“POOF PROCESS”

How Banks Make Money Out of Thin Air

BANK NOTES• banks are a business and must make a

profit to stay open• banks make money from services they

perform (i.e. late charges, ATM cards); the big earner is interest from loans

Fractional Reserve Banking• modern banking is called fractional

reserve banking because banks must store part (a fraction) of their funds at the Federal Reserve so they cannot loan out all the money in the bank at once

Alakazaam! Presto! POOF!

• banks have special powers to create money from thin air every time they give a loan out; Miss Thornton calls this the “Poof Process”

Types of Reserves • required reserves: the minimum money amount

a bank must keep at the Fed to back its demand deposits; calculated by demand deposits times the reserve requirement

• reserve requirement: percentage rate of money the bank must send to the Fed to back it money supply (determines the required reserves); set by the Fed and can be different for each bank

• Excess Reserves: money left in demand deposits after required reserves are subtracted; used to make loans

Poof Process Example

• Bubba Jose wants to open a bait and sushi shop

• He needs a loan for $100,000 to do this and goes to the local bank

So Bubba Jose goes to the local bank…

• Podunk Bank has $1 million worth of demand deposits

• Their reserve requirement set by the Fed is 20%

• So they send $200,000 to the Fed and can loan out $800,000 total

So the bank sends $200,000 to the Fed ($1,000,000 x .20) minimum

…and can loan out $800,000 total ($1,000,000 – $200,000)

Final Result of “Poof Process”– the bank lends the money and Bubba Jose pays

it back over a period of time making the money real instead of imaginary

– the bank does not take the money from anywhere to give the loan so it is imaginary money, while the checking accounts can be used in full by the owners of the money (customers)