When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Explain how banks create money by making loans.

When you have completed your study of this chapter, you will be able to

C H A P T E R C H E C K L I S T

Explain how banks create money by making loans.1

Explain how the Fed controls the quantity of money.2

18.1 HOW BANKS CREATE MONEY

Creating a Bank

To see how banks create money, we’ll work through the process of creating a bank and see how our new banks creates money.


There are eight steps:• Obtain a license to operate a commercial bank• Raise some financial capital• Buy some equipment and computer programs• Accept deposits• Establish a reserve account• Clear checks• Buy government securities• Make loans


Obtaining a Charter

Apply to the Comptroller of the Currency

Raising Financial Capital

Virtual College Bank creates 2,000 shares, each worth $100, and sells these shares in your local community.

Balance sheet

A statement that summarizes assets (amounts owned) and liabilities (amounts owed).


Table 18.1 shows Virtual College Bank’s balance sheet #1.


Buy some equipment and computer programs

Buy some office equipment, a server, banking database software, and a high-speed Internet connection.

These items cost you $200,000.


Table 18.2 shows Virtual College Bank’s Balance Sheet #2


Accepting Deposits

Offer the best terms available and the lowest charges on checkable deposits.

Deposits begin to roll in.

You have accepted $120,000 of deposits.




Establishing a Reserve Account

Establish a reserve account at local Federal Reserve Bank.




Reserves: Actual and Required

A bank’s required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold.

Suppose that the required reserve ratio is 25 percent of total deposits,

A bank’s required reserves are equal to its deposits multiplied by the required reserve ratio.

So Virtual College Bank’s required reserves are:

Required reserves = $120,000 x 25 ÷100 = $30,000.


Actual reserves minus required reserves are excess reserves.

Virtual College Bank’s excess reserves are:

Excess reserves = $120,000 - $30,000 = $90,000.

Whenever banks have excess reserves, they can make loans.


Clearing Checks

Virtual College Bank’s depositors want to be able to make and receive payments by check.

Funds must move from an account at your bank to an account at another bank.

In the process, one bank loses reserves and the other bank gains reserves.

Figure 18.1 on the next slide shows how a bank clears a check.


First American sends a $20,000 check for collection to the Dallas Fed.

The Dallas Fed increases FirstAmerican’s reserves anddecreases Virtual College’s reserves by $20,000.


First American increases Hal’s PCs’ checkable deposit by $20,000. Virtual Collegedecreases Jay’s checkable deposit by $20,000.


First American’s assets and liabilities have both increased by $20,000.Virtual College’s assets and liabilities have both decreasedby $20,000.


Buying Government Securities

Government securities provide a bank with an income and a safe asset that is easily converted back into reserves.

Suppose that Virtual College decides to buy $60,000 worth of government securities.

On the same day, First American decides to sell $60,000 of government securities.

In reality, a bond broker will match the First American sale with Virtual College’s purchase.


Virtual College buys $60,000 worth of government bonds from First American.

Virtual College’s government securities increase by $60,000 and First American’s government securities decrease by that amount.


Virtual College pays for the bonds by check and when the check clears, the Dallas Fed increases First American’s reserves by $60,000 and decreases Virtual College’s reserves by the same amount.


First American’sreserves have increasedand its government securities have decreased by $60,000.


Virtual College’sreserves have decreasedand its government securities have increased by the $60,000.




Making Loans

With reserves of $40,000 and required reserves of $25,000, Virtual College has excess reserves of $15,000.

So the bank decides to make loans of this amount.



Virtual College has now created $15,000 of new money.


Spending a Loan

To spend their loans, the borrowers write checks on their checkable deposits. Assume they spend the entire $15,000.

Most likely, the people to whom these checks are paid do not bank at Virtual College.

The receiving banks send the checks to the Dallas Fed for collection.

The Fed increases the reserves of the receiving banks by $15,000 and decreases the reserves of Virtual College by $15,000.



The deposits that Virtual College created are now at some other banks in the system.


Limits to Money Creation

When Virtual College creates money and its customers spend the new money, other banks receive reserves and have excess reserves.

These banks now create money just like Virtual College did.

At each stage the amount of new loans get smaller.


When a bank receives deposits, it keeps 25 percent in reserves and lends 75 percent. The amount loaned becomes a new deposit at another bank.

The next bank in the sequence keeps 25 percent and lends 75 percent, and the process continues until the banking system has created enough deposits to eliminate its excess reserves.

At the end of the process, an additional $100,000 of reserves creates an additional $400,000 of deposits.

Figure 18.3 on the next slide shows the multiple creation of bank deposits.



The Deposit Multiplier

The number by which an increase in bank reserves is multiplied to find the increase in bank reserves:

Deposit multiplier =1

Required reserve ratio

18.2 FED CONTROL OF MONEY SUPPLY

The Fed has three tools for controlling the money supply:

• Required reserve ratios• Discount rate• Open market operations


How Required Reserve Ratios Work

When the Fed increases the required reserve ratio, the banks must hold more reserves.

To increase their reserves, the banks must decrease their lending, which decreases the quantity of money.

When the Fed decreases the required reserve ratio, the banks may hold fewer reserves.

To decrease their reserves, the banks increase their lending, which increases the quantity of money.


How The Discount Rate Works

When the Fed increases the discount rate, the banks must pay a higher price for any reserves that they borrow from the Fed.

Faced with a higher cost of reserves, the banks are less willing to borrow reserves.

The banks must decrease their lending to decrease their borrowed reserves.

So when the discount rate increases, the quantity of money decreases.


When the Fed decreases the discount rate, the banks pay a lower price for any reserves that they borrow from the Fed.

Faced with a lower cost of reserves, the banks are willing to borrow more reserves and increase their lending.

The quantity of money increases.


How An Open Market Operation Works

The Fed’s major policy tool.

When the Fed buys securities in an open market operation, it pays for them with newly created bank reserves and money. The banks can use their new reserves to create even more money.

When the Fed sells securities in an open market operation, people pay for them with money and reserves.


The Fed Buys Securities

Suppose the Fed buys $100 million of U.S. government securities in the open market.

The seller might be:• A commercial bank• The non-bank public


Figure 18.4 shows what happens when the Fed buys securities from a bank.


Figure 18.5 shows what happens when the Fed buys securities from the public.


The Fed Sells Securities

Suppose the Fed sells $100 million of U.S. government securities in the open market.

The monetary base decreases.

The reserves of the banking system decrease.


The Multiplier Effect of an Open Market Operation

An open market purchase that increases bank reserves also increases the monetary base.

The increase in the monetary base equals the amount of the open market purchase, and initially, it equals the increase in bank reserves.


If the Fed buys securities from the banks, the quantity of deposits (and quantity of money) does not change.

If the Fed buys securities from the public, the quantity of deposits (and quantity of money) increases by the same amount as the increase in bank reserves.

Either way, the banks have excess reserves that they now start to lend.


The following sequence of events takes place:• An open market purchase creates excess reserves.• Banks lend excess reserves.• The quantity of money increases.• New money is used to make payments.• Some of new money is held as currency.• Some of the new money remains on deposit in banks.• Banks’ required reserves increase.• Excess reserves decrease but remain positive.


Figure 18.6 illustrates this sequence of events.

The process repeats until excess reserves have been eliminated.


Figure 18.7 provides an example of the multiplier effect of an open market operation with numbers.

• When the Fed provides the banks with $100,000 of additional reserves in an open market operation, the banks lend those reserves.

• Of the amount loaned, $33,333 (33.33 percent) leaves the banks in a currency drain and $66,667 remains on deposit.

• With additional deposits, required reserves increase by $6,667 (10 percent required reserve ratio) and the banks lend $60,000.


• Of this amount, $20,000 leaves the banks in a currency drain and $40,000 remains on deposit.

• The process repeats until the banks have created enough deposits to eliminate their excess reserves.

• An additional $100,000 of reserves creates $250,000 of money.

The next slide summarizes this sequence of events.



The Money Multiplier

The number by which an increase in the monetary base is multiplied to find the resulting increase in the quantity of money.

The larger the currency drain and the larger the required reserve ratio, the smaller is the money multiplier.

Change in quantity of money

=Money multiplier

xChange in monetary base

When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Explain how banks create money by making loans.

Documents

money reserves

new banks

money actual reserves

money table

slide shows

loans slide

quantity of money

ratio of reserves