chapter 32 how banks and thrifts create money the balance sheet of a commercial bank balance sheet =...

Chapter 32

How Banks and Thrifts Create Money

The Balance Sheet of a Commercial Bank

• Balance sheet = a statement of assets and claims on assets that summarizes the financial position of the bank at a certain time.

• As named, a balance sheet should balance at all times!

• What does this mean?– Assets = Liabilities + Net Worth

– Assets are anything of monetary value owned by a firm or individual (cash, property)

– Liabilities are debts with a monetary value; an amount owed by a firm or individual

– Net worth are the claims of the owner’s against the firms total assets; an individual’s own wealth

Fractional Reserve Banking System• The U.S. has a fractional reserve banking system

– Only a fraction of total money supply is held in reserve as currency

• Two significant characteristicsMoney Creation and Reserves –

Banks create money by lending. The amount created depends on how much currency reserves the bank feels obligated or is required to keep.

Bank Panics and Regulation–

Banks are vulnerable to “panics” since they would not be able to convert all paper money to hard currency if everyone tried to redeem their hard currency at once because lending exceeds deposits. The U.S. therefore places regulations and holds a system of deposit insurance.

How banks create money video

http://www.youtube.com/watch?v=Hg_1iXbIjFQ

A Single Commercial Bank

Creating a Bank: Balance Sheet 1 – Wahoo Bank

Assets Liabilities and Net Worth

1) Secure a state or national charter

2) Sell $250,000 worth of stocks

Cash $250,000 Capital Stock $250,000

Cash from stockholders(known as vault money)

Claim held by stockholders

Account = each item listed in a balance sheet

Transaction 1: Creating a Bank

Property and Equipment: Balance Sheet 2 – Wahoo Bank


1) A portion of the vault money buys equipment and property

2) Buy $240,000 worth of property, $10,000 worth of cash is left

Cash $10,000 Capital Stock $250,000

Adds up to $250,000 Claim held by stockholders

Transaction 2: Acquiring Property and Equipment

Property $240,000

Property and Equipment: Balance Sheet 3 – Wahoo Bank


1) Banks have two functions 1) accept deposits; 2) make loans

Cash $110,000

Capital Stock $250,000

When the bank accepts a deposit of $100,000 the cash value increases by this amount as an asset

The asset input of $100,000 is balanced by a liability in the form of checkable deposits – this is the claim the depositors have toward the money deposited.

Transaction 3: Accepting Deposits

Property $240,000

Checkable Deposits $100,000

• By law, banks that provide checkable deposits must keep required reserves.

• Required reserves = amount of funds equal to a specific percentage of a bank’s deposit liabilities

Reserve Ratio

• Example – If the reserve ratio is 1/10 then the required reserve is $10,000 out of the total $100,000 liabilities

Transaction 4: Depositing Reserves

Reserveratio

Commercial bank’srequired reserves

Commercial bank’scheckable-depositliabilities

=

1/10$ 10,000

$ 100,000=

Fyi – reserve ratio is 3% for $12.4 – 79.5M and 10% for above that amount

• If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then how much is the bank required to reserve? Remember:

Practice Problem #1

Reserveratio



=

• If by law the reserve ratio is mandated to be 20% or 1/5, and a bank’s checkable-deposit liabilities equals $200,000, then how much is the bank required to reserve?

• Known: • Reserve ratio = .20• Commercial bank’s checkable-deposit liabilities = $200,000

• Equation: • Required reserves = ratio X checkable-deposit liabilities• Required reserves = .20 X $200,000 =

Practice Problem #1 - Answer

Reserveratio



=

$ 40,000

• Excess Reserves

Excess Reserves

• Excess Reserves is what determines how much a bank can loan.


ExcessReserves – = Actual

ReservesRequiredReserves

• If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then the bank is required to reserve $40,000. If the bank actually reserves $120,000 calculate the excess reserves. Remember:

Practice Problem #2



• If by law the reserve ratio is mandated to be 20% or 1/20, and a bank’s checkable-deposit liabilities equals $200,000, then the bank is required to reserve $40,000. If the bank actually reserves $120,000 calculate the excess reserves.

• Known: • Actual Reserves=$120,000• Required Reserves=$40,000

• Equation: • Excess reserves = actual –required reserves• Excess reserves = $120,000 - $40,000 =

Practice Problem #2 - Answer



$80,000

Depositing Reserves at the Fed: Balance Sheet 4 – Wahoo Bank


1) By law, banks that provide checkable deposits must keep required reserves.

Cash $0


This is true if a bank deposits all of its cash in the Federal Reserve Bank


Property $240,000


Reserves $110,000

Transaction 5: Clearing a Check

Reserves of Wahoo bank-$50,000Reserves of Surprise bank+$50,000

Checkable deposits+$50,000

Reserves+$50,000

Reserves-$50,000

Checkable deposits-$50,000

Clearing a Check: Balance Sheet 5 – Wahoo Bank


1) By law, banks that provide checkable deposits must keep required reserves.

Cash $0


Transaction 5: Clearing a Check

Property $240,000

Checkable Deposits $100,000 – 50,000 = 50,000

Reserves $110,000 – 50,000 = 60,000

If a check of $50,000 is written against the Wahoo Bank, this amount is subtracted from both Assets and Liabilities/Net Worth

A Loan is Negotiated: Balance Sheet 6a – Wahoo Bank


1) When a bank makes a loan, they turn something that isn’t money – a promise to pay back a loan – into something that is money – a checkable deposit.

Reserves $60,000


Transaction 6: Granting a Loan

Property $240,000

Checkable Deposits $50,000 + 50,000 = 100,000

Loans $50,000

A loan creates money. This adds an amount to the bank’s assets. The money goes into checkable deposits as well.

Check is Drawn on the Loan: Balance Sheet 6b – Wahoo Bank


1) The person who took out the loan uses the money to pay someone else, money is transferred to another bank causing similar effects as when a check is cleared on actual reserves.

Loans $50,000


Transaction 6b: Check is Drawn on Loan

Property $240,000

Checkable Deposits $100,000 – 50,000 = 50,000

Reserves $60,000 – 50,000 = 10,000

Reserves and checkable deposits diminish by $50,000 when the loan money is used to pay another person and is put in another bank.

Repaying a Loan: Balance Sheet 7 – Wahoo Bank


1) When a person then comes back and repays a loan with a check, money is destroyed. The “Loans” are subtracted from the “Assets” and the amount is also subtracted from “Checkable Deposits”.

Reserves $10,000


Transaction 7: Repaying a Loan

Property $240,000

Checkable Deposits $50,000 – 50,000 = 0

Loans $50,000 – 50,000 = 0

The money that was created when the loan was made is destroyed when the loan is repaid.

Buying Government Securities: Balance Sheet 8 – Wahoo Bank


1) Buying and then selling government securities has the same effects on a bank’s balance sheet as does loaning and repaying loans accordingly.

Reserves $60,000


Transaction 8: Buying Gov’t Securities

Property $240,000


Securities $50,000

As with a loan, the buying of securities creates money.

Profits, Liquidity, Federal Funds Market

• Banks have two conflicting goals:– Profit – Why the banks make loans and buy securities (two

major earning assets)

– Liquidity – Safety lies with liquidity. Liquid assets are cash and excess reserves. Bankers must protect against depositors wishing to extract cash. Also, they must protect against a net outflow of reserves in which more checks are cleared against the bank than in favor of the bank.

• Banks can partly find a balance between the two goals by lending temporary excess reserves held at the Federal Reserve Bank to other commercial banks. The interest rate for these overnight loans is called the Federal funds rate.

Multiple – Deposit Expansion Process

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

Amount bankcan lend - Newmoney created

ABCDEFGHIJKLMNOther banks

$100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99

$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40

$80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59

$80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59

$400.00Total amount of money created by the banking system

The Monetary Multiplier• Monetary Multiplier exists because the reserves and

deposits lost by one bank are received by another bank.

Monetary

Multiplier

Max. Checkable-

Deposit Creation Max. CheckableDeposit Creation X = Excess

ReservesMonetary Multiplier

MonetaryMultiplier

1

Required reserve ratio=

Some Modifications• Leakages:

– Currency drains – some borrowers may request that part or all of their loan to be paid in currency, thereby diminishing the magnitude of the multiplier

– Excess reserves – if the bank keeps more as reserve than the legal minimum mandates, this would also diminish the multiplier, though this is less likely since loans earn interest income, thereby increasing profit.

Practice Problem #3• If the required reserve ratio is .20 or 20%, then how

big is the monetary multiplier? Remember:

Monetary

Multiplier

MonetaryMultiplier

1


Practice Problem #3 - Answer• If the required reserve ratio is .20 or 20%, then how big is the

monetary multiplier?

Monetary

Multiplier

• Known:

• Required reserve ratio = .20

• Equation:

• Monetary multiplier = 1 / (required reserve ratio)

• Monetary multiplier = 1 / .20 =

MonetaryMultiplier

1


5

Practice Problem #4• If the monetary multiplier is 5 and the value of excess

reserves equals $95,000, then how much will the money supply increase through loans? Remember:

Max. CheckableDeposit Creation X = Excess


Max. CheckableDeposit Creation

Practice Problem #4 - Answer• If the monetary multiplier is 5 and the value of excess reserves equals $95,000, then

how much will the money supply increase through loans?

• Known:

• Excess reserves = $95,000

• Monetary multiplier = 5

• Equation:

• Max. Checkable Deposit Creation = $95,000 x 5 =

Max. CheckableDeposit Creation X = Excess


Max. CheckableDeposit Creation

$475,000

Practice Problem #5

• If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves?

Practice Problem #5 - Answer• If a bank has $500 in checking deposits and the

bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves?

• Known:– Checking deposits = $500

– Required Reserves = $50

• Equation:– Reserve ratio = required reserve / checking deposits

= $50 / $500 =

– Excess Reserves = checking deposits – required reserves

= $500 - $50 =

.1 10 percent

$450

Once upon a time there was aand a 10% reserve ratio…

1a. Mrs. Dunnaway deposits $100 to: WHS BankAssets LiabilitiesRR: $10 Mrs. D’s Acct: $100ER: $90

1b. WHS Bank loans the $90 to Tim for a new bike…WHS BankAssets LiabilitiesRR: $19 Mrs. D’s Acct: $100ER: $ 81Loan to Tim: $90 Tim’s Acct: $90

2a. Tim gives $90 to Bryce’s Bike’s, who deposits it at Citizens’ Bank…Citizens’ BankAssets LiabilitiesRR: $9 Bryce’s Acct: $90ER: $81

2b. Citizens’ Bank them loans the $81 to Liz for a pair of boots…Citizens’ BankAssets LiabilitiesRR: $17.10 Bryce’s Acct: $90ER: $72.90 Liz’s Acct: $81Loan to Liz: $81

Money Multiplier=1/RR 10; Total Deposit Creation: 10*Initial Deposit=$1,000

THE END!!!

chapter 32 how banks and thrifts create money the balance sheet of a commercial bank balance sheet =...

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