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Chapter 15 – Money Creation

CHAPTER FIFTEEN

MONEY CREATION

CHAPTER OVERVIEW

The central topic of this chapter is the creation of checkable (demand) deposit money by commercial

banks. First, a number of routine but significant introductory transactions are covered, followed by an

assessment of the lending ability of a single commercial bank. Second, the lending ability and the money

multiplier of the commercial banking system are traced through the balance statements of individual

banks and through the summary Table 15.2.

WHAT’S NEW

There is a new Last Word on leverage banking.

Other than this new Last Word there are only a few minor modifications to this chapter.

All of the tables and graphs have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Recount the story of how fractional reserves began with goldsmiths.

2. Explain the effects of a currency deposit in a checking account on the composition and size of the

money supply.

3. Compute a bank’s required and excess reserves when you are given its balance-sheet figures.

4. Explain why a commercial bank is required to maintain a reserve and why it isn’t sufficient to

cover deposits.

5. Describe what happens to the money supply when a commercial bank makes a loan or buys

securities.

6. Describe what happens to the money supply when a loan is repaid or a bank sells its securities.

7. Explain what happens to a commercial bank’s reserves and checkable deposits after it has made a

loan.

8. Describe how a check drawn on one commercial bank and deposited in another will affect the

reserves and excess reserves in each bank after the check clears.

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9. Describe what would happen to a single bank’s reserves if it made loans that exceeded its excess

reserves.

10. Explain how it is possible for the banking system to create an amount of money that is a multiple of

its excess reserves when no single bank ever creates money greater than its excess reserves.

11. Compute the size of the monetary multiplier and the money-creating potential of the banking

system when provided with appropriate data.

12. Explain that the money multiplier process can also lead to multiple destruction of money.

13. Define and identify the terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. Emphasize that the money multiplier in this chapter is distinct from the income multiplier that was

discussed in earlier chapters.

2. Current data on the money multiplier can be obtained from two publications: Monetary Trends

(monthly) and US Financial Data (weekly), which are published by the Federal Reserve Bank of

St. Louis, (P.O. Box 442, St. Louis, MO 63166).

3. Remind the student that the chapter’s discussion of bank credit is in terms of the maximum

money-creating potential that would probably not ever be reached due to these modifications

introduced at the end of this chapter.

4. If you want to extend the discussion of the goldsmith to the topic of deposit insurance, you may

find the following “Concept Illustration” useful.

Concept Illustration … Deposit Insurance

We can easily extend the story of the goldsmiths to show

1. Why the Fed’s reserve requirement is inadequate to stop bank runs.

2. The reason deposit insurance is needed.

Recall that the goldsmiths wrote out gold receipts when people deposited their gold for storage.

The persons receiving the receipts began to use them to buy goods and services, and, thereafter, the

gold receipts circulated as money in the economy. Observing that holders of gold receipts rarely

withdrew gold, the goldsmiths began to issue loans in the form of newly issued gold receipts. The

amount of gold receipts circulating in the economy therefore exceeded the amount of gold in

storage (or “in reserve”). The fractional reserve banking system was born.

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Suppose that a fictional Federal Gold Reserve Board decided to place a 10 percent reserve

requirement on the goldsmiths. Thus, goldsmiths would need to hold 10 ounces of gold for each set

of gold receipts representing 100 ounces of gold. This requirement would not protect gold

depositors from potential losses. If holders of gold receipts lost confidence in the goldsmiths and

simultaneously demanded gold in exchange for their receipts, the goldsmiths would face

bankruptcy. Anything less than a 100 percent reserve requirement would be inadequate to protect

those holding receipts from losses.

So it is with the legal reserve requirement in the modern banking system. The requirement that

banks hold currency reserves equal to 10 percent of their total checkable deposits is inadequate to

protect depositors from losses resulting from bank runs. As we noted in the chapter, such

protection is not its purpose.

In the goldsmith economy, government could prevent “gold runs” through deposit insurance that

guaranteed gold payments for gold receipts. Knowing that the government has insured the gold

deposits, private owners of gold would view their gold receipts “as good as gold” and therefore

have no incentive to retrieve their gold from storage.

So it is in the modern economy. The Federal Deposit Insurance Corporation (FDIC) ensures each

individual bank and thrift deposit up to $100,000. Depositors thus view their checking account

entries “as good as currency” and are dissuaded from simultaneously running to banks and thrifts to

convert their checkable deposits to currency.

5. Have the students act out the process of requesting a loan. Appoint one student as the loan officer

and another as the customer. Encourage all students to participate in deciding what questions the

loan officer should ask and what criteria should be used to decide credit worthiness. Have the

student (customer) sign a promissory note and demonstrate the change in the bank’s balance sheet

on the overhead projector or blackboard. Point out to the students that the promissory note is

viewed as a debt by the customer but is treated as an asset by the bank. It is in fact an income-

earning asset that can be held by the bank or sold to someone else if desired.

The customer, of course, spends the proceeds of the loan. This is brand new spendable money, money

created by the loan. The customer’s IOU is literally a promise to pay; a promise to pay that was

monetized by the bank. The customer’s IOU is not generally accepted in the economy as money.

However, the bank’s IOU—the liabilities of the bank—in the form of checkable deposits are

generally accepted as money. This demonstration may help students remember that the nation’s

money supply is circulating debt and that promissory notes “back up” the money supply. Make it

clear to students that banks make loans because much of their profitability depends on it.

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STUDENT STUMBLING BLOCKS

1. The fact that banks can create money seems somewhat like magic. Part of the mystery lies in

forgetting that checkable deposits are money. Many students fall back on their old understanding

of money as currency and forget that much of the money supply is in checkable deposits. Federal

Reserve Banks have published simulations to make the money creation process more interesting

and concrete. Although designed for high schools, the simulations are perfectly suitable for use

with most college students. Check the publications catalog of the Federal Reserve Banks for their

educational materials, including an array of comic books that even college students enjoy.

2. Students without an accounting background may not understand T–accounts. Especially confusing

is the idea that checkable deposits are liabilities for banks. Emphasize that deposits belong to the

depositor and can be withdrawn at any time. Thus, they are not assets for the bank. On the asset

side there will be reserves or cash to back up the claim when the depositor first puts his/her money

in the bank. When the depositor withdraws funds or writes a check to someone who banks

elsewhere, both deposits and reserves decrease in the home bank. Problems at the end of the

chapter, or those found in the Study Guide or the computer tutorial provide practice.

3. The distinction between the money-creating potential of a single bank and the multiplied potential

of the entire system is difficult for students to grasp. When discussing the consolidated balance

sheet concept, it may be helpful to have students imagine that all banks are linked through an

imaginary island parent bank where there is no cash and no leakages of reserves or deposits from

this system. This may help them understand the difference between the situation in which a single

bank is one among many and the system as a whole.

LECTURE NOTES

I. Learning objectives – After reading this chapter, students should be able to:

A. Explain the basics of a bank’s balance sheet and discuss why the U.S. banking system is

called a “fractional reserve” system.

B. Explain the distinction between a bank’s actual reserves and its required reserves.

C. Describe how a bank can create money.

D. Describe the multiple expansion of loans and money by the entire banking system.

E. Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance.

II. Introduction: Although we are fascinated by large sums of currency, people use checkable

deposits for most transactions.

A. Most transaction accounts are “created” as a result of loans from banks or thrifts.

B. This chapter demonstrates the money-creating abilities of a single bank or thrift and then

looks at the system as a whole.

C. The term depository institution refers to banks and thrift institutions, but in this chapter the

term bank will be often used generically to apply to all depository institutions.

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III. The Fractional Reserve System: The Goldsmiths

A. Banks in the U.S. and most other countries are only required to keep a percentage (fraction)

of checkable deposits in cash or with the central bank.

B. In the 16th century goldsmiths had safes for gold and precious metals, which they often kept

for consumers and merchants. They issued receipts for these deposits.

C. Receipts came to be used as money in place of gold because of their convenience, and

goldsmiths became aware that much of the stored gold was never redeemed.

D. Goldsmiths realized they could “loan” gold by issuing receipts to borrowers, who agreed to

pay back gold plus interest.

E. Such loans began “fractional reserve banking,” because the actual gold in the vaults became

only a fraction of the receipts held by borrowers and owners of gold.

F. Significance of fractional reserve banking:

1. Banks can create money by lending more than the original reserves on hand. (Note:

Today gold is not used as reserves).

2. Lending policies must be prudent to prevent bank “panics” or “runs” by depositors

worried about their funds. Also, the U.S. deposit insurance system prevents panics.

IV. A Single Commercial Bank

A. A balance sheet states the assets and claims of a bank at some point in time.

B. All balance sheets must balance, that is, the value of assets must equal value of claims.

1. The bank owners’ claim is called net worth.

2. Nonowners’ claims are called liabilities.

3. Basic equation: Assets = liabilities + net worth.

C. Formation of a commercial bank: Following is an example of the process.

1. In Wahoo, Nebraska, the Wahoo bank is formed with $250,000 worth of owners’ stock

shares (see Balance Sheet 1).

2. This bank obtains property and equipment with some of its capital funds (see Balance

Sheet 2).

3. The bank begins operations by accepting deposits (see Balance Sheet 3).

4. Bank must keep reserve deposits in its district Federal Reserve Bank (see Table 15.1 for

requirements).

a. Banks can keep reserves at Fed or in cash in vaults (“vault cash”).

b. Banks keep cash on hand to meet depositors’ needs.

c. Required reserves are a fraction of deposits, as noted above.

D. Other important points:

1. Terminology: Actual reserves minus required reserves are called excess reserves.

2. Control: Required reserves do not exist to protect against “runs,” because banks must

keep their required reserves. Required reserves are to give the Federal Reserve control

over the amount of lending or deposits that banks can create. In other words, required

reserves help the Fed control credit and money creation. Banks cannot loan beyond their

excess reserves.

3. Asset and liability: Reserves are an asset to banks but a liability to the Federal Reserve

Bank system, since now they are deposit claims by banks at the Fed.

E. Continuation of Wahoo Bank’s transactions:

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1. Transaction 5: A $50,000 check is drawn against Wahoo Bank by Mr. Bradshaw, who

buys farm equipment in Surprise, Nebraska. (Yes, both Wahoo and Surprise exist).

2. The Surprise company deposits the check in Surprise Bank, which gains reserves at the

Fed, and Wahoo Bank loses $50,000 reserves at Fed; Mr. Bradshaw’s account goes down,

and Surprise company’s account increases in Surprise Bank.

3. The results of this transaction are shown in Balance Sheet 5.

V. Money-creating transactions of a commercial bank are shown in the next two transactions.

A. Transaction 6: Wahoo Bank grants a loan of $50,000 to Gristly in Wahoo (see Balance Sheet

6a).

1. Money ($50,000) has been created in the form of new demand deposit worth $50,000.

2. Wahoo Bank has reached its lending limit: It has no more excess reserves as soon as

Gristly Meat Packing writes a check for $50,000 to Quickbuck Construction (See

Balance Sheet 6b).

3. Legally, a bank can lend only to the extent of its excess reserves.

B. Transaction 7: When banks or the Federal Reserve buy government securities from the

public, they create money in much the same way as a loan does (see Balance Sheet 7).

Wahoo bank buys $50,000 of bonds from a securities dealer. The dealer’s checkable deposits

rise by $50,000. This increases the money supply in same way as the bank making the loan

to Gristly.

C. Likewise, when banks or the Federal Reserve sell government securities to the public, they

decrease supply of money like a loan repayment does.

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D. Profits, liquidity, and the federal funds market:

1. Profits: Banks are in business to make a profit like other firms. They earn profits

primarily from interest on loans and securities they hold.

2. Liquidity: Banks must seek safety by having liquidity to meet cash needs of depositors

and to meet check clearing transactions.

3. Federal funds rate: Banks can borrow from one another to meet cash needs in the federal

funds market, where banks borrow from each other’s available reserves on an overnight

basis. The rate paid is called the federal funds rate.

VI. The Banking System: Multiple-Deposit Expansion (all banks combined)

A. The entire banking system can create an amount of money which is a multiple of the system’s

excess reserves, even though each bank in the system can only lend dollar for dollar with its

excess reserves.

B. Three simplifying assumptions:

1. Required reserve ratio assumed to be 20 percent. (The actual reserve ratio averages 10

percent of checkable deposits.)

2. Initially banks have no excess reserves; they are “loaned up.”

3. When banks have excess reserves, they loan it all to one borrower, who writes check for

entire amount to give to someone else, who deposits it at another bank. The check clears

against original lender.

C. System’s lending potential: Suppose a junkyard owner finds a $100 bill and deposits it in

Bank A. The system’s lending begins with Bank A having $80 in excess reserves, lending

this amount, and having the borrower write an $80 check which is deposited in Bank B. See

further lending effects on Bank C.

D. Monetary multiplier is illustrated in Table 15.2.

1. Formula for monetary or checkable deposit multiplier is:

Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.

2. Maximum deposit expansion possible is equal to: excess reserves x monetary multiplier,

D = M × e.

3. Figure 15.1 illustrates this process.

4. Higher reserve ratios generate lower money multipliers.

a. Changing the money multiplier changes the money creation

potential.

b. Changing the reserve ratio changes the money multiplier but be careful!

It also changes the amount of excess reserves that are acted on by the multiplier.

Cutting the reserve ratio in half will more than double the deposit creation potential

of the system.

E. The process is reversible. Loan repayment destroys money, and the money multiplier

increases that destruction.

VII. LAST WORD: Banking, Leverage, and Financial Stability

A. Leverage boosts banking profits, but makes the banking system less stable.

B. The term leverage is used in finance to describe how the use of borrowed money can magnify

both profits and losses. That is, you only put-up part of the money out of your own pocket to

make an investment and you borrow the rest.

C. A modern bank uses a lot of leverage.

1. Only 5% of the money that it invests comes for shareholders.

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2. 25% comes from issuing bonds.

3. The other 70% comes from checking and saving deposits (borrowing from costumers).

D. The problem with that much leverage is that it takes only a very small loss to drive the bank

into insolvency.

E. So why do banks use this much leverage? The answer, it is very profitable when things work

out.

QUIZ

1. Bank panics:

A. occur frequently in fractional reserve banking systems.

B. are a risk of fractional reserve banking, but are unlikely when banks are highly regulated and

lend prudently.

C. cannot occur in a fractional reserve banking system.

D. occur more frequently when the monetary system is backed by gold.

2. Other things equal, if the required reserve ratio was lowered:

A. banks would have to reduce their lending.

B. the size of the monetary multiplier would increase.

C. the actual reserves of banks would increase.

D. the Federal funds interest rate would rise.

3. A bank owns a 10-story office building. In the bank’s balance sheet, this would be an example of:

A. An asset

B. A liability

C. Capital stock

D. A checkable deposit

4. What is one significant characteristic of fractional reserve banking?

A. Banks are not subject to “panics” or “runs.”

B. Banks use deposit insurance for loans to customers

C. Bank loans will be equal to the amount of gold on deposit

D. Banks can create money through lending their reserves

5. A commercial bank has actual reserves of $50,000 and checkable deposits of $200,000, and the

required reserve ratio is 20%. The excess reserves of the bank are:

A. $10,000

B. $20,000

C. $40,000

D. $50,000

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6. When a check is cleared against a bank, it will lose:

A. Cash and securities

B. Checkable deposits and reserves

C. Reserves and capital stock

D. Loans and demand deposits

7. Assume that Johnson deposits $350 of currency in his account in the XYZ bank. Later the same

day Swanson negotiates a loan for $2,000 at the same bank. In what direction and by what

amounts has the supply of money changed?

A. Increased by $2,350

B. Increased by $2,000

C. Decreased by $350

D. Decreased by $1,650

8. Maximum checkable-deposit expansion is equal to:

A. Actual reserves minus excess reserves

B. Assets plus net worth and liabilities

C. Excess reserves times the monetary multiplier

D. Excess reserves divided by the monetary multiplier

9. Assume that the legally required reserve is 15 percent and commercial banks choose to hold

additional excess reserves equal to 5 percent of any newly acquired deposits. Under these

circumstances the monetary multiplier for the commercial banking system is:

A. 6.67

B. 5

C. 4

D. 3

10. A commercial bank has checkable deposit liabilities of $400,000, reserves of $150,000, and a

required reserve ratio of 25%. The amount by which a single commercial bank and the amount by

which the banking system can increase loans are, respectively:

A. $50,000 and $100,000

B. $50,000 and $150,000

C. $50,000 and $200,000

D. $150,000 and $200,000

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