How Banks and Thrifts Create Money

CHAPTER FOURTEEN HOW BANKS AND THRIFTS CREATE MONEY

LECTURE NOTES
I. Introduction: Although we are fascinated by large sums of currency, people use checkable deposits for most transactions. A. Most transaction accounts are created as a result of loans from banks or thrifts. B. This chapter demonstrates the money-creating abilities of a single bank or thrift and then looks at that of the system as a whole. C. The term depository institution refers to banks and thrift institutions, but in this chapter the term bank will be often used generically to apply to all depository institutions. II. Balance Sheet of a Single Commercial Bank A. A balance sheet states the assets and claims of a bank at some point in time. B. All balance sheets must balance, that is, the value of assets must equal value of claims. 1. The bank owners claim is called net worth. 2. Nonowners claims are called liabilities. 3. Basic equation: Assets = liabilities + net worth. III. History of Fractional Reserve Banking: The Goldsmiths A. In the 16th century goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants. They issued receipts for these deposits. B. Receipts came to be used as money in place of gold because of their convenience, and goldsmiths became aware that much of the stored gold was never redeemed. C. Goldsmiths realized they could loan gold by issuing receipts to borrowers, who agreed to pay back gold plus interest. D. Such loans began fractional reserve banking, because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold. E. Significance of fractional reserve banking: 1. Banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves). 2. Lending policies must be prudent to prevent bank panics or runs by depositors worried about their funds. Also, the U.S. deposit insurance system prevents panics. IV. Money Creation Potential by a Single Bank in the Banking System A. Formation of a commercial bank: Following is an example of the process. 1. In Wahoo, Nebraska, the Wahoo bank is formed with $250,000 worth of owners capital stock (see Balance Sheet 1). 2. This bank obtains property and equipment with some of its capital funds (see Balance Sheet 2). 3. The bank begins operations by accepting deposits (see Balance Sheet 3).

179

How Banks and Thrifts Create Money 4. Bank must keep reserve deposits in its district Federal Reserve Bank (see Table 14-1 for requirements). a. Banks can keep reserves at Fed or in cash in vaults. b. Banks keep cash on hand to meet depositors needs. c. Required reserves are a fraction of deposits, as noted above. B. Other important points: 1. Terminology: Actual reserves minus required reserves are called excess reserves. 2. Control: Required reserves do not exist to protect against runs, because banks must keep their required reserves. Required reserves are to give the Federal Reserve control over the amount of lending or deposits that banks can create. In other words, required reserves help the Fed control credit and money creation. Banks cannot loan beyond their fraction required reserves. 3. Asset and liability: Reserves are an asset to banks but a liability to the Federal Reserve Bank system, since now they are deposit claims by banks at the Fed. C. Continuation of Wahoo Banks transactions: 1. Transaction 5: A $50,000 check is drawn against Wahoo Bank by Mr. Bradshaw, who buys farm equipment in Surprise, Nebraska. (Yes, both Wahoo and Surprise exist). 2. The Surprise company deposits the check in Surprise Bank, which gains reserves at the Fed, and Wahoo Bank loses $50,000 reserves at Fed; Mr. Bradshaws account goes down, and Surprise implement companys account increases in Surprise Bank. 3. The effects of this transaction are traced in Figure 14-1 and Balance Sheet 5. D. Money-creating transactions of a commercial bank are shown in the next 3 transactions. 1. Transaction 6: Wahoo Bank grants a loan of $50,000 to Gristly in Wahoo (see Balance Sheet 6a). a. Money ($50,000) has been created in the form of new demand deposit worth $50,000. b. Wahoo Bank has reached its lending limit: It has no more excess reserves as soon as Gristly Meat Packing writes a check for $50,000 to Quickbuck Construction (See Balance Sheet 6b). c. Legally, a bank can lend only to the extent of its excess reserves. 2. Transaction 7: Loan repayments result in a decline in demand deposits and, therefore, a decrease in money supply at the time the loan is repaid (see Balance Sheet 7). Gristly repays its $50,000 loan. 3. Transaction 8: When banks or the Federal Reserve buy government securities from the public, they create money in much the same way as a loan does (see Balance Sheet 8). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealers checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly. 4. Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does. E. Profits, liquidity, and the federal funds market:

180

How Banks and Thrifts Create Money 1. Profits: Banks are in business to make a profit like other firms. They earn profits primarily from interest on loans and securities they hold. 2. Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors and to meet check clearing transactions. 3. Federal funds rate: Banks can borrow from one another to meet cash needs in the federal funds market, where banks borrow from each others available reserves on an overnight basis. The rate paid is called the federal funds rate. V. The Entire Banking System and Multiple-Deposit Expansion (all banks combined) A. The entire banking system can create an amount of money which is a multiple of the systems excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves. B. Three simplifying assumptions: 1. Required reserve ratio assumed to be 20 percent. (The actual reserve ratio averages 10 percent of checkable deposits.) 2. Initially banks have no excess reserves; they are loaned up. 3. When banks have excess reserves, they loan it all to one borrower, who writes check for entire amount to give to someone else, who deposits it at another bank. The check clears against original lender. C. Systems lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The systems lending begins with Bank A having $80 in excess reserves, lending this amount, and having the borrower write an $80 check which is deposited in Bank B. See further lending effects on Banks C and D. The possible further transactions are summarized in Table 14-2. D. Monetary multiplier is illustrated in Table 14-2. 1. Formula for monetary or checkable deposit multiplier is: Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example. 2. Maximum deposit expansion possible is equal to: multiplier, or D =M e. 3. Figure 14-2 illustrates this process in a diagram. 4. Modifications to simple monetary multiplier concept reduce the final result and include complications due to leakages. a. Currency drains (cash kept by customers) dampen M, because that money is not part of bank reserves so cant be loaned out further. b. Excess reserves kept on hand by banks also dampen M, because those reserves are not loaned out and therefore not expanded. E. Need for monetary control: 1. During prosperity, banks will lend as much as possible and reserve requirements provide a limit to expansion of loans. 2. During recession, banks may cut lending, which can worsen recession. Federal Reserve has ways to encourage lending in such cases. 3. The conclusion is that profit-seeking bankers will be motivated to expand or contract loans that could worsen business cycle. The Federal Reserve uses monetary policy excess reserves monetary

181

How Banks and Thrifts Create Money to counteract such results in order to prevent worsening recessions or inflation. Chapter 15 explains this. VI. LAST WORD: The Bank Panics of 1930-1933 A. Bank panics in 1930-33 led to a multiple contraction of the money supply, which worsened Depression. B. Many of failed banks were healthy, but they suffered when worried depositors panicked and withdrew funds all at once. More than 9000 banks failed in three years. C. As people withdrew funds, this reduced banks reserves and, in turn, their lending power fell significantly. D. Contraction of excess reserves leads to multiple contraction in the money supply, or the reverse of situation in Table 14-2. Money supply was reduced by 25 percent in those years. E. President Roosevelt declared a bank holiday, closing banks temporarily while Congress started the Federal Deposit Insurance Corporation (FDIC), which ended bank panics on insured accounts.

ANSWERS TO END-OF-CHAPTER QUESTIONS

14-1 Why must a balance sheet always balance? commercial banks balance sheet? What are the major assets and claims on a

A balance sheet is a statement of assets and claims (or liabilities and net worth). It must balance because every asset is claimed by someone, so that assets (the left-hand side) = liabilities + net worth (the right-hand side). The major assets of a bank are: cash (including cash reserves held by the Fed), its property, the loans it has made, and the securities it holds over and above general loans. Its liabilities are the deposits of its customers. The difference between the assets and liabilities is the banks net worth, which is shown on the liabilities side, thus ensuring that the balance sheet balances. 14-2 (Key Question) Why are commercial banks required to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is their significance? Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy. Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Bank. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes; they are claims that commercial banks have against it. Excess reserves are the amount by which actual reserves exceed required reserves: Excess reserves: Excess reserves = actual reserves - required reserves. Commercial banks can safely lend excess reserves, thereby increasing the money supply. 14-3 Whenever currency is deposited into a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced. Do you agree? Explain. Students should not agree. The M1 money supply consists of currency outside of the banks (cash in the hands of the public) and checking account deposits of the public in the commercial banks. The deposit of currency into a checking account in a bank has changed the form of the money supply but not the amount.

182

How Banks and Thrifts Create Money 14-4 (Key Question) When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed. Explain. Banks add to checking account balances when they make loans; these checkable deposits are part of the money supply. People pay off loans by writing checks; checkable deposits fall, meaning the money supply drops. Money is destroyed. 14-5 Explain why a single commercial bank can safely lend only an amount equal to its excess reserves but the commercial banking system can lend by a multiple of its excess reserves. What is the monetary multiplier? How does it relate to the reserve ratio? When a bank grants a loan, it can expect that the borrower will not leave the proceeds of the loan sitting idle in his or her account. Most people borrow to spend. Therefore the lending bank can expect that checks will be written against the loan and that the bank will shortly lose reserves to other banks, as the checks are presented for payment, to the full extent of the loan. In short, when a bank grants loans to the full extent of its excess reserves, it can shortly expect to lose these excess reserves to other banks. From this it can be seen why a bank cannot safely lend more than its excess reserves. If it did, it would soon find that its cash reserves were below its legal reserve requirement. From the above it can be seen why the commercial banking system can safely lend a multiple of its excess reserves. Whereas one bank loses reserves to other banks, the system does not. With a legal cash reserve requirement of, say, 20 percent, Bank B on receiving as a new deposit the $100 loaned by Bank A (the excess reserves of Bank A), may safely lend $80 (80 percent of $100). Bank C, on receiving as a new deposit the $80 loan of Bank B, loans 80 percent of that, namely $64. Note that the $100 initial excess reserves of the banking system have already resulted in the money supply increasing by $244 (= $100 + $80 + $64). The money supply will continue to increase, at a diminishing rate (Bank D will increase the money supply by $51.20 in loaning this amount), until the total increase in the money supply is $500. The algebra underlying the monetary multiplier is that of an infinite geometric progression. Designating the fixed fraction of the previous number as b (0.8 in our case) and k as the sum of the progression, we have:

k =1 + b + b2 + b3 + ...... + bn
Solving this for a very large n, we get, k =1 / (1 b )

In our example, the multiplier k is 1/(1 - 0.8) = 1/.2 = 5. And 5 is the reciprocal of the reserve ratio of 20 percent of 0.2. The multiplier is inversely related to the reserve ratio. 14-6 Assume that Jones deposits $500 in currency into her checkable deposit account in the First National Bank. A half-hour later Smith negotiates a loan for $750 at this bank. By how much and in what direction has the money supply changed? Explain. The loan of $750 to Smith increases the money supply by $750, and that is the only change. The deposit of $500 by Jones does not change the money supply. Whether Jones $500 is in her purse or in her demand deposit, the $500 are still part of the money supply. 14-7 Suppose the National Bank of Commerce has excess reserves of $8,000 and outstanding checkable deposits of $150,000. If the reserve ratio is 20 percent, what is the size of the banks actual reserves? Required reserves = 20 percent of $150,000 = $30,000 Therefore, required reserves = $30,000; Excess reserves = $ 8,000; Actual reserves = $38,000.

183

How Banks and Thrifts Create Money 14-8 (Key Question) Suppose the Continental Bank has the following simplified balance sheet. The reserve ratio is 20 percent. Liabilities and net worth (1) (2) Demand deposits $100,000 _____ _____

Assets (1) (2) Reserves Securities Loans $22,000 38,000 40,000

a. What is the maximum amount of new loans which this bank can make? Show in column 1 how the banks balance sheet will appear after the bank has loaned this additional amount. b. By how much has the supply of money changed? Explain. c. How will the banks balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against this bank? Show this new balance sheet in column 2. d. Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent. (a) $2,000. Column 1 of Assets (top to bottom): $22,000; $38,000; $42,000. Column 1 of Liabilities: $102,000. (b) $2,000. The bank has lent out its excess reserves, creating $2,000 of new demand-deposit money. (c) Column 2 of Assets (top to bottom): $20,000; $38,000; $42,000. Column 2 of Liabilities; $100,000. (d) $7,000. 14-9 The Third National Bank has reserves of $20,000 and demand deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5,000 in currency into the bank which is added to reserves. How much excess reserves does the bank now have? Demand deposits have risen to $105,000. Twenty percent of this is $21,000, which is its required reserves. The banks actual reserves have risen to $25,000. Therefore, its excess reserves are $4,000 ($25,000 - $21,000). 14-10 Suppose again that the Third National Bank has reserves of $20,000 and demand deposits of $100,000. The reserve ratio is 20 percent. The bank now sells $5,000 in securities to the Federal Reserve Bank in its district, receiving a $5,000 increase in reserves in return. What level of excess reserves does the bank now have? Why does your answer differ (yes, it does!) from the answer to question 9? The bank now has excess reserves of $5,000 (rather than $4,000) because in this case the demand deposits on the liabilities side of its balance sheet did not change. In the former case, $1,000 of new cash reserves were needed against the $5,000 increase in demand deposits. In the present case, nothing occurred on the liabilities side of the balance sheet. The sale of the securities to the Fed caused changes on the assets side onlyone asset (securities) was exchanged for another (reserves). 14-11 Suppose a bank discovers its reserves will temporarily fall slightly short of those legally required. How might it remedy this situation through the Federal funds market? Next, assume

184

How Banks and Thrifts Create Money the bank finds that its reserves will be substantially and permanently deficient. What remedy is available to this bank? (Hint: Recall your answer to question 4.) Banks can borrow temporarily from other banks that have temporary excess reserves. These funds are transferred from one banks reserve account to the other and allow the lending bank to earn interest on otherwise idle excess reserve funds for an overnight period, while replenishing the reserves of the deficient bank. If a bank finds that its reserves are substantially deficient, it should suspend lending and gradually build up its reserves as borrowers repay loans made by the bank earlier. 14-12 Suppose that Bob withdraws $100 of cash from his checking account at Security Bank and uses it to buy a camera from Joe, who deposits the $100 in his checking account in Serenity Bank. Assuming a reserve ratio of 10 percent and no initial excess reserves, determine the extent to which (a) Security Bank must reduce its loans and demand deposits because of the cash withdrawal and (b) Serenity Bank can safely increase its loans as demand deposits because of the cash deposit. Have the cash withdrawal and deposit changed the money supply? (a) Security Bank will have to reduce its loans and demand deposits by $90, the amount of its new deficiency of reserves. (b) Serenity Bank can safely increase its loans and demand deposits by $90, the amount of its new excess reserves. The money supply has not changed. Bobs checking account has decreased by $100 and Joes checking account has increased by $100. There has been no change in the overall excess reserves in the banking system. 14-13 (Key Question) Suppose the simplified consolidated balance sheet shown below is for the commercial banking system. All figures are in billions. The reserve ratio is 25 percent. Assets (1) Reserves Securities Loans $ 52 ___ 48 ___ 100 ___ Demand deposits Liabilities and Net Worth (2) $200 ___

a. What amount of excess reserves does the commercial banking system have? What is the maximum amount the banking system might lend? Show in column 1 how the consolidated balance sheet would look after this amount has been lent. What is the monetary multiplier? b. Answer question 13a assuming that the reserve ratio is 20 percent. Explain the resulting difference in the lending ability of the commercial banking system. (a) Required reserves = $50 billion (= 25% of $200 billion); so excess reserves = $2 billion (= $52 billion - $50 billion). Maximum amount banking system can lend = $8 billion (= 1/.25 $2 billion). Column (1) of Assets data (top to bottom): $52 billion; $48 billion; $108 billion. Column (1) of Liabilities data: $208 billion. Monetary multiplier = 4 (= 1/.25). (b) Required reserves = $40 billion (= 20% of $200 billion); so excess reserves = $12 billion (= $52 billion - $40 billion). Maximum amount banking system can lend = $60 billion (= 1/.20 $12 billion). Column (1) data for assets after loans (top to bottom); $52 billion; $48 billion; $160 billion. Column (1) data for liabilities after loans: $260 billion. Monetary multiplier = 5 (= 1/.20). The decrease in the reserve ratio increases the banking systems excess reserves from $2 billion to $12 billion and increases the size of the monetary multiplier from 4 to 5. Lending capacity becomes 5 $12 = $609 billion.
185

How Banks and Thrifts Create Money 14-14 What are banking leakages? banking system? How might they affect the money-creating potential of the

Banking leakages are reductions in the money available to banks in each successive round of money-supply creation that occurs as banks lend money deposited with them. The first leakage is government-ordained: The banks are required to keep a certain percentage of their deposits as cash reserves. Thus, when Bank A receives a deposit of $100 it may only loan, say, $80. And when the $80 is deposited in Bank B, it, too, may only loan 80 percent, or $64; and so on. The $20 Bank A must retain is a leakage, as is the $16 that Bank B must retain. If these and all other leakages did not exist, the monetary multiplier would be infinite, for the initial deposit would be continuously relent without any part being retained in the system. There are, in fact, two other leakages. The first is called currency drains. If those who borrow from a bank take part of the loan in cash and they or others retain it as additional cash in hand, then less than the amount of the loan will be redeposited in other banks in the system. For instance, Bank B would not be able to lend $80, but only, say, $40 if only $50 of the $100 loan was deposited in it. The third leakage is excess reserves that are not loaned out; that is, that are retained by a bank in excess of the legal reserve required by law. Since reserves earn no interest for the bank, it is not usual for a bank to hold excess reserves, but when it does happen (presumably because the bank is not satisfied that it can lend safely), the monetary multiplier is diminished. 14-15 Explain why there is a need for the Federal Reserve System to control the money supply. Without the Fed, in a boom the commercial banks would lend as much as they could, subject only to the legal reserve requirement. This could well increase the inflationary pressures that might already be building. Therefore, the Fed has the means to decrease the money supply (or its rate of increase) and thus the inflationary lending ability of the commercial banks. Again, in a recession, without the Fed, the commercial banks might well be disinclined to lend because they fear loans will not be repaid. The banking system thus would fail to provide the liquidity needed for recovery. 14-16 (Last Word) Explain how the bank panics of 1930 to 1933 produced a decline in the nations money supply. Why are such panics highly unlikely today? Because we have a fractional reserve banking system, bank reserves support a multiple amount of demand deposit money. When depositors collectively withdraw funds and cash out their accounts, bank reserves fall. Although demand deposits fall by the amount of cash withdrawn, the remaining demand deposits are too high relative to the reduced reserves. Banks therefore must call in loans or sell securities to get reserves. Both actions reduce the money supply. Such panics are unlikely today because deposits are insured by the Federal Deposit Insurance Corporation (FDIC), which covers the Bank Insurance Fund (BIF) for bank deposits up to $100,000 for each depositor, and also the Savings Association Insurance Fund (SAIF), which covers deposits up to $100,000 in savings and loan associations. Because Congress stands behind these insurance funds, depositors are not worried about the loss of their funds and, therefore, will not rush to withdraw them whenever they might be slightly worried about a particular institutions financial health. .

186