1. BANKING
AND MONEY
CREATION
MODULE 25

2. THE MONETARY ROLE OF
BANKS
• More than half of M1 consists of currency
in circulation.
• The rest of M1 consists of bank deposits,
which are a major component of the
money supply.
• Although we are fascinated by large sums
of currency, people use checkable
deposits for most transactions.
• Most transaction accounts are “created” as
a result of loans from banks or thrifts.
• The term bank will be used generically to
apply to all depository institutions.

3. HISTORY OF FRACTIONAL RESERVE
BANKING: THE GOLDSMITHS
• 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.
• 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.
• Goldsmiths realized they could “loan” gold by issuing
receipts to borrowers, who agreed to pay back gold
plus interest.

4. HISTORY OF FRACTIONAL RESERVE
BANKING: THE GOLDSMITHS
• 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.
• 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

5. WHAT DO BANKS DO?
• Banks are financial intermediaries, that
use liquid assets in the form of bank
deposits to finance the illiquid investments
of borrowers.
• Banks are in business to make a profit like
other firms. They earn profits primarily
from interest on loans and securities they
hold.
• Because not all of the depositors will want
to withdraw all of their funds at the same
time, a bank can provide these liquid
assets yet still invest much of the
investor’s funds in loans for illiquid assets,
such as mortgages and business loans.

6. WHAT DO BANKS DO?
• Banks cannot lend out all their funds,
because they need to have some on hand
to satisfy any depositor that wants to
withdraw their funds at any time.
• These required funds may be kept as
currency in the bank’s vault, or as deposits
held in the bank’s account at the Federal
Reserve (this money can be converted into
currency rapidly)
• These funds held in the vault or at the Fed
are called bank reserves, and are not
counted as part of the money supply, as
they are not part of the currency in
circulation.

7. A BANK’S BALANCE SHEET
• A balance sheet states the assets and
claims of a bank at some point in time.
• 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. Non-owners’ claims are called liabilities.
3. Basic equation:
Assets = liabilities + net worth.

8. THE T-ACCOUNT
• The T-account is a simple tool for
analyzing a bank’s financial position.
• Just like the T-account for an ordinary
business, it summarizes a bank’s financial
position by showing the banks assets and
liabilities.
• The assets are on the left side and they
represent the funds that those who have
borrowed from the bank are expected to
repay. The bank’s other assets are its
reserves, either held in the bank’s vault or
as deposits at the Fed.

9. THE T-ACCOUNT
• The liabilities of the bank are shown on the
right side of the T-account. These are
funds that must be repaid to depositors
• By law, banks are required to have their
assets larger than their liabilities by a
specific percentage.
• The fraction of bank deposits that a bank
is required to hold as reserve is called its
reserve ratio.
• The banking system sets a required
reserve ratio, which is the smallest
fraction of bank deposits a bank must hold.
• This required reserve acts as protection
against a bank run.

10. WHAT IS A BANK RUN?
• A bank can lend out most of the funds
deposited in it because only a small
fraction of its depositors want to
withdraw their funds at one time.
• If they did demand their money back at
the same time, the bank would not be
able to raise enough cash to meet those
demands, because most of the
depositor’s funds are converted into
loans made to borrowers.
• That is how the banks earn revenue: by
charging interest on loans.

11. WHAT IS A BANK RUN?
• However, bank loans are illiquid, which
means that they cannot be easily
converted into cash on short notice.
• Banks may be forced to sell off their
loans quickly and cheaply in order to
raise the funds demanded by depositors,
which may lead to a bank failure, in
which the bank would be unable to pay
off its depositors in full.
• The fear of a bank failing may be a self-
fulfilling prophecy, in which the rush
itself cause the bank to fail.

12. WHAT IS A BANK RUN?
• A bank run is a phenomenon in which
many of a bank’s depositors try to
withdraw their funds due to fears of a
bank failure.
• A run on a bank may be contagious and
spread to other banks or even the whole
banking system, as occurred in the
1930s in the United States.
• Modern governments have established a
system of bank regulations that protect
depositors and prevent most bank runs.

13. BANK REGULATION
• After the banking crisis of the 1930s, most countries put
into place a system designed to protect depositors and
the economy as a whole against bank runs.
• This protective system has three main components and
a source of loans:
1. deposit insurance
2. capital requirements
3. reserve requirements
4. discount window

14. 1. DEPOSIT INSURANCE
• The FDIC (Federal Deposit Insurance Corporation)
provides deposit insurance, which is a guarantee that
depositors will be paid even if the bank cannot come up
with the funds.
• The maximum amount that the FDIC insures is $250,000
per account.
• This deposit insurance doesn’t only protect depositors if
the bank fails, it also eliminates the main reason bank
runs occur, because depositors will be assured of their
funds and will not run to pull them out because of a
rumor that the bank is in trouble.

15. 2. CAPITAL REQUIREMENTS
• Because the deposit insurance may create an incentive
problem: the depositors may feel safe and fail to monitor
the bank’s financial health, and the bank may incur in
risky investment behavior. They may make questionable
loans at high interest rates because they stand to make
a large profit, and if things go badly, the government will
cover the losses through the deposit insurance.
• Regulators require banks to hold substantially more
assets than the value of bank deposits, so that the bank
will still have assets larger than their deposits even if
some of its loans go bad, and these losses will reduce
the bank owner’s assets and not the government.
• This excess of a bank’s assets over its bank deposits
and other liabilities (debts) is called the bank’s capital.

16. 3. RESERVE REQUIREMENTS
• Another rule set by the Federal Reserve to reduce the
risk of a bank run is to establish reserve requirements,
which establish the required reserve ratio (a fraction of
the deposits) that a bank must keep on hand.
• The United States uses a 10% required reserve ratio
for checkable bank deposits. This means that the banks
must keep 10% of the value of the checkable deposits as
cash on hand to meet the depositor’s needs.
• This required reserve may be kept as cash in the bank’s
vaults or as reserves at the Fed, in the bank’s own
account.
• 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.

17. 3. RESERVE REQUIREMENTS
• The reserves over and above the amount needed to
satisfy the minimum reserve ratio are called excess
reserves.
• The reserves over and above the amount needed to
satisfy the minimum reserve ratio are called excess
reserves.
• Required reserves do not exist only to protect against
bank runs. 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, because banks cannot loan
beyond their fraction required reserves.

18. 4. THE DISCOUNT WINDOW
• This final protection against bank runs is the fact that the
Federal Reserve stands ready to lend money to banks,
which is an arrangement known as the discount
window.
• This ability to borrow money from the Fed means that a
bank can avoid being forced to sell its assets at cheap
prices in order to satisfy the demands of a sudden rush
of depositors demanding their funds.
• A bank has the option of turning to the Federal Reserve
to borrow the funds it needs to pay off depositors.

19. DETERMINING THE MONEY SUPPLY
• If banks did not exist, there would be no checkable
deposits, and the quantity of currency in circulation
would equal the money supply.
• Because there are banks, and they create checkable
bank deposits, they affect the money supply in two ways:
1. Banks remove some currency from circulation because
the currency sitting in bank vaults is not part of the
money supply.
2. Banks create money by accepting deposits and making
loans. That means that they make the money supply
larger than just the value of currency in circulation.
• The monetary base is the sum of currency in circulation
and bank reserves.

20. THE ENTIRE BANKING SYSTEM AND
MULTIPLE DEPOSIT EXPANSION
• 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.
• Three simplifying assumptions:
1. Required reserve ratio assumed to be 10 percent.
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.

21. THE ENTIRE BANKING SYSTEM AND
MULTIPLE DEPOSIT EXPANSION
Example of the system’s lending potential:
1. Suppose a junkyard owner finds a $100 bill and
deposits it in Bank A. The system’s lending begins with
Bank A having $90 in excess reserves, lending this
amount, and having the borrower write an $90 check
which is deposited in Bank B.
2. Bank B keeps 10% ($9) and can then lend out $81 it
has in excess reserves, and the borrower writes out an
$81 check, which is then deposited at Bank C.
3. Bank C then keeps $8.10, and lends out the other
$72.90, and so on…

22. THE MONETARY MULTIPLIER
The formula for monetary or checkable deposit multiplier is:
Monetary multiplier = 1/required reserve ratio
m = 1/R
Maximum deposit expansion possible is equal to:
excess reserves x monetary multiplier

23. THE MONETARY MULTIPLIER
• Modifications to simple monetary multiplier concept
reduce the final result and include complications due to
“leakages.”
a. Currency drains (cash kept by customers) dampen M,
because that money is not part of bank reserves so
can’t be loaned out further.
b. Excess reserves kept on hand by banks also dampen
M, because those reserves are not loaned out and
therefore not expanded.

24. NEED FOR MONETARY CONTROL
1. During prosperity, banks will lend as much as possible
and reserve requirements provide a limit to expansion
of loans.
2. During recession, banks may cut lending, which can
worsen recession. Federal Reserve has ways to
encourage lending in such cases.
3. The conclusion is that profit-seeking bankers will be
motivated to expand or contract loans that could worsen
business cycle. The Federal Reserve uses monetary
policy to counteract such results in order to prevent
worsening recessions or inflation.