How Banks Create Money (2024)

Chapter 13
Money Creation: How Banks Create Money

• OPTIONAL: http://www.federalreserveeducation.org/fed101/policy/basics.htm

Preview / Review

The following figure and graphs illustrates what we have already done in chapters 8, 10, and 12, and what we will be doing in chapter 13 and 14. The graphs show what would happen if there is an increase in the money supply. In chapter 10 (Aggregate Supply / Aggregate Demand) we learned: MS Interest Rates I AD

In this unit on monetary policy we will expand this cause-effect chain. So it will look like:

FED TOOLSERMSInt.RatesIAD

-

FED TOOLS ER MS Int. RatesI AD

real GDP UE Price Level IN

OMO
DR
RR

In chapter 10 we used the AS/AD model - the third graph above. In chapter 8 we learned about the investment demand graph (the middle graph above). In Chapter 14 we will learn a graph of the market for money (money supply and money demand). Then we will put it all together in a series of cause/effect steps. Please note that it all works from left to right. So we get the following:

• the Fed has three tools that it can use to change the MS (OMO, DR, and RR) that we will study in chapter 14.
• a change in Excess Reserves (ER) can cause a change in the money supply. We will study this in chapter 13.
• a change in the money supply (MS) causes a change in interest rates (Int. Rates) [the first graph above, from chapter 14]
• a change in interest rates (Int. Rates) results in a change in Investment (I) [the second graph above, from chapter 8]
• a change in Investment (I) will change Aggregate Demand (AD) [the third graph above, from chapter 10]
• a change in Aggregate Demand (AD) will change real GDP and therefore unemployment (real GDP UE)
• a change Aggregate Demand (AD) will also change the price level, assuming we are in the intermediate range of the AS curve, and therefore it will also change inflation (Price Level IN).

Putting all the chapter graphs together: IF the MS increases:

What is left to learn?

1. Chapter 13:

• How money is created to increase the money supply (MS)
• How excess reserves affects the money supply (ER MS)

2. Chapter 14:

• The money demand and money supply graphs will be developed (MS and MD)
• How the Fed controls the money supply: FED TOOLS
  • open market operations (OMO)
  • changing the discount rate (DR)
  • changing the require reserve ratio (RR)

Goldsmith Banking: the origin of the FRACTIONAL RESERVES systemof banking

Money Creation and Reserves

In the 16th century gold was used as a medium of exchange (money) Goldsmiths had safes for gold and precious metals. Often consumers and merchants would keep their gold (money) in these safes. The goldsmiths then issued receipts for these deposits. These receipts came to be used as MONEY in place of gold because of their convenience. Goldsmiths became aware that much of the stored gold was never redeemed, people just used the receipts

Goldsmiths realized they could "loan" gold by issuing more receipts to borrowers, who agreed to pay back gold plus interest. HENCE, THE GOLDSMITHS CREATED MONEY. 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. Significance of fractional reserve banking: banks can create money by lending more than the original reserves on hand. (Note: Today gold is not used as reserves).

Bank panics and Regulation

Note that the amount of gold in the goldsmith's safe was less than the value of the receipts circulating as money. Present day banks also lend more than the deposits on hand. This means that not all depositors can get their money back at once. We cannot all go to the back and get all of our money out at the same time. If we tried it is called a "run" on the back. You probably have seen this in the Christmas movie "It's a Wonderful Life.

Therefore lending policies must be prudent to prevent bank "panics" or "runs" by depositors worried about their funds. Also, runs on banks are prevented by the U.S. government's deposit insurance system by insuring deposits up to $100,000.

The Money Creation Process

There are two interesting things that we will learn in thischapter. FIRST, banks create money when doing their normal businessof accepting deposits and making loans. When banks make loans theycreate money. remember from chapter 12 that money (M1) is currency(coins and bills) ANDcheckable deposits. When I got a loan formy boat the bank called me up and said that they deposited the loanin my checking account. This new deposit is NEW MONEY created by thebank. they just turned on their computer, logged into my account, andchanged the amount that I had. They created money. The FederalReserve has tool that it can use to control how much money bankscreate.

To understand the money creation process we first need to learnabout the balance sheet of a bank

Balance Sheet of a Bank

A balance sheet states the assets and liabilities of a bank at some point in time. "Assets" are things of value that the bank OWNS and "claims" are what the bank OWES.

All balance sheets must balance, that is, the value of assets must equal value of claims.

a. The bank owners’ claim is called net worth. The bank owes this to its owners

b. Nonowners’ claims are called liabilities.

Basic equation: Assets = liabilities + net worth. (Assets = Claims)

a. assets = what a bank OWNS

(1) The assets of a bank include:

• cash in the vault
• deposits at the Fed. (All member banks keep deposits at the Fed. Nonmember banks keep deposits at a member bank. These deposits are used by the Fed to help banks "clear" checks.)
• loans made to customers
• government securities (bonds) bought by the banks
• Other (the building, computers, land, etc.)

(2) The banks RESERVES are its cash in vault + deposits at the Fed

(3) A banks interest earning assets are its loans and government securities

b. liabilities = what a bank OWES

The liabilities of a bank include:

• Checking deposits of customers (called Demand Deposits or DD)
• Savings Accounts and CDs of customers
• Loans borrowed by the bank from the Fed or other banks

c. net worth

Net worth is what is left over IF a bank goes out of business selling all of its assets and paying off all of its liabilities.

Assets - Liabilities = Net Worth

They are also called "owner's equity". It's what the owners of the bank have in the bank, i.e. what is left over after seeing their assets and paying off their liabilities.

c. SUMMARY: the balance sheet or T-account:

ASSETS	LIABILITIES & NET WORTH
cash in the vault deposits at the Fed. (all member banks keep deposits at the Fed. Nonmember banks keep deposits at a member bank. These deposits are used by the Fed to help banks "clear" checks. loans made to customers government securities (bonds) bought by the banks Other (the building, computers, land, etc.)	Checking deposits of customers (call Demand Deposits (DD) Savings Accounts and CDs of customers Loans borrowed by the bank from the Fed or other banks Net Worth

Bank Reserves:

1. Total Reserves = cash in vault + Deposits at Fed.
(also called "actual reserves")

2. Required Reserves = RR x Liabilities

• NOTE! Students often forget this !!!!!!!!!!!!
• RR = Legal Reserve Ratio
• Liabilities are the Demand Deposits or DD
• The required reserves are a requirement of all banks.
• Banks must keep a fraction of their reserves that they can not use.
• These are not kept to pay back depositors.
• The required reserves are required by the Fed as a means to control the money supply (see chapter 14).
• See: http://www.federalreserve.gov/monetarypolicy/reservereq.htm

• If I put $10 in my checking account, how much is the bank required to keep?

  ANSWER: Nothing

  The require reserve ratio is 0% for many small banks.

  The Fed's Reserve Requirements for Banks:
  Type of liability	Current Requirements	Legal limits
  Checkable Deposits
  $0 to $7.8 million		3%
  $7.8 million to $48.3 million	3	3%
  More than $48.3 million	10	8-14%
  Noncheckable personal savings and time deposits		0-9%

3. Excess Reserves = Total Reserves - Required Reserves

Excess reserves are used by banks to:

1. pay back depositors (like when I write a check - my bank uses its excess reserves to cover that check)
2. to make loans (this is one way that banks earn revenue)
3. to buy government securities (another way for banks to earn revenue - it is like loaning funds to the US government)

4. Reserve Formulas Summary:

Total Reserves = cash in vault + Deposits at Fed.

Required Reserves = RR x Liabilities

Excess Reserves = Total Reserves - Required Reserves

How a bank creates money when it grants a loan: A Single Bankand a Cash Deposit

WORKSHEET

Print the following to use while going through this worksheet:
moneycreblank.htm

The worksheet should teach you :

1. How a Cash Deposit at a bank effects:

• the bank's balance sheet
• M1 (the money supply) - HINT: there is no effect

2. How Money is Created when a bank grants a loan

• Know the balance sheet changes when the loan is granted (see below)
• Know the balance sheet changes when the check is cleared (see below)

3. How much money can be created by:

• a single bank, and
• the banking system when there is an increase in excess reserves

• NOTE: there is a MULTIPLIEReffect here

Banks create money during their normal operations of accepting deposits and making loans. In this example we'll use M1 as our definition of money. (M1 = currency in our pockets and balances in our checking accounts.) When a bank makes a loan it creates money. For example when I got a loan to buy my boat, my credit union called an told me that the loan was approved and that I should come in and get the check. I told them to just deposit it in my checking account. So they did. They turned on their computers, typed in my account number, and added the loan to my checking account balance. I now had more money (M1). The bank created this money when they gave me the loan.

To learn how banks create money during their normal activities of accepting deposits and making loans lets assume that a $10 bill is deposited in the First National Bank (FNB). We will use the balance sheets of banks to see the effects. Our balance sheets will only show the CHANGES made to them. Our study guide has problems where they show actual (but hypothetical) amounts in the bank's T-account.

Major Point: An initial increase in funds available to the banking industry results in a MULTIPLE increase in the money supply.

See Also

Here's why it's gotten so much harder to get a loan in the US | CNN BusinessHow to get an LLC loan | BankrateStartup Funding: What It Is, How to Get Capital - NerdWalletHow Hard is it to Get a Business Loan? - Credibly

There is a Three Step Process per Round:

1. An increase in demand deposits or other liabilities of a bank increases the bank’s reserves.
2. Bank can make loans equal to its excess reserves. Loans made by increasing demand deposits.
3. The loan check is spent, deposited in a different bank, and CLEARS. First bank now has no excess reserves, but second does and can therefore make a loan.

Formulas:

Total Reserves = Cash in vault + Deposits at Fed.

Required Reserves = RR x Liabilities

• Liabilities are the Demand Deposits or DD
• RR is the Required Reserve ration set by the Fed
• NOTE: a common error is that students calculate the Required Reserves by: RR x Reserves. DON'TDOTHIS!. To calculate the Required Reserves: RR x Liabilities

  • CORRECT: Req. Res = RR x Liabilities
  • WRONG: Req. Res = RR x Reserves

• total reserves are also called "actual reserves"

Excess Reserves = Total Reserves - Required Reserves

Excess Reserves are used by banks to:

1. make loans
2. pay back depositors when they remove their funds from their accounts (like write a check)

Change in Money Supply = Initial Excess Reserves x Money Multiplier

Money Multiplier = 1 / RR

These two formulas are very important!

SUMMARY OF FORMULAS

Total Reserves = Cash in vault + Deposits at Fed. Required Reserves = RR x Liabilities Excess Reserves = Total Reserves - Required Reserves Change in Money Supply = Initial Excess Reserves x Money Multiplier Money Multiplier = 1 / RR

Given:

Required Reserve Ratio = 20%

FNB = First National Bank
SNB = Second National Bank
TNB = Third National Bank

ER = excess reserves
DD = Demand Deposits (checking account deposits = liabilities)

All banks initially have no excess reserves

Banks make loans equal to their excess reserves (This is not always true - see textbook)

$10 cash is deposited in a checking (DD) account at FNB

Show:

The CHANGES in the balance sheets of each bank as a result of this $10 cash deposit and the increased loan making ability of the banks.

I strongly suggest that you print out a blank copy of the table below, if you haven't already done so, (see: moneycreblank.htm) and fill it in as you go through this lecture. You should actually do the calculations.

Round One

Step 1: $10 deposited in FNB

The $10 bill becomes cash in the bank's vault so it becomes part of the bank's reserves. the deposit in the customer's checking account is a liability to the bank. Note that the balance sheet still balances.

Now calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed = 10

Required Reserves = RR x Liabilities = .20 x 10 = 2

Excess Reserves = Total Reserves - Required Reserves = 10 - 2 = 8

Step 2: FNB makes loan equal to its excess reserves

We will assume that when the bank makes a loan for $8 (the amount of its excess reserves above) it credits the borrower's checking account. THIS IS NEWLY CREATED MONEY !

Note that the balance sheet still balances: the $8 loan is an asset to the bank and the $8 credited to the borrower's checking account (DD) is an additional liability.

Now calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 10

Required Reserves = RR x Liabilities = .20 x 18 = 3.60

Excess Reserves = Total Reserves - Required Reserves = 10 - 3.60 = 6.40

You may notice that the FNB still has excess reserves BUT Excess Reserves are used by banks to:

1. make loans
2. buy government securities AND
3. pay back depositors when they remove their funds from their accounts (like write a check)

and since the FNB just made a loan it can figure that the borrower will probably spend it, so they better keep some excess reserves available to pay back depositor's when they remove their funds from their accounts (like write a check)

KNOW: The most money that a SINGLE bank can safely create is equal to its initial excess reserves !!!!!!!

The Banking System: Multiple Deposit Expansion (all bankscombined)

Step 3: Loan is spent, deposited in SNB, and the check clears

Sure enough, the borrower did spend the loan by writing a check which was deposited in the SNB.

When the check clears, the FNB sends the SNB $8 of its reserves. So the reserves of the FNB go down by $8, to $2, and the reserves at the SNB go up by $8. Since all banks either directly or indirectly have deposits at the Fed, checks can clear rapidly simply by having the Fed transfer the funds ($8 from the Fed account of the FNB to the Fed account of the SNB).

Now calculate the changes in the bank's (FNB) excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 2

Required Reserves = RR x Liabilities = .20 x 10 = 2

Excess Reserves = Total Reserves - Required Reserves = 2 - 2 = 0
With no more excess reserves, the FNB cannot make any more loans. (It was a good idea not to make another loan when they had ER of $6.40.)

Round Two

Step 1: Check from round one deposited in SNB

Now the SNB has $8 more reserves (this was transferred from the FNB to cover the check from a depositor of that bank.) and therefore $6.40 in additional excess reserves. It also has $8 in additional liabilities, when an $8 check from a customer of the FNB is spent and then deposited in the SNB.

To calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 8

Required Reserves = RR x Liabilities = .20 x 8 = 1.60

Excess Reserves = Total Reserves - Required Reserves = 8 - 1.60 = 6.40

Step 2: SNB makes loan equal to its excess reserves

And the process continues . . . . The SNB can now make a loan equal to its new excess reserves ($6.40). This will be NEW MONEY, increasing the Money Supply !

You may notice that the SNB still has excess reserves ($5.12) BUT Excess Reserves are used by banks to:

1. make loans
2. buy government securities AND
3. pay back depositors when they remove their funds from their accounts (like write a check)

and since the SNB just made a loan it can figure that the borrower will probably spend it, so they better keep some excess reserves available to pay back depositor's when they remove their funds from their accounts (like write a check)

Step 3: Loan is spent, deposited in TNB, and the check clears

The loan is spent and after covering the check (transferring reserves to the bank where the check was deposited (the TNB), the SNB has no additional excess reserves. It was a good idea not to make another loan.

See Also

Why Are Small Business Loans from a Bank So Hard to Get

Round Three

Step 1: Check from round two deposited in TNB

But the TNB now has new excess reserves.

The $ 6.40 loan from the SNB was spent and then deposited in the TNB (DD + $6.40). when the check clears the SNB transfers $ 6.40 from its reserves to the TNB. With these new reserves and new liabilities, the TNB now has $5.12 in new excess reserves.

To calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 6.40

Required Reserves = RR x Liabilities = .20 x 6.40 = 1.28

Excess Reserves = Total Reserves - Required Reserves = 6.40 - 1.28 = 5.12

The TNB can now make a loan equal to $5.12. this would be NEW MONEY.

SUMMARY: Money Supply Changes:

1. How much money was created in round one? ____$ 8____

2. How much money was created in round two? ____$ 6.40_

3. How much money can be created in round three? ____$ 5.12_

If the process continued with each additional bank making loans equal to its excess reserves, the maximum possible change in the money supply will be:

Total Change in Money Supply = initial excess reserves X money multiplier

4. What is the money multiplier? _____5______

money multiplier = 1/RR - 1/.2 = 5

5. What is the maximum total increase in the money supply that can occur as a result of the initial $10 cash deposit? ____$ 40_____

Change in the MS = ER x money multiplier = $8 x 5 = $40

6. What are the limitations on this money creation process?

The formula above gives us the MAXIMUM possible change in the money supply. The chapter’s discussion of bank credit is in terms of the maximum money-creating potential that would probably not ever be reached due to these modifications introduced at the end of this chapter:

_____1) banks may hold ER _______________________

_____2) people may hold money_________________________

_____3) the required reserve ratio_______________________

To print the completed worksheet: moneycredone.htm

When banks or the Federal Reserve buy government securitiesfrom the public

Transaction 7: 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 7). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer's checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly.

Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does.

OUTLINE - CHAPTER 13 - MONEY CREATION

I. Learning objectives - In this chapter students will learn:

A. Why the U.S. banking system is called a "fractional reserve" system.

B. The distinction between a bank's actual reserves and its required reserves.

C. How a bank can create money through granting loans.

D. About the multiple expansion of loans and money by the entire banking system.

E. What the monetary multiplier is and how to calculate it.

II. Introduction: Although we are fascinated by large sums ofcurrency, 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.

III. The Fractional Reserve System: The Goldsmiths

A. Banks in the U.S. and most other countries are only required to keep a percentage (fraction) of checkable deposits in cash or with the central bank.

B. 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.

C. 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.

D. Goldsmiths realized they could "loan" gold by issuing receipts to borrowers, who agreed to pay back gold plus interest.

E. 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.

F. 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. 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.

C. 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' stock shares (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).

4. Bank must keep reserve deposits in its district Federal Reserve Bank (see Table 13.1 for requirements).

a. Banks can keep reserves at Fed or in cash in vaults ("vault cash").

b. Banks keep cash on hand to meet depositors' needs.

c. Required reserves are a fraction of deposits, as noted above.

D. 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 excess 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.

E. Continuation of Wahoo Bank's 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. Bradshaw's account goes down, and Surprise implement company's account increases in Surprise Bank.

3. The results of this transaction are shown in Balance Sheet 5.

F. Money-creating transactions of a commercial bank are shown in the next two 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: 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 7). Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer's checkable deposits rise by $50,000. This increases the money supply in same way as the bank making the loan to Gristly.

3. Likewise, when banks or the Federal Reserve sell government securities to the public, they decrease supply of money like a loan repayment does.

G. Profits, liquidity, and the federal funds market:

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 other's available reserves on an overnight basis. The rate paid is called the federal funds rate.

V. The Banking System: Multiple Deposit Expansion (all bankscombined)

A. The entire banking system can create an amount of money which is a multiple of the system's 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. System's lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in Bank A. The system's 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 Bank C. The possible further transactions are summarized in Table 13.2.

D. Monetary multiplier is illustrated in Table 13.2.

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: excess reserves monetary multiplier, or

3. Figure 13.1 illustrates this process.

4. Higher reserve ratios generate lower money multipliers.

a. Changing the money multiplier changes the money creation potential.

b. Changing the reserve ratio changes the money multiplier but be careful! It also changes the amount of excess reserves that are acted on by the multiplier. Cutting the reserve ratio in half will more than double the deposit creation potential of the system.

E. The process is reversible. Loan repayment destroys money, and the money multiplier increases that destruction.

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 13.2. 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.