Give me a loan so Give me a loan so there will be more there will be more DD in the system.DD in the system.

How Banks Create How Banks Create MoneyMoney[[MSMS]]MSMS = Currency + DD of Public = Currency + DD of Public

Banks Banks [thru loans][thru loans] Create MoreCreate More DDDD

How Banks and Thrifts Create MoneyHow Banks and Thrifts Create Money

RRRR Excess ReservesExcess Reserves

Total(Actual) ReservesTotal(Actual) Reserves

PMC = M x ER, so 10 x .90 = $9PMC = M x ER, so 10 x .90 = $9TMS = PMC[$9] + DD[$1] = $10TMS = PMC[$9] + DD[$1] = $10[[MSMS = = currencycurrency + DD+ DD of of publicpublic]]

Dennis Rodman deposits $1 with A 10% RRDennis Rodman deposits $1 with A 10% RR

.1010 90 cents90 cents

One DollarOne Dollar

Excess ReservesExcess Reserves

Total(Actual) ReservesTotal(Actual) Reserves

PMC = M x ER, so 10 x $1 = $10PMC = M x ER, so 10 x $1 = $10TMS [$10] = PMC[$10] TMS [$10] = PMC[$10] [[MSMS = = currencycurrency + + DDDD of public of public]]

Rodman’s Bank Borrows $1 From The Fed [10% RR]Rodman’s Bank Borrows $1 From The Fed [10% RR]

RRRR

One DollarOne Dollar

One DollarOne Dollar00

Rodman’s BankRodman’s Bank

BALANCE SHEET OF A COMMERCIAL BANKBALANCE SHEET OF A COMMERCIAL BANK

ASSETS [cash]ASSETS [cash] = LIABILITIES[DD]LIABILITIES[DD][The cash is property of the bank] [“liable”, DDs are owed to depositors]

Cash Cash $100,000$100,000 DD $100,000 DD $100,000

The GoldsmithsGoldsmithsFractional Reserve Banking System

Money Creation & ReservesBank Panics and Regulation

$1,000 DD by Brian [MS=Currency+DD of Public]

Canon

Sam’s

Dell

Target

(1) (2) (3) (4) BANK New Deposits NEW REQUI RED DD CREATED By (new reserves) RESERVES NEW LOANS

DD RR = 20% (equal to new ER)

A $1,000.00 $200.00 $800.00

B 800.00 160.00 640.00

C 640.00 128.00 512.00

D 512.00 102.40 409.60

E 409.60 81.90 327.70

________ _____________ _____________ ______________ Totals $5,000 $1,000 $4,000 (rounded)

DD by L indsay PMC in Banking Sys TMS in Banking Sys

$1,000 + $4,000 = $5,000

MS grows by a multiple of 5

KatyKaty

640.00

512.00

409.60

800.00800.00

327.70

4,000.00

$1$1,,000.00000.00

$1,000

800.00

640.00

512.00

409.60

5,000.00

Katy

(1) (2) (3) (4) BANK New Deposits NEW REQUI RED DD CREATED By (new reserves) RESERVES NEW LOANS

DD RR = 10% (equal to new ER)

A $1,000.00 $100.00 $900.00

B 900.00 90.00 810.00

C 810.00 81.00 729.00

D 729.00 72.90 656.10

E 656.10 65.61 590.49 __________ _______________ ____________ _____________ Totals $10,000 $1,000 $9,000

DD by L indsay PMC in bank sys. Total Money Supply

$1,000 + $9,000 = $10,000

36 in.

Now a “Dell Dude”

Digital camcorder

Canon

Sam’s

Best Buy

Dell

Pool Table

Target

19 inch LCD

Monitor

$1,000 DD by TammyTammy [MS=Currency + DD of Public]

MS growsby a factor

of “10”

729.00

656.10

900.00

810.00

729.00

656.10

590.49

Tammy

$9,000

$1,000.00

900.00

810.00

729.00

656.10

$10,000

1. Joe BikerJoe Biker deposits $10,000 in his bank.

2. Suzie Rah RahSuzie Rah Rah borrows $8,000

RR = 20%

3. SuzieSuzie pays $8,000 for a new car.GoNow Auto deposits the $ in 2nd Bank.

4. 2nd Bank lends Sports Shop $6,400.

5. Eventually the MS will be $$5050,,000000

Joe

$$1010,,000000+$+$4040,,000000=$=$5050,,000000

MSMS$10,000 $8,000$18,000

MSMS$10,000 $8,000 $6,400$24,400

MSMS = = DDDD + + CurrencyCurrency of the of the PublicPublic[A DD of $10,000 will incr MS by another $40,000($50,000 MS]

RR=20%

MSMS is$10,000

How Banks Create Money [Vocabulary]How Banks Create Money [Vocabulary] 1. Fractional Reserve Banking SystemFractional Reserve Banking System – a fraction of DD are kept in reserve(say, 10%) at either the banks vault or at the Fed.

2. Vault cashVault cash – cash held by a bank (banks rarely keep more than 2%2% of their in cash)

3. Required Reserve(RR)Required Reserve(RR) –specified percentage of DD that banks must keep as RR.

4. Excess reservesExcess reserves – total reserves(TR) – RR. ER is what can be loaned out. Also some ER is used to meet sudden withdrawal demands.

5. Actual(Total) reservesActual(Total) reserves – RR + ER.

6. Deposit MultiplierDeposit Multiplier – one/RR or 1/.10 or $1/10 cents or 10

MultipliersMultipliers 1/RR[$1/5 cents = 20]

1/5% = 20 1/25% = 4 1/10% = 10 1/33.3%= 3 1/12.5% = 8 1/40 = 2.5 1/20% = 5 1/50% = 2

7. BalanceBalance SheetSheet–statement of assets & liabilities[assets=liabilitiesassets=liabilities].

8. Discount RateDiscount Rate – when banks borrow from the Fedbanks borrow from the Fed. [symbolic-emergencies] “wholesale price of money”

9. Federal Funds RateFederal Funds Rate – banks borrow from other banksbanks borrow from other banks for overnight loans.

10. Prime RatePrime Rate – when a bank’s prime customersprime customers [good credit] get loans. “retail price of money”

11. Buying BondsBuying Bonds – ““buying”buying” bonds means ““biggerbigger”” supply of money and “lower interest rates”. [So, more “C”, “Ig”, and “Xn” ]

12. Selling BondsSelling Bonds – ““selling”selling” bonds means ““smaller”smaller” supply of money and “higher interest rates”. [So, less “C”, “Ig”, and “Xn”]

Most Famous Most Famous “Panic Run”“Panic Run” in Movie in Movie History History

History of Deposit InsuranceHistory of Deposit Insurance

In 1934, federaldeposit insurance made its debut at$2,500$2,500 to protect the average family’s savings and end thebank runsbank runs that hadshut down businessesand contributed to the Great DepressionGreat Depression.Through the yearsthe coverage rosein $5,000 increments$5,000 incrementsuntil the 70suntil the 70s when itjumped to $40,000.In 19801980, it was raisedto $100,000$100,000.

Once upon a time there was a gold-smithygold-smithy who offered to store people’s gold in his vault. He issued paper receipts for the gold, and it was not long before the townsfolk used the paper to purchase eggs and beer. The smithy’s paper receipts became as “good as gold.”“good as gold.” Our Smithy was not stupidnot stupid. He said to himself. “I have 2000 ounces of gold“I have 2000 ounces of goldstored in my vault, but in the last year I was never called upon to pay outmore than 100 ounces100 ounces in a single day. What harm could it do if I lent out say,half the goldhalf the gold I now have? I’ll still have more than enough to pay off any depositors that come in for a withdrawal. No one will know the difference. Icould earn 30 additional ounces ofearn 30 additional ounces of goldgold each week. I think I’ll do it.”““The smithy has invented the Fractional Reserve Banking System.”The smithy has invented the Fractional Reserve Banking System.”Advantages of LendingAdvantages of Lending [One disadvantage was the possibility of “bank runs”]1. Depositors haven’t lost money [Goldsmiths paid them instead of other way]2. With the interest you earned you could give some to depositors.3. The loans benefited the community thru loans

The fractional banking system began when someone issuedclaims for gold that alreadybelonged to someone else.

The Very Early Days Of BankingThe Very Early Days Of Banking

There were more claims to gold thanthere wereounces ofgold.

“Wow, you mean we can create money out of thin air.?”

Birth of a COMMERCIAL BANKBirth of a COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

TRANSACTION 1

Creating a bank$250,000$250,000 Cash

forCapital Stock

Cash $250,000$250,000 Capital Stock $250,000$250,000

FORMATION OF A COMMERCIAL BANKFORMATION OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

DepositDeposit Added to Vault Cash

Cash $250,000$250,000 Capital Stock $250,000$250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES ANDNET WORTH

TRANSACTION 2

Acquiring Acquiring Property andProperty andEquipmentEquipment

$240,000240,000 Cash

Cash $ 10,000$ 10,000 Property 240,000240,000

Capital Stock $250,000$250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

Lovelady BankLovelady Bank

Cash $ 10,000$ 10,000Property 240,000240,000

Capital Stock $250,000$250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

TRANSACTION 3

AcceptingDeposits

$100,000$100,000 Cash

$250,000$250,000 $250,000$250,000

Cash $110,000$110,000Property 240,000240,000

DD $100,000$100,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

Was $10,000$10,000

$350,000$350,000

Cash $110,000$110,000Property 240,000240,000

DD $100,000$100,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

Was $10,000$10,000

$350,000$350,000

Cash $110,000$110,000Property 240,000240,000

DD $100,000$100,000Capital Stock 250,000250,000

FORMATION OF A COMMERCIAL BANKFORMATION OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 4

A $50,000$50,000 check is written against the bank

$350,000$350,000 $350,000$350,000

Cash $ 60,000$ 60,000Property 240,000240,000

DD $ 50,000$ 50,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETSLIABILITIES AND

NET WORTH

WasWas $110,000$110,000

$300,000$300,000 $300,000$300,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

NOTES:Banks create moneyby lending ER and destroy money byloan repayment.Purchasing bondsfrom the public alsocreates money.

Cash $ 60,000$ 60,000Property 240,000240,000

DD $ 50,000$ 50,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETSLIABILITIES AND

NET WORTH

TRANSACTION 5

Make a loan from excess

reservesof $50,000$50,000

Cash $ 60,000$ 60,000Loans 50,00050,000Property 240,000240,000

DD $100,000$100,000Capital Stock 250,000250,000

FORMATION OF A COMMERCIAL BANKFORMATION OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

Making the loancreated money!

Cash $ 60,000$ 60,000Loans 00Property 240,000240,000

DD $ 50,000$ 50,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

After a check for the $50,000$50,000is written against the bank

Balance Sheet: Lovelady Bank [J oe Bozo buys 50 HP computers at $1,000 each, so

writes $50,000 check to Best Buy in Hateman, Texas]

Federal Reserve Bank of Dallas Assets Liabilities & Net Worth

Reserves of Lovelady Bank - $50,000 Reserves of Hateman Bank + $50,000

Lovelady Bank Hateman Bank

Assets Liabilities & Net Worth Assets Liabilities & Net Worth

Reserves -$50,000 DD -$50,000 Reserves +$50,000 DD +$50,000

(a) J oe Bozo pays Best Buy with a $50,000 check.

(c) Cleared check is returned to Lovelady Bank

(b) Hateman Bank sends check for collection

(a) Joe Bozo pays Best Buy a $50,000 check

Hateman BankHateman BankLovelady BankLovelady Bank

FEDERAL RESERVE BANK OF THE U.S.FEDERAL RESERVE BANK OF THE U.S.Dallas

Big “D”Big “D”

Joe BozoJoe Bozo

Reserves $ 10,000$ 10,000Loans 50,00050,000Property 240,000240,000

DD $ 50,000$ 50,000Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

TRANSACTION 6

Repaying a loan with cash$50,000$50,000

Reserves $ 10,000$ 10,000Loans 00Property 240,000240,000

DD $ 00Capital Stock 250,000250,000

Birth OF A COMMERCIAL BANKBirth OF A COMMERCIAL BANKIn Lovelady, TexasIn Lovelady, Texas

ASSETS LIABILITIES AND NET WORTH

$50,000$50,000 in money supplyis destroyed!

MULTIPLE DEPOSIT EXPANSION PROCESSMULTIPLE DEPOSIT EXPANSION PROCESSRR= 20%RR= 20%

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

Amount bankcan lend - Newmoney created

ABCDEFGHIJKLMNOther banks

$100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97

$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 $400.00$400.00 PPotential MMoney CCreation in the banking system

TMS = $500.00TMS = $500.00

11stst 1010

$$357357ofof

the the $400$400

Paris HiltonParis Hilton

Susie RahRahSusie RahRah

Ronald McDonaldRonald McDonald

Manuel LaborManuel Labor

Maximumcheckable-

depositexpansion

= ERER x

DepositDepositMultiplierMultiplier RRRR

11

=

THE DEPOSIT MULTIPLIERTHE DEPOSIT MULTIPLIER

TThe he deposit mdeposit multiplier ultiplier is theis the reciprocal reciprocal of the reserve requirement.of the reserve requirement.

Potential moneyCreation in theBanking System

[PMCPMC]MMDD

$1,000$1,000New reserves

$$1,0001,000Initial

Deposit

$$4,0004,000PMCPMC thru bank lending

$$200200

RRRR

$800$800Excess

reserves

Ashley Olsen Ashley Olsen DepositsDeposits $1,000 in her $1,000 in her bankbank

TMS = $5,000TMS = $5,000

Ashley OlsenAshley Olsendeposits $$1,0001,000

Money Created

RR = 20%RR = 20%

New reservesNew reserves$1,000$1,000Excess

Reserves

$5,000$5,000PMCPMC thru Bank Lending

FedFed Buys A Buys A $1,000 Bond$1,000 Bond From From Ashley’s Ashley’s BankBank

TMSTMS isis $$50005000

20% RR20% RR

$20$20Requiredreserves

$100$100New reserves

$100Initial

Deposit

$400Bank system lending

Money Created

$80Excess

reserves

OUTCOME OF MONEY EXPANSIONOUTCOME OF MONEY EXPANSION

Leakages exist...

Currency Drains Excess Reserves

NS 31-35 AP EconNS 31-35 AP Econ [[MSMS = = CurrrencyCurrrency++DDDD of of PublicPublic]]

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(Public)+DD=TMS; PMC(Fed)=TMSPMC(Public)+DD=TMS; PMC(Fed)=TMS

31. The $40 billion deposit$40 billion deposit of Currency into DDDD will result in MSMS staying at ($8/$40/$160) billion. 32. The $40 billion deposit$40 billion deposit of currency into checking accounts will create ERER of ($20/$32/$40) billion.

33. The Potential Money CreationPotential Money Creation of the banking system through loans is ($40/$160/$$200) bil. The Potential TMSPotential TMS [all DDDD of the public] could be as much as ($40/$160/$200)34. The RR applies to checkable deposits at (banks/S&Ls/ credit unions/ all depository institutions). 35. If the Duck National Bank has ER of $6,000ER of $6,000 & DD of $100,000DD of $100,000 what is the size of the bank’s TRTR if the RR is 25%RR is 25%? ($25,000/$75,000/$31,000) [RR($____)+ER($___)+TR($____)

Excess ReservesExcess Reserves prior to new currency deposit ( prior to new currency deposit (DDDD) = ) = $0$0Britney Spears Britney Spears depositsdeposits in the banking system = in the banking system = $40$40 billionbillionLegal Reserve RequirementLegal Reserve Requirement [RR] = 20%[RR] = 20%

25,00025,000 6,0006,000 31,00031,000

NS 36-45 AP Econ NS 36-45 AP Econ [[MSMS = = CurrrencyCurrrency++DDDD of of PublicPublic]]

36. A stranger deposits $1,000deposits $1,000 in a bank that has a RR of 10%.RR of 10%. The maximum possible change in the dollar value of the local bank’s loans would be $______. PMCPMC[M M XX ER ER] in the banking system is $_____. Potential TMSPotential TMS could become as high as $_______.37. Suppose a commercial bank has DD of $100,000DD of $100,000 and the RR is 10%RR is 10%. If the bank’s RR & ER are equalRR & ER are equal, then its TRTR are ($10,000/$20,000/$30,000).38. Total Reserves (minus/plus) RR = ERER.39. Suppose the Thunderduck Bank has DD of $500,000DD of $500,000 & the RR is 10%RR is 10%. If the institution has ER of $4,000ER of $4,000 then its TRTR are ($46,000/$54,000/$4,000).40. If ERER in a bank are $4,000are $4,000, DD are $40,000DD are $40,000, & the RR is 10%RR is 10%, then TRTR are ($4,000/$8,000). 41. The main purpose of the RRmain purpose of the RR is to (have funds for emergency withdrawals/ influence the lending ability of commercial banks). 42. If I write you a check for $1check for $1 & we both have our checking accts at the Poorman Bank, the bank’s balance sheet will (increase/decrease/be unchanged).43. Banks (create/destroy) money when they make loansmake loans and repaying bankrepaying bank loansloans (create/destroy) money.44. When a bank loan is repaidbank loan is repaid the MSMS is (increased/decreased).45. The Fed Funds rateFed Funds rate is a loan by one bank (to another bank/from the Fed).

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(Public)+DD=TMS; PMC(Fed)=TMSPMC(Public)+DD=TMS; PMC(Fed)=TMS

900900 9,0009,00010,00010,000

47. If borrowers take a portion of their loans as cashloans as cash, the maximum amount by which the banking system increases the MSMS by lending will (increase/decrease).

NS 46-47 AP Econ NS 46-47 AP Econ [[MSMS = = CurrrencyCurrrency++DDDD of of PublicPublic]]

LeakagesLeakages(limitations)(limitations) of the Money Creating Process of the Money Creating Process 1. Cash leakages [taking part of loan in cash] 1. Cash leakages [taking part of loan in cash] 2. ER (banks don’t loan it or we don’t borrow]2. ER (banks don’t loan it or we don’t borrow]

RR+ER=TR; TR-RR=ER;RR+ER=TR; TR-RR=ER; TR-ER=RR; TR-ER=RR; MMXXERER=PMC=PMC; ; PMC(Public)+DD=TMS; PMC(Fed)=TMSPMC(Public)+DD=TMS; PMC(Fed)=TMS

46. If the RR was loweredRR was lowered [say, from 50% to 10%], the size of the monetary multipliermonetary multiplier [MMMM] would (increase/decrease).

The EndThe End