Bob the Goldsmith. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000.

Bob the Goldsmith

Bob the Goldsmith

Assets Liabilities + Owners' Equity

Gold coins $100,000 Demand Deposits $100,000

Bob the Goldsmith



Suppose Bob makes a $1000 loan. Assume he gives the loan in

currency.

The money supply increases by $1000.



Loan $1000

Bob the Goldsmith

What if Bob had made the loan as a checking account

balance?

The money supply still increases by

$1000.Assets Liabilities + Owners' Equity


Loan $1000

General Principle of money and banking:

Whenever a bank makes a loan the

money supply increases by the

amount of the loan.

What happens when the loan is

paid back?

What happens when the loan is paid back?

Assume the loan was made in

currency (gold coins) and is

repaid with currency.



Loan $1000

Before the loan is repaid.

After the loan is repaid with currency.



Result:

The money supply

decreases by $1000.


paid back?


Assume the loan was made in

currency (gold coins) and is

repaid with a check.



Loan $1000


After the loan is repaid with a check.



The money supply

decreases by $1000.

Result:


paid back?


Assume the loan was made as

a checking account balance

and is paid back with a check.



Loan $1000


After the loan is repaid with a check.



Result:

The money supply

decreases by $1000.


paid back?


Assume the loan was made as

a checking account balance

and is paid back with currency.



Loan $1000


After the loan is repaid with currency



Result:

The money supply

decreases by $1000.

General Principle of money and banking:

When a loan of a financial institution is

repaid, the money supply decreases by the amount of the loan repayment.

These first two general principles

imply a third.

Individual banks create and destroy money one a

one-to-one basis with their loans. Every dollar created through loans is destroyed when the loans are repaid.

Fractional Reserve Banking

Reserves = Vault Cash + Deposits with the Fed

Reserves = Vault Cash + Deposits with the Fed

Required Reserves = r x (Demand Deposit Liabilities)

r = required reserve ratio

Total Reserves = Required Reserves + Excess Reserves

Let's impose a 20 percent reserve requirement on Bob

(i.e., r=.2).

Assets Liabilities +Owners' Equity

Reserves = $100,000 Demand Deposits $100,000

Required = .2 ($100,000)

= $20,000Excess = $80,000

Since Bob has excess reserves of $80,000, let's have him make an

$80,000 loan.

Since Bob has excess reserves of $80,000, let's have him make an

$80,000 loan.

Assets Liabilities +Owners' Equity

Reserves = $100,000

Loan = $80,000

Demand Deposits $180,000

Required = .2 ($180,000)

= $36,000Excess = $64,000

Assume Bob makes the loan as a checking account balance.

Note that Bob still has excess reserves of $64,000.

It looks like Bob could make another $64,000 loan.

But........

What if the person Bob made the $80,000 loan to writes a check for $80,000

to a person who has an account at another bank?

Let's go to the board and see what happens to Bob's

balance sheet.

Bob the Goldsmith. AssetsLiabilities + Owners' Equity Gold coins $100,000Demand Deposits $100,000.

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