How Money is Created

Unit 4- Part 3

Textbook Reference

• Module 25
• Pages 243-252

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• McConnell
• Chapter 32

Banks & The Money Supply

• Banks are financial intermediaries in business to earn profit.
• Banks, simply by facilitating saving and borrowing, can affect the supply of money in the economy.
• The way deposits lead to money creation is a key to understanding how central banks conduct monetary policy.
• Recall M1 = currency + coin + traveler’s checks + checking deposits
• The last component of M1 is where the role of banks comes into focus. If a large part (about half) of the money supply is accounted for by checking deposits into banks, the banks must play a crucial role in the supply of money in the economy.

Banks…

offer a safe place for depositors to put money and they offer lending services to borrowers who need money.

1. A saver is paid interest on his or her savings, and a borrower is charged interest on his or her borrowing.
2. Banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital equipment).
3. Once loans are made, there is now more money in circulation, and the money supply increases.

The T-Account

• A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right.

Assets

Liabilities

How Money Is Created

• People put money in the bank. This money is called a…Demand Deposit, it can also be referred to as a Checkable Deposit.
• For banks…Demand Deposits go in the liability section of their T-account chart. Why?
• For you…Receipts for your deposits go in your assets column. Why?
• Demand Deposits themselves do not create new money. That money is already in circulation.

Demand Deposits Then Become…

• Reserves

Three Kinds of Reserves

• Required Reserves
• Excess Reserves
• Total Reserves

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Required Reserves

• The amount that banks are required to keep on deposit at a Federal Reserve Bank.
• Every bank has to keep “Required Reserves” or “Reserve Requirements”.
• This is the set amount of the money the bank cannot use of your Direct Deposits.
• Why?

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Excess Reserves = �Total Reserves-Required Reserves

• The money the bank does not have to keep in required reserves is considered “Excess Reserves”.
• The bank can now loan this money out and/or can buy bonds, treasury certificates and stock.

The Monetary Base vs. The Money Supply

The Monetary Base =

1. The sum of reserves held by the banks +

2. Currency in circulation.

The Money Supply =

1. The total amount in circulation.

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• Katie takes $1000 from under her mattress, deposits it at ECB, and opens a checking account. ECB must put $100 in required reserve, but the remaining $900 are excess reserves and can be either kept on reserve or lent.

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• ECB lends all $900 in excess reserves to Bob, a local farmer. This loan does not yet count as newly created money.

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• Bob uses his $900 at Tractor Supply, which has a checking account with ECB. Checking deposits have now increases by $900 and this is new money. ECB must keep $90 as required reserves and there are now $810 of excess reserves.

• ECB makes an $810 loan to Brent, who is looking to buy some furniture. Brent spends $810 at Furniture Factory, which also banks with ECB, increasing checking deposits by $810. ECB must keep $81 in required reserves and there are now $729 in excess reserves.

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Let’s Practice! �Take Out a Sheet of Paper and…

Bank Expansion of Demand Deposits

The Money Multiplier

also known as... �The Deposit Expansion Multiplier

• This is how much of brand new money the bank will create by lending it out.
• The Equation to Determine This is 1/R
• R = Required Reserve Ratio

Let’s Practice! �

The Reserve Requirement & the Monetary Multiplier

AC/DC Video Connection