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

• 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

• 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)

• 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