12.1 HOW BANKS CREATE MONEY

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12.1 HOW BANKS CREATE MONEY

• Creating a Bank
• To see how banks create money, well work through
  the process of creating a bank and see how our
  new banks creates money.

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12.1 HOW BANKS CREATE MONEY

• There are eight steps
• Obtain a license to operate a commercial bank
• Raise some financial capital
• Buy some equipment and computer programs
• Accept deposits
• Establish a reserve account
• Clear checks
• Buy government securities
• Make loans

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12.1 HOW BANKS CREATE MONEY

• Obtaining a Charter
• Apply to the Comptroller of the Currency
• Raising Financial Capital
• Virtual College Bank creates 2,000 shares, each
  worth 100, and sells these shares in your local
  community.
• Balance sheet
• A statement that summarizes assets (amounts
  owned) and liabilities (amounts owed).

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12.1 HOW BANKS CREATE MONEY

• Table 12.1 shows Virtual College Banks balance
  sheet 1.

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12.1 HOW BANKS CREATE MONEY

• Buy some equipment and computer programs
• Buy some office equipment, a server, banking
  database software, and a high-speed Internet
  connection.
• These items cost you 200,000.

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12.1 HOW BANKS CREATE MONEY

• Table 12.2 shows Virtual College Banks Balance
  Sheet 2

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12.1 HOW BANKS CREATE MONEY

• Accepting Deposits
• Offer the best terms available and the lowest
  charges on checkable deposits.
• Deposits begin to roll in.
• You have accepted 120,000 of deposits.

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12.1 HOW BANKS CREATE MONEY

• Table 12.3 shows Virtual College Banks Balance
  Sheet 3

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12.1 HOW BANKS CREATE MONEY

• Establishing a Reserve Account
• Establish a reserve account at local Federal
  Reserve Bank.

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12.1 HOW BANKS CREATE MONEY

• Table 12.4 shows Virtual College Banks Balance
  Sheet 4

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12.1 HOW BANKS CREATE MONEY

• Reserves Actual and Required
• A banks required reserve ratio is the ratio of
  reserves to deposits that banks are required, by
  regulation, to hold.
• Suppose that the required reserve ratio is 25
  percent of total deposits,
• A banks required reserves are equal to its
  deposits multiplied by the required reserve
  ratio.
• So Virtual College Banks required reserves are
• Required reserves 120,000 x 25 100 30,000.

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12.1 HOW BANKS CREATE MONEY

• Actual reserves minus required reserves are
  excess reserves.
• Virtual College Banks excess reserves are
• Excess reserves 120,000 - 30,000 90,000.
• Whenever banks have excess reserves, they can
  make loans.

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12.1 HOW BANKS CREATE MONEY

• Clearing Checks
• Virtual College Banks depositors want to be able
  to make and receive payments by check.
• Funds must move from an account at your bank to
  an account at another bank.
• In the process, one bank loses reserves and the
  other bank gains reserves.
• Figure 12.1 on the next slide shows how a bank
  clears a check.

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12.1 HOW BANKS CREATE MONEY

• Buying Government Securities
• Government securities provide a bank with an
  income and a safe asset that is easily converted
  back into reserves.
• Suppose that Virtual College decides to buy
  60,000 worth of government securities.
• On the same day, First American decides to sell
  60,000 of government securities.
• In reality, a bond broker will match the First
  American sale with Virtual Colleges purchase.

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12.1 HOW BANKS CREATE MONEY

• Table 12.5 shows Virtual College Banks Balance
  Sheet 5

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12.1 HOW BANKS CREATE MONEY

• Making Loans
• With reserves of 40,000 and required reserves of
  25,000, Virtual College has excess reserves of
  15,000.
• So the bank decides to make loans of this amount.

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12.1 HOW BANKS CREATE MONEY

• Table 12.6 shows Virtual College Banks Balance
  Sheet 6

Virtual College has now created 15,000 of new
money.
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12.1 HOW BANKS CREATE MONEY

• Spending a Loan
• To spend their loans, the borrowers write checks
  on their checkable deposits. Assume they spend
  the entire 15,000.
• Most likely, the people to whom these checks are
  paid do not bank at Virtual College.
• The receiving banks send the checks to the Dallas
  Fed for collection.
• The Fed increases the reserves of the receiving
  banks by 15,000 and decreases the reserves of
  Virtual College by 15,000.

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12.1 HOW BANKS CREATE MONEY

• Table 12.7 shows Virtual College Banks Balance
  Sheet 7

The deposits that Virtual College created are now
at some other banks in the system.
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12.1 HOW BANKS CREATE MONEY

• Limits to Money Creation
• When Virtual College creates money and its
  customers spend the new money, other banks
  receive reserves and have excess reserves.
• These banks now create money just like Virtual
  College did.
• At each stage the amount of new loans get smaller.

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12.1 HOW BANKS CREATE MONEY

• When a bank receives deposits, it keeps 25
  percent in reserves and lends 75 percent. The
  amount loaned becomes a new deposit at another
  bank.
• The next bank in the sequence keeps 25 percent
  and lends 75 percent, and the process continues
  until the banking system has created enough
  deposits to eliminate its excess reserves.
• At the end of the process, an additional 100,000
  of reserves creates an additional 400,000 of
  deposits.
• Figure 12.3 on the next slide shows the multiple
  creation of bank deposits.

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12.1 HOW BANKS CREATE MONEY
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12.1 HOW BANKS CREATE MONEY

• The Deposit Multiplier
• The number by which an increase in bank reserves
  is multiplied to find the increase in deposits

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12.2 FED CONTROL OF MONEY SUPPLY

• The Fed has three tools for controlling the money
  supply
• Required reserve ratios
• Discount rate
• Open market operations

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12.2 FED CONTROL OF MONEY SUPPLY

• How Required Reserve Ratios Work
• When the Fed increases the required reserve
  ratio, the banks must hold more reserves.
• To increase their reserves, the banks must
  decrease their lending, which decreases the
  quantity of money.
• When the Fed decreases the required reserve
  ratio, the banks may hold fewer reserves.
• To decrease their reserves, the banks increase
  their lending, which increases the quantity of
  money.

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12.2 FED CONTROL OF MONEY SUPPLY

• How The Discount Rate Works
• When the Fed increases the discount rate, the
  banks must pay a higher price for any reserves
  that they borrow from the Fed.
• Faced with a higher cost of reserves, the banks
  are less willing to borrow reserves.
• The banks must decrease their lending to decrease
  their borrowed reserves.
• So when the discount rate increases, the quantity
  of money decreases.

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12.2 FED CONTROL OF MONEY SUPPLY

• When the Fed decreases the discount rate, the
  banks pay a lower price for any reserves that
  they borrow from the Fed.
• Faced with a lower cost of reserves, the banks
  are willing to borrow more reserves and increase
  their lending.
• The quantity of money increases.

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12.2 FED CONTROL OF MONEY SUPPLY

• How An Open Market Operation Works
• The Feds major policy tool.
• When the Fed buys securities in an open market
  operation, it pays for them with newly created
  bank reserves and money. The banks can use their
  new reserves to create even more money.
• When the Fed sells securities in an open market
  operation, people pay for them with money and
  reserves.

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12.2 FED CONTROL OF MONEY SUPPLY

• The Multiplier Effect of an Open Market Operation
• An open market purchase that increases bank
  reserves also increases the monetary base.
• The increase in the monetary base equals the
  amount of the open market purchase, and
  initially, it equals the increase in bank
  reserves.

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12.2 FED CONTROL OF MONEY SUPPLY

• If the Fed buys securities from the banks, the
  quantity of deposits (and quantity of money) does
  not change.
• If the Fed buys securities from the public, the
  quantity of deposits (and quantity of money)
  increases by the same amount as the increase in
  bank reserves.
• Either way, the banks have excess reserves that
  they now start to lend.

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12.2 FED CONTROL OF MONEY SUPPLY

• The following sequence of events takes place
• An open market purchase creates excess reserves.
• Banks lend excess reserves.
• The quantity of money increases.
• New money is used to make payments.
• Some of new money is held as currency.
• Some of the new money remains on deposit in
  banks.
• Banks required reserves increase.
• Excess reserves decrease but remain positive.

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12.2 FED CONTROL OF MONEY SUPPLY

• The Money Multiplier
• The number by which an increase in the monetary
  base is multiplied to find the resulting increase
  in the quantity of money.

The larger the currency drain and the larger the
required reserve ratio, the smaller is the money
multiplier.