U.S. banks operate on a fractional reserve banking system. This means
that banks are required to keep only a fraction of deposits on hand to
satisfy withdrawals. The bank then lends out the remaining fraction of
deposits. The assets kept by the bank are known as reserves. Banks are
required by law to keep a certain percent of deposits as reserves. This
is known as the required reserve ratio.
Reserve ratio = commercial banks required reserve/ checkable-deposit liability
We will now show how banks actually create money. Of course they can print money or mint new coins. But we also know that in addition to currency and coins checking accounts are also money. It is in the checking account area that we are concerned with here to demonstrate how banks create money.
Banks lend money, that is they make loans, and those loans usually go into the checking account of the person borrowing the money and then they write checks. Note, checks are money thus banks have the power to create money. The money banks lend to businesses and people are based on the deposits that people made in the bank. Since they only have to keep a percentage of the deposit as a required reserve ratio they can lend out the rest. Table 13.1 in the book shows what the required ratio is. The difference between their actual reserves and required reserves is called excess reserves.
Excess reserves = actual reserves- required reserves.
The reason there is a reserve ratio is so that the Federal Reserve Bank
(Fed) can control the lending ability of commercial banks. This way
they can help the economy avoid wild business fluctuations by either allowing
banks to lend more (smaller reserve ratio) or lend less (larger reserve
We can demonstrate how banks can create money by making loans, or destroy money when the loan is repaid and how banks create money by purchasing government bonds from the public. T accounts shows a bank's assets and liabilities. A bank's assets are the way a bank uses its funds (lending money). A bank's liabilities are the sources of a bank's funds (people deposit money in the bank).
Suppose Milton deposit a 100 bill into his account. The banks balance
sheet will change when Milton opens his account in the Maynard national
Maynard national Bank
+$100 +$100 deposits
Notice that assets must equal liabilities.
The bank receives the $100 and puts it in their safe, increasing its assets by $100.
The bank opens Milton’s account, which is a liability, since Milton can withdraw the money at any time.
Look at how this has changed the money supply. A $100 bill was
taken out of circulation thus M1 has fallen by $100, but $100 was put into
a checking account offsetting the decrease in M1. So there was no change
in the money supply as a result of the initial transaction of opening an
account with the $100 bill.
If the required reserve ratio is 20%. This means the bank must keep $20 of Milton's deposit, but can lend out the other $80:
Maynard national Bank
$20 required reserves +$100 deposits
$80 excess reserves
Suppose the bank uses the $80 to loan to Warren, crediting Warren with
$80 in his account. With $180 in deposits, the bank must keep 20%, or $36
and is free to lend the excess:
Maynard national Bank
$36 required reserves +$100 deposits (Milton)
$64 excess reserves $80 deposit (warren)
Total assets =$180 total liabilities =$180
Suppose the bank lends the excess $64 to Frank, increasing deposits to $180 + $64 = $244. Required reserves are (.2 x $244 = $48.80):
Maynard national Bank
$48.8 required reserves +$100 deposits (Milton)
$51.2 excess reserves 80 deposit (warren)
$144 loans $64 deposit Frank
Total assets =$244 total liabilities =$244
The bank can then lend the $51.20, and the process continues. But look
at the T-account above, and you see that Milton’s deposit and the banks
use of it has increased the money supply, by $244 which is $144 MORE than
the initial $100 increase in bank reserves
If we carried this example through, how much money can be created from the initial $100 in reserves? This depends on the required reserve ratio.
Insert Table 13.2 here
It would be a pain in the neck to make each calculation like in table
13.2. Fortunately we don’t have to.
The money multiplier = 1 / (required reserve ratio)
Potential deposit creation = initial excess reserves x money multiplier
In our example, there was an initial deposit of $100, so initial excess reserves are $80. The money multiplier is 1/. 2 = 5. Then total deposit creation is 5 x $80 = $400. The $100 deposit creates $400 in new lending capacity (see table 12.2 for a demonstration).
The money multiplier allows us to calculate only potential money creation. In reality, money creation may be smaller than what the money multiplier shows because there are leakages from the amount that is lent out.
Borrowers might ask for part of their loan to be in cash rather than a check. This will cause the excess reserves and hence the potential amount lent out to decline.
Banks may keep some excess reserves in addition to the required reserves
It is important to remember that banks have to be willing to lend money and borrowers have to be willing to borrow. If neither wants to borrow or lend then the supply of money will decline. Banks might not want to lend during a recession because they fear default on the loans. When they lend less the money supply declines, with a decline in money supply aggregate demand declines, which makes the recession even worse.
If times are good and the economy is doing well banks will want to lend because they do not fear default and see the potential for profits. Money supply increases with loans and this stimulates aggregate demand. If the economy is at full capacity this can cause inflation.
Since banks seek to maximize profit sometimes they will do things to protect their profits, which can hurt the economy. This is done through their ability to change the money supply. This is why the Federal Reserve Bank has a certain amount of monetary tools that they can use to stabilize the economy via the money supply, which is what we discuss in the next chapter.
Just as a bank creates money by lending it they also destroy money when loans are paid back.
Banks also create money when they buy government bonds. Here is how it works. If the bank was going to make a loan we saw how that created money because the person who got the loan spent it and it was deposited in their checking account and part of that was lent etc. Remember when a loan is made the borrower now has money, something they didn’t have prior to receiving the loan, thus money was created. The exact same thing happens when the bank buys bonds from the public.
Instead of making the $100 loan the bank buys $100 bond. The bank gets the bond (which is not money) and now they gave someone $100, which is deposited into the checking account, and the process starts.
When the bank sells a bond to the public they reduce the money supply just like when a loan was repaid.
Banks will often lend excess reserves to the Federal Reserve Bank who
will lend them to other banks for a short period of time, usually overnight.
So instead of the excess reserve siting in the vault of the bank waiting
to lend it the next day to a businessperson they lend it overnight to the
Fed. They earn a little bit of interest. The interest rate
for overnight money is called the Federal Funds rate. If a bank needs
money overnight they also borrow money from the Fed. This rate is
the rate we always read about when we hear that the fed is either raising
or lowing the interest rate.