10/13/2015© 2002 Claudia Garcia-Szekely1 Money Creation Chapter 12: Money and the Banking System When it comes to money, everybody is of the same religion.

04/19/23 © 2002 Claudia Garcia-Szekely 1

Money Creation

Chapter 12: Money and the Banking System

When it comes to money, everybody is of the same religion

- Voltaire


What is money?

What does the Federal Reserve Bank consider

money?

Coins and Paper MoneyChecking Deposits


Liquid Assets

Assets in the form of cash (or easily convertible into cash)

M11,383Billion

Credit extended to (debt owed by)

Currency (754b)Travelers checks (6.6b)Demand deposits at banks(310b)Other demand deposits (312b)

M1Savings deposits Money market deposit accountsSmall time depositsRetail-type money market mutual fund balancesOvernight repurchase agreements (RPs)OvernightEurodollars

M2 Large time depositsWholesale-type money market mutual fund balancesTerm (beyond overnight)RPsTerm Eurodollars

Federal governmentState and local governmentsHouseholdsNon-financial businesses

Monetary and Credit Aggregates

M310,336

(2006 Discontinued)

M27,211 Billion

M11,383 Billion

GDP ~ 13,926 Billion

Velocity = Nominal GDP/M1

V = 13,926/1,383 = 10Each dollar was used 10 times during the year

Velocity of money: Number of times a dollar

is used


The Money Supply is

+First National Bank

Demand Deposits at banks

Ms = Currency held outside banks + Demand Deposits

The amount of money in circulation is the Money Supply

(760b) (590b)(1,350b)


The First Banks

Goldsmiths


The FED imposes a reserve requirement: r

If r = 10%

90%

If r = 20%

80%


The FED imposes a 10% reserve requirement


The FED imposes a 10% reserve requirement

These loans become deposits at another bank


Banks are Fully Loaned Up

Reserves59

Deposits 590

Loans531

59 in reserves allow banks up to 531 in loans

Holding loans outstanding at 531

New loans are made.

As loans are paid back,

r = 10%

R = D x r

L=D-R


The Supply of Money and the Federal Reserve

System

How Banks Create Money


The bank does not keep all your money in its

vault.First National Bank

Your deposit$20,000

The bank makes loans and holds a portion as reserve in vault.

$5,000

$5,000

2,000Reserve

loans

$8,000


By lending

Banks allow several individuals to write checks on the same amount of money…

Lending Create Money

out of thin air…


The Bank has created Money

Now you and other three individuals can write checks up to:

20,0005,0005,0008,000

38,000

The bank holds only 2,000

If all these payments must be made at the same time, the bank does not have enough in reserves.

Only 2,000 “support” 38,000 in spending!


Why is secrecy necessary in banking?


531B

There are only $59B in banks’ reserves supporting $590B in deposits…if everyone tries to cash $590 at the same time there is NOT enough

money for everyone…

In a business based on confidence, when that

confidence evaporates, so does

the business.


"There is absolutely no truth to the rumors of liquidity problems that circulated today in the market."

Bear Stearns Press Release

Monday, March 10/08


True?

On Monday, the firm had about $17 billion in cash.


Tuesday, March 11:

In previous weeks, banks such as Goldman Sachs had agreed to stand in for institutions nervous that Bear wouldn't be able to cough up its obligations on deal.

In the morning, Goldman Sachs's sent its clients an e-mail announcing that it would no longer step in for them on Bear deals.


TUESDAY, MARCH 11:Bear again tried to reassure investors: “The rumors are false, there is no liquidity crisis. No margin calls. It's nonsense." CFO Molinaro on CNBC.


WEDNESDAY, MARCH 12:

When word of the Goldman e-mail leaked out, the floodgates opened. Hedge funds and other clients, eventually running into the hundreds, began yanking their funds.

Bear continued to maintain publicly that all was well.

"We don't see any pressure on our liquidity, let alone a liquidity crisis."

CEO Alan Schwartz

THURSDAY, MARCH 13The gravity of the situation finally registered at Bear.

Liquidity was plummeting: $2 billion at week's end (from 17 billion on Monday)

Even as the firm frantically negotiated a rescue package with J.P. Morgan, Bear executives continued to try to convince the world that everything was under control.

That evening Schwartz contacted a well-known New York hedge fund manager to plead with him to appear on CNBC the next morning and express his confidence in Bear. The hedge fund manager declined politely but wondered why Bear needed a client to convince the world of its health. He wouldn't wonder long.

FRIDAY, MARCH 14: IT'S ALL GONE NOW

AT 9 A.M., Bear announced $30 billion in funding provided by J.P. Morgan and backstopped by the government.

Schwartz still fighting reality: "Bear Stearns has been subject to a significant amount of rumor. Customer requests to cash out

"accelerated yesterday ... there could be continued liquidity demands that would outstrip liquidity

resources." The new loan facility, he said, would restore calm.

Of course, that didn't happen: Bear's stock dropped nearly 40% in the first half-hour of trading. Within days, Bear's 85 years as an independent entity were at an end.

2008

200 billion dollar government bail-out of US mortgage lenders Fannie Mae and Freddie Mac

85 billion dollar loan to US insurance giant AIG

29 billion dollars to support the bail-out of investment bank Bear Stearns.


700 B Financial Bail Out US Treasury Secretary Hank Paulson given unlimited

authority to buy the "troubled assets“ so banks can "resume the flow of credit to American families and businesses“

The US government would appoint agents, likely to be Wall Street firms, to manage the purchases.

The Treasury would have "full discretion over the management of assets" which it could "sell at its discretion or may hold assets to maturity". Any cash received "will be returned to the Treasury's general fund for the benefit of US taxpayers".

The price of the assets will be determined "by market mechanisms where possible" but no real market exists for many of these complex financial instruments


Finding a true value will be challenging:If the government prices them too low, some

banks will significantly revalue their assets, increasing the credit crunch and making the situation worse.

Too high, and it will hand a windfall profit to Wall Street firms that speculated on a bail-out - leaving the government open to accusations that it is taking money from tax-payers to bail out rich banks which caused the problem in the first place.


700 B Financial Bail Out


When the bank gets that loan…

A “Money Multiplier” process should be set in motion…

57Bank C

Reserves

$700Deposit

Each round a portion (r) of the $700 goes into the vault as reserves….

10%90%

90%10%

10%90%

r=10%


Deposits

700

700(0.9)=630

630(0.9)=567

567(0.9)=510

.

.

.

Reserves

700(0.1)=70

630(0.1)=63

567(0.1)=57

510(0.1)=51

.

.

.SUM of New Deposits = ? SUM of New

Reserves = 700 the original deposit.

The Change in Deposits = New Loans + Original Deposit

Loans


The entire 700 deposit becomes reserves

All BanksReserves

Each bank holds a portion of the new deposit as reserves and makes loans that becomeNew deposits…

Deposit=700

700

All BanksDeposits

?


The Money MultiplierThe stream of deposits generated by the original 700 can be written as:

700 + 700 (0.9) + 700 (0.9)(0.9) +

700(0.9)(0.9)(0.9) + …or

700 + 700 (0.9) + 700 (0.9)2+ 700 (0.9)3

+ 700 (0.9)4 +…

700 [1+ (0.9) + (0.9)2+ (0.9)3 + (0.9)4 +…]

or


The Multiplier Formula

This sum of terms can be written:D = 700 [1+ (0.9) + (0.9)2+ (0.9)3 + (0.9)4 +…]

1

1-0.9

1

0.1

Since 1 – 0.9 = 0.1We can write:

1

r

Since 0.1= rWe can write:

If we keep adding terms…the limit of this sum is:


The Change in Deposits is

Deposits =1

0.1x 700

Deposits = 10 x 700 = 7,000

1

r D = x Original

Deposit


The Money Multiplier1

r D = x Original

Deposit

1

r D = x New

Reserves

1

r D = x R

Money

Multiplier

Multiple by which deposits increase for

every one dollar increase in reserves


The Money Multiplier1

0.1 D = x 700

L = D - R

Increase in Deposits = 7,000Of these 7,000 in newly created deposits, only

700 is “really” in reserves and the rest6,300 are loans: money that does not exist.

L = 7,000- 700 = 6,300

How many loans were created?


When you deposit $700 the banks create $6,300 out of thin air…

All BanksReserves

Each bank holds a portion of the new deposit as reserves and makes loans that become deposits of 6,300…

Deposit=700

R=700

All BanksDeposits

R = r(D)


When a 700 deposit generates loans

And loans generate additional bank deposits…The increase in the money supply ( Ms)

is:The increase in deposits + increase in the amount of cash held by the public.

Ms = deposits + currency outside banks

Federal Reserve Bank

Bank Reserves

at FedR = 59

R = r D59 = 0.1 D

D =590Bank Reserves

increase toR = 59+700

R=759

New Deposit New Loan

New Deposit New Loan

R = r D759 = 0.1 D

D =7,590Or:

D= R (1/r)D= 700 (1/0.1)

D= 7,000

r = 10%

D = 590+7,000

700

New Money Money in circulationDepositsD = 590

Money in circulation

39

Ms = 1,376b until “new” money is injected into the system…

All BanksDeposits

D=590b

d1= 100bd2= 80bd3=120b

d4= 125bd5= 165b

When checks are used to make a payment, the money simply changes “owner”

Only new money is multiplie

d!

Ms = Currency held outside banks + Demand Deposits (760b) (590b)(1,350b)


Where does new Money come from?

The FED : Buying bonds from the public or the Government (Monetizing the Debt).

The FED :lending to banks

The public: money under the matress

Bank’s excess reserves: money that was not circulating as loans before.

New Money

d6= 7,000700

D= 7,590

1.The following is the “T-Account” for the entire banking system. Banks are fully loaned up r= 10%

Reserves = D= 600b

Loans =

a) Reserves for the entire banking system are _____b) Loans for the entire banking system are ________c) If the amount of currency held outside banks by

the public is 700b, the Money Supply is __________

Questions for test

D = 700

Currency = 800

R=10%

R=70

L= 630

1b previously held as currency by

public is deposited into the banking

system.

D = R x (10)=10

R=10%

R=1

L= D – R = 9 Ms = 800 + 700

=1,500

R = 71 D = 710

L = 639

Ms = 800-1 + 700+10 Ms = 799 +

710Ms = D + Currency

1509

Ms = +10 + -1+9


Three Kinds of Reserves

Required Reserves (RR). The amount that must be held by law, the required reserve ratio times deposits:

RR = r(D)Actual Reserves (AR). The amount of

reserves actually held by the bank. This could be higher or lower than RR.

Excess Reserves(ER). Any amount held above required reserves.

Questions for test

D = 700

Currency = 800

R=10%

R=71

L= 629

1b held as excess reserves by banks is used to make loans

D = x (10)=10

R=10%

R=0

L= D – R = 10

Ms = 800 +700=1,500

AR = 71 D = 710

L = 639

AR=71RR=70ER=1

Ms = 800+700+10 Ms = 800 +

710Ms = D + Currency

1510

Ms = +10 + 0+10

10 – 0

45

What if some money “leaks” into currency?

In our story, the original 20,000 deposit set in motion a chain of loans and deposits at several banks…

What if part of the loan is kept as “cash” and only part of it becomes a deposit at a bank?

The deposit expansion will be smaller than previously calculated when we assumed that the entire amount of the loans became bank deposits.


What if some banks decide to hold more

reserves than required?

In our story, banks kept ONLY required amount of reserves

What if one or more banks in the chain hold more reserves than required?

The deposit expansion will be smaller than previously calculated when we assumed that banks only hold the amount of reserves they are required.


The deposit expansion depends on:

1. The amount of Excess Reserves.

2. Currency leak.

The Money Multiplier

Gives the largest change in deposits that can occur if there is no currency leak no excess reserves.

1.The following is the “T-Account” for the entire banking system. Banks are fully loaned up r= 7%

Reserves = D= 1,000,000

Loans =

The money multiplier is 1/0.07 = 14.28a)Reserves for the entire banking system are 0.07*1,000,000b)Loans for the entire banking system are D-R =1,000,000-70,000=930,000c)If the amount of currency held outside banks by the public is 600,000, the money supply is=D + currency = 1,000,000+600,000=1,600,000

2. The following is the “T-Account” for the entire banking system. Banks are fully loaned up. Currency held outside banks = 500,000. r = 8

%

Reserves = D= 1,000,000

Loans =

Suppose that the public deposits in the banking system 100,000 previously held as currency outside banks.a)Reserves in the banking system (Increase/decrease/remain the same)__________ by ____________ b)Loans in the banking system (Increase/decrease/remain the same)__________ by ____________ c)Deposits in the banking system (Increase/decrease/remain the same)__________ by ____________ d)The money supply (Increase/decrease/remain the same)__________ by ____________

2. Currency held outside banks = 500,000. r = 8%.The public deposits in the banking system 100,000 previously

held as currency outside banks.

a) Reserves in the banking system increase by 100,000

b) Deposits in the banking system increase by 1,250,000

c) Loans in the banking system increase by 1,150,000 d) The money supply increase by 1,150,000

Reserves =80,000 + 100,000 D= 1,000,000 + 100,000(1/0.08) =2,250,000

Loans = D-R = 2,250,000 - 180,000 = 2,070,000

R= 80,000 D= 1,000,000

Loans =920,000

3. The following is the “T-Account” for the entire banking system.

r= 10%Reserves = 190,000 D= 1,000,000

Loans =

Suppose that banks decide to hold only the required amount of reserves.a)Reserves in the banking system (Increase/decrease/remain the same)__________ by ____________ b)Loans in the banking system (Increase/decrease/remain the same)__________ by ____________ c)Deposits in the banking system (Increase/decrease/remain the same)__________ by ____________ d)The money supply (Increase/decrease/remain the same)__________ by ____________

810,000


r= 10%Actual Reserves = 190,000Required Reserves = 100,000

D= 1,000,000 + 90,000*10 D =1,900,000

Excess Reserves = 90,000

Loans = D – R = 1,900,000-190,000 = 1,710,000

Suppose that banks decide to hold only the required amount of reserves.a)Reserves in the banking system remain the same.b)Loans in the banking system Increase by 900,000c)Deposits in the banking system Increase by 900,000 d)The money supply Increase by 900,000

Reserves = 190,000

D= 1,000,000

Loans = 810,000

2. The following is the “T-Account” for the entire banking system. Banks are fully loaned up. Currency held outside banks = 700b r = 10%

Reserves = D= 600b

Loans =

Suppose that the public deposits in the banking system 50b previously held as currency outside banks.a)Reserves in the banking system (Increase/decrease/remain the same)__________ by ____________ b)Loans in the banking system (Increase/decrease/remain the same)__________ by ____________ c)Deposits in the banking system (Increase/decrease/remain the same)__________ by ____________ d)The money supply (Increase/decrease/remain the same)__________ by ____________


r= 10%Reserves = 70b D= 600b

Loans =

Actual reserves =______; Required reserves= _______;Excess reserves= _________Suppose that banks decide to hold only the required amount of reserves.a)Reserves in the banking system (Increase/decrease/remain the same)__________ by ____________ b)Loans in the banking system (Increase/decrease/remain the same)__________ by ____________ c)Deposits in the banking system (Increase/decrease/remain the same)__________ by ____________ d)The money supply (Increase/decrease/remain the same)__________ by ____________


The Money Supply

The Fed manipulates the amount of money in circulation (Ms)in two ways:

1. Changing the required reserve ratio.2. Changing the amount of total

reserves in the banking system.

Ms = Currency outside banks + Demand Deposits

10/13/2015© 2002 Claudia Garcia-Szekely1 Money Creation Chapter 12: Money and the Banking System When it comes to money, everybody is of the same religion.

Documents

claudia garciaszekelymonetary

supply of money

money supply760b590b1

money creationchapter

reserve requirement

federal reserve bank

banks reserves

banks demand depositsthe