Chapters 29.3-29.5: Money Creation 

Money-Creating Transactions of a Commercial Bank

Refer to worked example: https://knowt.io/note/e0389526-256f-4b2e-a266-ef2c3e59df10/AP-Macro-291-292-money-creation

Transaction 6: Granting a Loan

  • a meat packing company requests and is granted a $50,000 loan from the Wahoo bank
    • the bank loans out its $50,000 of excess reserves
  • the company gets a $50,000 increase in its checkable-deposit account in the bank.
  • the $50,000 is an interest-earning loan (asset) and a checkable deposit (liability) to the bank

 Balance sheet after transaction 6, part a

  • ^^When a bank makes loans, it creates money^^
    • there is a change in the supply of money
    • Much of the money used in the United States is created through the extension of credit by commercial banks
  • the borrower draws a check for its $50,000 loan and gives it to the construction company, who deposits it into another bank

 Balance sheet after transaction 6, part b

  • After the check has been collected, Wahoo bank just meets the required reserve ratio of 20 percent (= $10,000/$50,000)
    • its excess reserves have gone from $50,000 to $0
    • it could not have lent more than its excess reserves (more than $50,000) because it wouldn’t meet the required reserve ratio afterwards
  • A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves.
  • since a bank creates checkable-deposit money when it lends its excess reserves, money is “destroyed” when borrowers pay off loans

Transaction 7: Buying Government Securities

  • ^^a bank creates money by buying government bonds from the public^^
  • suppose we go back to transaction 5
  • instead of making a $50,000 loan, the Wahoo bank buys $50,000 of government securities from a securities dealer.
  • The bank receives the interest bearing bonds (“Securities” asset) and gives the dealer an increase in its checkable deposit account (liabilities)

 Balance sheet after transaction 7

  • Bond purchases from the public by commercial banks increase the supply of money in the same way as lending to the public does
    • The bank accepts government bonds (which are not money) and gives the securities dealer an increase in its checkable deposits (which are money).
  • the selling of government bonds to the public by a commercial bank reduces the supply of money like repaying a loan does

Profits, Liquidity, and the Federal Funds Market

  • a banker has 2 conflicting goals:
    • profit
    • profit is why the bank makes loans and buys securities—the two major earning assets of commercial banks
    • liquidity
    • safety lies in liquid assets as cash and excess reserves.
    • A bank must be on guard for depositors who want to transform their checkable deposits into cash.
  • before the crisis of 2008
    • to balance profit and liquidity, banks that had excess reserves could lend them overnight to the banks that were deficient.
    • These loans allowed the banks that were deficient to meet their reserve requirements while also allowing the banks making the loans to earn a little interest.
    • this was the federal funds market
  • federal funds rate::
    • The interest rate that U.S. banks and other depository institutions charge one another on overnight loans made out of their excess reserves.

The Monetary Multiplier

  • monetary multiplier::
    • defines the relationship between any new excess reserves in the banking system and the magnified creation of new checkable-deposit money by banks as a group.
    • aka the checkable deposit multiplier
  • The monetary multiplier m is the reciprocal of the required reserve ratio R
    • ^^m = 1 / R^^

 

  • m represents the maximum amount of new checkable-deposit money that can be created by a single dollar of excess reserves, given the value of R
  • By multiplying the excess reserves E by m, we can find the maximum amount of new checkable-deposit money, D, that can be created by the banking system
    • ^^D = E * m^^

 

  • Higher reserve ratios mean lower monetary multipliers and less creation of new checkable-deposit money via loans
  • Smaller reserve ratios mean higher monetary multipliers and more creation of new checkable-deposit money via loans

Reversibility: The Multiple Destruction of Money

  • Loan repayment sets off a process of multiple destruction of money the opposite of the multiple creation process
  • If the dollar amount of loans made in some period exceeds the dollar amount of loans paid off, checkable deposits will expand and the money supply will increase.
  • if the dollar amount of loans is less than the dollar amount of loans paid off, checkable deposits will contract and the money supply will decline