Money Creation
Lesson 22

T-Account Transactions

• T-account - shows changes in a balance sheet
  • Show various transactions for a single commercial bank
• Balance sheet - shows a business's assets, liabilities, and capital
  1. Liabilities - a debt or obligation
     • Example: Bank loan
     • An asset to the bank, but a liability to the borrower
  2. Assets - something of value
     • Example - cash
     • An asset to person holding cash
  3. Net worth - amount left over when liabilities are subtracted from assets
     • Creditors want net worth to be positive
     • Ensures business can meet financial obligations
• Accounting system - each transaction has two entries
  • Double entry system
  • Conforms to the equation

Total Assets = Total Liabilities + Net Worth

Your Bank

Example 2: The bank uses $16,000 cash to buy a building for $15,000 and $1,000 for a computer system

Your Bank

Example 3: You get family and friends to deposit $50,000 cash into your bank

     Note - Deposits are a liability to the bank, but an asset to the depositors<

     Note - The money supply does not change because $50,000 is converted from cash to checkable deposits

Your Bank

• Banks are required to hold a percentage of deposits as cash or a deposit at the Federal Reserve Bank
  • Required reserves - amount of vault cash or deposits at the Federal Reserve that banks must hold
  • Required reserve ratio - the percentage of reserves banks must hold
  • Excess reserves - amount of reserves a bank holds above required reserves
• Re-doing last transaction
  • required reserve ratio is 20%
  • Required reserves are $10,000
    • Multiply $50,000 by 20%
  • Excess reserves are $40,000
    • Subtract $10,000 from $50,000

Your Bank

• Federal Reserve Requirements are shown below
  • Theoretically, reserve requirements are supposed to help banks meet depositor's withdrawal
  • Bank run - depositors panic and rush to the bank to withdraw their money
    • Bank fails because it cannot pay back all the depositors
    • Rumors of a bank failure could lead to a bank run, which could cause a financially healthy bank to fail
  • Deposit insurance - government insures deposits up to a limit
    • Prevents bank runs
    • Federal Deposit Insurance Corporation (FDIC)
      • Insures bank deposits up to $250,000
      • Note - Depositor is only insured for a total of $250,000
      • Depositor could get only $250,000 if he had 5 accounts with $250,000 in each one.

Source: Federal Reserve System

Example 4: Bank buys a $1,000 U.S. Treasury bill from a person using vault cash. Then person deposits funds into a bank account.

     Note - Money supply increases by $1,000 as vault cash is changed into checkable deposit

Your Bank

Example 5: Bank reserves at the Federal Reserve can help banks clear checks

     Note - You write a check for $500 to buy a laptop from a Californian store

          The store deposits the check with his bank in California

          The process is actually more complicated

Californian Store's Bank

The Californian bank sends the check to the Federal Reserve, so it can be cleared.

     The Federal Reserve increases the Californian bank's reserves and lowers your bank reserve

     Your bank lowers your account balance by $500

Your Bank

Californian Store's Bank

The check clearing process was greatly simplified. There is a time delay when clearing checks. This $500 existed in two places before the check "cleared."

Fractional Reserve System

Goldsmiths

• During 16th century
  • Unsafe to carry gold around
  • People would deposit their gold with goldsmiths
  • Goldsmith charged a fee and issued a receipt
  • People would exchange these receipts as money
  • People could always redeem receipts for gold
• A hundred percent (100%) reserve system
  • The total value of receipts equals the gold in the safe
  • Even if all depositors withdrew their gold, all of them would be paid
• Fractional reserve system - banks hold only a portion of deposits
  • Goldsmith could issue more receipts than the amount of gold in his safe
  • Goldsmith created money out of thin air!

• Two characteristics
  • Fractional reserve system allows banks to create money as a whole
    • All banks together create money
  • Sometimes an economy experiences a financial panic
• Commercial banks' purpose
  • Earn profits by charging a higher interest rate to borrowers than interest paid to depositors
  • Ensure banks have plenty of liquid assets to meet depositors' withdrawals
  • Example
    • U.S. government securities - very liquid and easy to sell for a known price
    • Banks can quickly sell liquid securities for cash
  • Federal Funds - banks lend amoung themselves overnight their excess reserves that are hold by the Federal Reserve Bank
    • Banks with excess reserves at the Fed can lend funds to banks who are short on required reserves.
    • Source of funds for temporary withdrawals or meet required reserves
    • Transfer of funds is electronic and done through the Fed wire
    • Interest rate is called Federal Funds rates
    • Important interest rate because monetary policy has an immediate impact on this interest rate

• Example - Federal Reserve buys a $10,000 Treasury bill from Compass bank
  • Required reserve ratio, r _r, is 10%
  • No required reserves because there is no checkable deposits.
  • Federal Reserve injected $10,000 of reserves into the banking system

Compass Bank

• Compass bank can loan out its excess reserves as a loan.
  • Compass grants a $10,000 loan to an internet business that buys new computers from Dell
  • Dell receives this money and deposits this money into its account with U.S. Bank
  • Money supply increases by $10,000

U.S. Bank

• U.S. bank has $9,000 in excess reserves that it can lend out.
  • U.S. bank grants a home improvement loan to Mr. Smith.
  • Mr. Smith writes a check to Home Depot.
  • Home Depot deposits this check at their bank which is Regions Bank
  • Money supply increases by $10,000 + $9,000

Regions Bank

• Regions bank has $8,100 in excess reserves that it can lend out.
  • Regions Bank grants an auto loan for Mr. Johnson
  • Mr. Johnson buys a car from Scambag Motors and Scambag Motors deposits this check at their bank, Arkansas National Bank
  • Money supply increases by $10,000 + $9,000 + $8,100

Arkansas National Bank

• Infinite process and is similar to investment multiplier
  • reserves - amount the Federal Reserve System changes
  • r _r is required reserve ratio
  • money supply, M _s, changes by:

• In our case, the money supply would increase by:

• The money multiplier is:

• The money multiplier is:

• The money multiplier is smaller in the real world
  1. People withdraw cash
  2. Money leaves the country
  3. Banks may not lend all their excess reserves
     • Financial crisis - banks may stop lending and hold onto all reserves

Similar to the investment multiplier, the Federal Reserve can decrease the money supply by selling U.S. Treasury securities, causing bank reserves to decrease. A Fed check is based on nothing! Federal Reserve cannot bounce checks; its creates money out of thin air! When a banks gets a Fed check, the Federal Reserve adds the money to their reserves. Same result if the Federal Reserve purchased the U.S. Treasury security from a person. That person deposits the Fed check at a bank.

Terminology