Lecture Macroeconomics - Chapter 13: How banks create money

After studying this chapter you will be able to understand: How a single chartered bank can create (or destroy) money through loans to the public, about the multiple-deposit expansion of the entire chartered banking system, what the monetary multiplier is and how to calculate it.

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How Banks Create Money

Chapter 13

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In this chapter you will learn

How a single chartered bank can create

(or destroy) money through loans to the

public

About the multiple-deposit expansion of

the entire chartered banking system

What the monetary multiplier is and how

to calculate it

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Chapter 13 Topics

The Balance Sheet of a Chartered Bank

Prologue: The Goldsmiths

A Single Chartered Bank

The Banking System: Multiple-Deposit

Expansion

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The Balance Sheet of a Chartered Bank

ASSETS = LIABILITIES + NET WORTH

ASSETS LIABILITIES AND NET WORTH

BALANCE SHEETS WILL BE USED

TO DESCRIBE THE CREATION OF

MONEY

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Chapter 13 Topics

Expansion

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Goldsmiths accepted gold deposits and

issued paper receipts

Paper receipts were used as a medium

of exchange

100% reserve system

eventually led to fractional reserve

system

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Fractional Reserve System

Money creation & reserves Bank panics & regulation

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Chapter 13 Topics

Expansion

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Formation of a Chartered Bank

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Cash $250,000 Capital Stock $250,000

Formation of a Chartered Bank Vancouver Bank

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Cash $250,000 Capital Stock $250,000

TRANSACTION 2

Acquiring Property and Equipment

Vancouver Bank

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Acquiring Property and Equipment

Property 240,000

Capital Stock $250,000

Vancouver Bank

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$100,000 Cash

Accepting Deposits

Vancouver Bank

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Vancouver Bank

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Note: demand

deposits are LIABILITIES

to the bank

Note: demand

deposits are LIABILITIES

to the bank

Vancouver Bank

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Reserves $ 110,000

Demand Deposits $100,000 Capital Stock 250,000

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Reserves $110,000

Bank deposits are subject to a desired reserve ratio

Reserves

Vancouver Bank

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Reserves $110,000

Excess Reserves

Two Important Points

1 Excess Reserves (E)

= Actual Reserves - Desired Reserves

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Reserves $110,000

Excess Reserves

• E = $110,000 - 10,000 = $100,000

Vancouver Bank

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Reserves $110,000

Excess Reserves

2 Bank of Canada can influence the lending ability

of banks through reserves

2 Bank of Canada can influence the lending ability

of banks through reserves

Vancouver Bank

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TRANSACTION 4

A cheque is drawn against the Vancouver

bank

Vancouver Bank

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Reserves $ 60,000

After Cheque Clearing

TRANSACTION 4

This bank

loses reserves

and deposits to the

Bank of

Vancouver Bank

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Money Creation: Single Bank

The maximum amount of new money

which can be created by a single bank

is equal to its excess reserves

The bank creates money when it

creates new loans

Money is destroyed when loans are

repaid

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Reserves $ 60,000

Demand Deposits $ 50,000 Capital Stock 250,000

Creating a New Loan

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TRANSACTION 5

Reserves $ 60,000

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New Loan Before Cheque Clearing

Reserves $ 60,000

Loans 50,000

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Reserves $ 60,000

Loans 50,000

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Reserves $ 60,000

Loans 50,000

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Reserves $ 60,000

Loans 50,000

NO!

Vancouver Bank

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Reserves $ 60,000

Loans 50,000

Vancouver Bank

Grisley Co writes a cheque worth $50,000 payable to Quickbuck

Co which banks at the

Manitoba Bank

Grisley Co writes a cheque worth $50,000 payable to Quickbuck

Co which banks at the

Manitoba Bank

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Reserves $ 10,000

Loans 50,000

New Loan After Cheque Clearing

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Reserves $ 10,000

Loans 50,000

New Loan After Cheque Clearing

Vancouver Bank

A bank MUST have excess reserves to

create loans

A bank MUST have excess reserves to

create loans

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Months later

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Reserves $ 10,000

Loans 50,000

Repaying a Loan

TRANSACTION 6

Repaying a

loan worth

$50,000

Vancouver Bank

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Reserves $ 10,000

Loans 0

Repaying a Loan

Vancouver Bank

Note that the amount of money - demand deposits - has declined by $50,000

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TRANSACTION 7

Reserves $ 60,000

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Reserves $ 60,000

Securities 50,000

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Government Securities

Bond purchases from the public by the

chartered banks increase the money

supply

Bond sales to the public decrease the

money supply

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Chapter 13 Topics

Expansion

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The Banking System Multiple Deposit Expansion

A single bank can lend one dollar for

each dollar of excess reserves

The banking system can lend (create

money) by a multiple of its excess

reserves

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Three Assumptions

Reserve ratio is 20%

Initially, no banks have excess reserves

Any bank with excess reserves will lend

to ONE person

who will write a cheque to someone else who will then deposit it in another bank

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Acquired reserves and deposits

Desired reserves

Excess reserves

Amount bank can lend New money created

Junkyard owner finds

$100 bill in a junked car, &

deposits it

Junkyard owner finds

$100 bill in a junked car, &

deposits it

Multiple Deposit Expansion Process Table 13-1

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Excess reserves

Note that at this

stage

NO new money

has been created

Table 13-1

Multiple Deposit Expansion Process

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Excess reserves

$ 20.00

Table 13-1

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Excess reserves

$ 20.00

$80.00

Table 13-1

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Excess reserves

$ 20.00

$80.00

Money is created once the loan is

made

Money is created once the loan is

made

$80.00

Table 13-1

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Excess reserves

$ 20.00

$80.00

Loan recipient now spends the money.

He/she buys something;

seller deposits proceeds in his/her

bank.

Loan recipient now spends the money.

He/she buys something;

seller deposits proceeds in his/her

bank.

Table 13-1

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Excess reserves

Amount bank can lend New money created A

B

$100.00 80.00

$ 20.00

$80.00

New deposit means excess

reserves

in seller’s bank;

process repeats

New deposit means excess

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Excess reserves

B

$100.00 80.00

$ 20.00 16.00

$80.00 64.00

Table 13-1

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Excess reserves

B

C

$100.00 80.00 64.00

$ 20.00 16.00 12.80

$80.00 64.00 51.20

Table 13-1

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Excess reserves

$ 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 Total amount of money created by the bank system = $400.00

Table 13-1

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Excess reserves

$ 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

$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

Monetary destruction works the same way in reverse

Table 13-1

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The Monetary Multiplier

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The Monetary Multiplier

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$100 New reserves

$ 20 Desired reserves

$80 Excess reserves

$100 initial deposit

$400 Bank system lending

Outcome of Money Expansion - Fig 13-1

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Some Modifications

Other Leakages

Currency Drains

Excess Reserves

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Need for Monetary Control

an unregulated banking system can destabilize the economy

there is a role for a central bank

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Chapter 13 Topics

Expansion

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The Bank of Canada

and Monetary Policy

Chapter 14

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