a bank loan is made, a process is
started in the economy and the process culminates
in a multiple expansion of the money supply.
Multiple here means more than the amount that
occurred at first. Lets now turn to the process
of multiple deposit expansion.
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Round 2

A LNW
The person who obtained the first loan bought
something. The seller of that stuff gets the
check and deposits it in the bank. We see that
first here. Next you see that since the bank
wants to only hold 20 of deposits as reserves it
loans .8(80) 64 by creating an asset called
loans and adds to checkable deposits for the
person who gets the loan. The third point is the
person with the loan spends the money and the
bank loses an equal amount of reserves. At the
bottom here you see the final position for the
bank. The 80 in new deposits will support 64 in
loans.
D 80
BR 80
A LNW
L 64
D 64
A L NW BR -64 D -64
A LNW
BR 16 L 64
D 80
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Before I move on to more of the story, note what
happened on the previous screen. 1) In the
banking system 80 new dollars in checking account
balances was added because someone was able to
get a loan. 2) The bank added to the first round
by making another 64 in loans. 3) At the end of
the day the bank has looked at its new deposits,
evaluated what it wants to hold on to as reserves
and lends out the rest. Another round of lending
can still occur lets see that next.
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Round 3


A LNW
The person who obtained the second loan bought
something. The seller of that stuff gets the
check and deposits it in the bank. We see that
first here. Next you see that since the bank
wants to only hold 20 of deposits as reserves it
loans .8(64) 51.20 by creating an asset called
loans and adds to checkable deposits for the
person who gets the loan. The third point is the
person with the loan spends the money and the
bank loses an equal amount of reserves. At the
bottom here you see the final position for the
bank. The 64 in new deposits will support 51.20
in loans.
D 64
BR 64
A LNW
L 51.20
D 51.20
A L NW BR -51.20 D -51.20
A LNW
BR 12.80 L 51.20
D 64
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Multiple deposit expansion
Lets review again. The first bank received 100
in new deposits and since it only needs to keep
20 (because most folks dont want all their
funds on any one day) it lent out 80. This ended
up in another bank because the person who got the
loan didnt want to take the money home, throw it
on the floor, and roll in the cash (would you do
that?). The person wanted to spend it! That
spending meant someone else sold some goods and
got a check to put in their bank. That bank
evaluated its position and made a loan DO you
see a pattern here? Note each successive loan is
for a smaller amount than the previous loan.
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Begin
Round 1
Round 2
Round 3
D 80
BR 100
D 100
BR 20 L 80
D 100
BR 16 L 64
BR12.80
D 64
L 51.20
Bit of a review again bring the last few slides
together. On this slide you see the beginning
when 100 in cash was put in the bank. Then I
show three rounds, but more will occur. Recall
that money is made up of currency and checkable
deposits. The beginning and round 1 is the first
bank involved. While there are 100 more in
checking there is 100 less in cash in the hands
of the non-bank public. This means no change in
the money supply. But rounds 2, 3 and on have
new deposits that are new additions to the money
supply. On the next slide I show some math, but
you only need to have the end result of that math.
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New money from the lending process here 80 64
52.10 80(1 .8 .82 ) (math folks
help us get to the next line) 801/(1 - .8)
(wow, look at that!) 80(1/0.2) 80(5) 400
Lets look at this a little more closely. The 80
was the initial amount of excess reserves in the
system when cash was put in the bank. The 5 is
the money multiplier (It is similar to the
multiplier we saw back with aggregate demand).
Note the 5 is from 1/0.2, where the 0.2 is the
20 banks like to hold in reserve to meet the
needs of its depositors. These two items make up
the money multiplier.
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Required reserves
Hey, you want to know something? Well, listen
up! The 20 I mentioned that banks want to hold
to meet the needs of the depositors is too high a
number. Many banks would really only need to
keep way less than 20. Moreover, some banks
would like to earn more money and they might hold
less than they really need. The Federal Reserve
system has a rule banks must follow so that they
dont have too few reserves. The rule is called
reserve requirements. The Fed sets, and does
change from time to time, the minimum reserve
required amount banks must hold to meet the
amount of checking account balances that are in
the bank.
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Required reserves
If the reserve requirement is 20 banks have to
have in reserves (BR) 20 of the checking account
balances. So if D 100 BR must be no lower than
20. If D 500 BR must be no lower than 100. We
will assume in class that whatever the Fed sets
as the reserve requirement will be the target
banks shoot for. So, if the reserve requirement
is 20 the money multiplier is 5. If the reserve
requirement is 10 the money multiplier is 10.
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Summary 1) FED dropped 100 single dollar bills
on public for a money supply of 100, 2) Public
put all money in the bank in checking accounts,
for a money supply still of 100, 3) Banks only
desired to hold reserves equaling 20 (because we
now see that is what the FED set) of deposits and
they lent out the rest. 4) After many rounds of
lending bank deposits end up at 400 of
additional checking account balances in addition
to the 100 start. 5) The 100 of new bank
reserves ends up supporting a money supply of
500, the 400 of new deposits from the lending
process and the initial 100 Fed dropped, but
transferred to checking by public.