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Kevin Brady and Eric Chiang

Money Creation Process

Interactive Examples

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Material from this presentation can be found in:

Chapter 22

CoreEconomics, 2e

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One of the key features of the financial markets in the United States is the fractional reserve banking system.

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Question: What is meant by “fractional reserve banking system”?

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Answer



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Answer: When someone deposits money into a bank account, the bank is required to hold part of this deposit in its vault as cash, or else hold it in an account with the regional Federal Reserve Bank.

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Question: Why was fractional reserve banking introduced in the United States?

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Question: Why was fractional reserve banking introduced in the United States?

Answer: To prevent bank runs. Bank runs occur when all depositors demand their cash back at the same time. By forcing banks to hold a portion of the deposits they receive, banks should have enough money on hand to meet their clients’ normal cash demands.

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One of the neat features of the fractional reserve banking system is that it permits banks to create money.

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Question: How does fractional reserve banking permit banks to create money?

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Answer: Let’s map out the process. Assume you deposit $100 dollars into Bank One and that the reserve requirement is 10%. In other words, Bank One must hold 10% of your deposit in its vault.

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Answer: Let’s map out the process. Assume you deposit $100 dollars into Bank One and that the reserve requirement is 10%. In other words, Bank One must hold 10% of your deposit in its vault.

Question: What will Bank One’s balance sheet look like?

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Bank One

Assets Liabilities

Reserves = $10 Deposits = $100

Loans = $90

Answer:

When you deposit your $100, it becomes a liability for Bank One because it owes you $100. Because of the 10% reserve requirement, Bank One must keep at least $10 in its vault as reserves.

Of course Bank One could hold reserves above the minimum requirement, but do not forget Bank One is in the business of making money! In order to make money, let’s assume Bank One loans out $90 to Richie, the owner of Richie’s Records.

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Question: If Richie pays Tonie $90 for her record collection to use as inventory for his store, what might happen in the banking system?

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Question: If Richie pays Tonie $90 for her record collection to use as inventory for his store, what might happen in the banking system?

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Answer: Bank Two

Assets Liabilities


Loans = $81

If Tonie deposits the $90 she received from Richie into Bank Two, it becomes a liability for Bank Two because it owes Tonie $90. Because of the 10% reserve requirement, Bank Two must keep at least $9 in its vault as reserves. If it holds the minimum and lends out the remaining deposits, Bank Two will have $81 of loans on its balance sheet.

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Question: If we stop here and look at just these two banks, what are the combined reserves, loans, and deposits in the banking system?

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Question: If we stop here and look at just these two banks, what are the combined reserves, loans, and deposits in the banking system?

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Answer: Bank One and Two

Assets Liabilities


Loans = $171

What is amazing here is that just through the normal course of business, combined with the fractional reserve banking system, the total deposits are $190! In our simple example, this $190 is the new money supply right now. Remember that we started with a simple $100 deposit made by you! It is as if the additional $90 appeared out of thin air!

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Question: If we let this process continue, in other words, if the person who borrowed money from Bank Two now spends that money and it is deposited into Bank Three, which in turn loans the most it could after obeying the reserve requirement, and so on and so forth, what will be the ending level of reserves, loans, and deposits in the economy?

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Question: If we let this process continue, in other words, if the person who borrowed money from Bank Two now spends that money and it is deposited into Bank Three, which in turn loans the most it could after obeying the reserve requirement, and so on and so forth, what will be the ending level of reserves, loans, and deposits in the economy?

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Answer: All Banks

Assets Liabilities

Reserves = $100 Deposits = $1,000

Loans = $900

The easiest way to figure out these numbers is by using the money multiplier formula. The money multiplier tells you the maximum amount the money supply can increase when new deposits enter the system and is calculated as 1 divided by the reserve requirement percentage.

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Answer continued: In our example the reserve requirement was 10%. Thus, the money multiplier was 1 / .10 = 10

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If you take the initial deposit of $100 and multiply it by the money multiplier, you arrive at the ending deposit balance of $1,000. Since we have been assuming that banks hold only the minimum reserves required and lend everything else, the banking system will have $100 in reserves and $900 in loans when the process runs its course.

All Banks

Assets Liabilities

Reserves = $100 Deposits = $1,000

Loans = $900

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slides created by kevin brady and eric chiang money creation process interactive examples to...

Documents

interactive examples

bank account

deposits money

interactive examples

regional federal reserve

bank runs

reserve requirement

united states