Fractional reserve banking system - Only a portion (fraction) of checkable deposits are backed up by cash in bank vaults or deposits at the central bank

• Banks can create money through lending

• Currency itself serves as bank reserves so that the creation of checkable deposit money by banks (via their lending) is limited by the amount of currency reserves that the banks feel obligated, or are required by law, to keep

• Deposit insurance helps to prevent economic panics

Balance sheet - A statement of assets and claims on assets that summarizes the financial position of the bank at a certain time

• Divided into assets and liabilities + net worth

• Assets = Liabilities + net worth

• Must always be balanced

Transaction 1: Creating a bank

• Vault cash - Cash held by a bank

• Shares of stock constitute bank’s net worth

• Each item listed in a balance sheet is called an account

Transaction 2: Acquiring property + equipment

• Purchasing property + equipment changes the composition of the bank’s assets

• Less cash, more property assets

Transaction 3: Accepting deposits

• Receiving cash as checkable deposits constitute claims that the depositors have against the assets of the Wahoo bank and thus are a new liability account

• Change in composition of money supply occurs

Transaction 4: Depositing reserves in a federal reserve bank

• Required reserves - An amount of funds equal to a specified percentage of the bank’s own deposit liabilities

• Reserve ratio - The “specified percentage” of checkable-deposit liabilities that a commercial bank must keep as reserves

• The Fed has the authority to establish and vary the reserve ratio within limits legislated by Congress

• Excess reserves - Actual reserves - required reserves

• Commercial bank deposits protected by periodic bank examinations + insurance funds

• Required reserves help the Fed control the lending ability of commercial banks

Transaction 5: Clearing a check drawn against the bank

• Whenever a check is drawn against one bank and deposited in another bank, collection of that check will reduce both the reserves and the checkable deposits of the bank on which the check is drawn

• If a bank receives a check drawn on another bank, the bank receiving the check will, in the process of collecting it, have its reserves and deposits increased by the amount of the check

Transaction 6: Granting a loan

• When a bank makes loans, it creates money

• Much of the money we use in our economy is created through the extension of credit by commercial banks

• A single commercial bank in a multibank banking system can lend only an amount equal to its initial pre-loan excess reserves

Transaction 7: Buying government securities

• When a commercial bank buys government bonds from the public, new money is created

• The selling of government bonds to the public by a commercial bank—like the repayment of a loan— reduces the supply of money

Profits, liquidity, + the federal funds market

• 2 goals of profit + liquidity

• An interesting way in which banks can partly reconcile the goals of profit and liquidity is to lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks

• Federal funds rate - Interest paid on banks lending excess reserves to other banks on an overnight basis

The banking system + multiple-deposit expansion

• Reserves lost by a single bank are not lost to the banking system as a whole

• Although reserves can be, and are, lost by individual banks in the banking system, there is no loss of reserves for the banking system as a whole

• An individual bank can safely lend only an amount equal to its excess reserves, but the commercial banking system can lend by a multiple of its collective excess reserves

Monetary multiplier - Exists because the reserves and deposits lost by one bank become reserves of another bank. It magnifies excess reserves into a larger creation of checkable-deposit money.

• Maximum checkable deposit creation = Excess reserves * monetary multiplier

• Higher reserve ratios mean lower monetary multipliers and therefore less creation of new checkable-deposit money via loans (and vice versa)

Just as checkable-deposit money is created when banks make loans, checkable-deposit money is destroyed when loans are paid off