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Chapter 26

Chapter 26. Money Creation and the Banking System. Economic Principles. The fractional reserve system The legal reserve requirement A bank’s balance sheet, its assets and liabilities Demand deposits and bank loans. Economic Principles. The potential money multiplier Bank failure

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Chapter 26

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  1. Chapter 26 Money Creation and the Banking System Gottheil — Principles of Economics, 6e

  2. Economic Principles • The fractional reserve system • The legal reserve requirement • A bank’s balance sheet, its assets and liabilities • Demand deposits and bank loans Gottheil — Principles of Economics, 6e

  3. Economic Principles • The potential money multiplier • Bank failure • The Federal Deposit Insurance Corporation (FDIC) Gottheil — Principles of Economics, 6e

  4. How Banks Create Money Fractional reserve system • A banking system that provides people immediate access to their deposits but allows banks to hold only a fraction of those deposits in reserve. Gottheil — Principles of Economics, 6e

  5. How Banks Create Money The fractional reserve system serves as the basis of all modern banking. Gottheil — Principles of Economics, 6e

  6. How Banks Create Money If all depositors lost faith in the banking system and demanded their money back, banks would be unable to meet their demands. Gottheil — Principles of Economics, 6e

  7. How Banks Create Money Balance sheet • The bank’s statement of liabilities (what it owes) and assets (what it owns). Gottheil — Principles of Economics, 6e

  8. How Banks Create Money Banks make a profit on the loans they provide, not on their deposits. Gottheil — Principles of Economics, 6e

  9. How Banks Create Money Legal reserve requirement • The percentage of demand deposits banks and other financial intermediaries are required to keep in cash reserves. Gottheil — Principles of Economics, 6e

  10. Cyberspace Banking What is a cyberspace banking? • Cyberspace is banking conducted over the Internet. Gottheil — Principles of Economics, 6e

  11. How Banks Create Money 1. Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts? • $100,000 + $80,000 = $180,000. Gottheil — Principles of Economics, 6e

  12. How Banks Create Money 1. Suppose that the banking system initially has $100,000 in demand deposits, and loans out $80,000. Those who borrow this money in turn put it in their demand deposit accounts. How much money is now held in demand deposit accounts? • Thus fractional reserve banking creates money through loans. Gottheil — Principles of Economics, 6e

  13. How Banks Create Money Financial intermediaries • Firms that accept deposits from savers and use those deposits to make loans to borrowers. Gottheil — Principles of Economics, 6e

  14. How Banks Create Money 2. What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. Gottheil — Principles of Economics, 6e

  15. How Banks Create Money 2. What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. • People willing to make demand deposits. Gottheil — Principles of Economics, 6e

  16. How Banks Create Money 2. What three factors are needed for a banking system to create money? • A fractional reserve system operating within financial intermediaries. • People willing to make demand deposits. • Borrows prepared to take out loans. Gottheil — Principles of Economics, 6e

  17. How Banks Create Money Potential money multiplier • The increase in the money supply that is potentially generated by a change in demand deposits. Gottheil — Principles of Economics, 6e

  18. How Banks Create Money 3. If the legal reserve requirement is 10 percent, what is the potential money multiplier? • The potential money multiplier “m” = 1/(legal reserve requirement) = 1/0.1 = 10 Gottheil — Principles of Economics, 6e

  19. How Banks Create Money 4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)? • M = ID/LRR Gottheil — Principles of Economics, 6e

  20. How Banks Create Money 4. If the legal reserve requirement (LRR) is 25 percent and the initial demand deposit (ID) is $100,000, then what is the maximum potential increase in the money supply (M)? • M = $100,000/.25 = $400,000 Gottheil — Principles of Economics, 6e

  21. How Banks Create Money 5. Why might the actual increase in the money supply be less than the maximum potential increase in the money supply? • Because there may not be a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system. Gottheil — Principles of Economics, 6e

  22. How Banks Create Money Excess reserves • The quantity of reserves held by a bank in excess of the legally required amount. Gottheil — Principles of Economics, 6e

  23. How Banks Create Money If there is not a sufficient number of borrowers to take advantage of all the available loanable reserves in the banking system, then the banking system will end up holding excess reserves. Gottheil — Principles of Economics, 6e

  24. How Banks Create Money 6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Required reserves are 0.2 × ($100,000) = $20,000. Gottheil — Principles of Economics, 6e

  25. How Banks Create Money 6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Excess reserves = (total reserves) – (required reserves) Gottheil — Principles of Economics, 6e

  26. How Banks Create Money 6. Suppose that a bank holds $100,000 in demand deposits, has a legal reserve requirement of 20 percent, and holds $35,000 in reserves. How much of these reserves are required, and how much are excess? • Excess reserves = $35,000 – $20,000 = $15,000. Gottheil — Principles of Economics, 6e

  27. How Banks Create Money 7. How are required reserves recorded on a bank’s balance sheet? • Required reserves are an asset. Gottheil — Principles of Economics, 6e

  28. How Banks Create Money 8. How are excess reserves recorded on a bank’s balance sheet? • Excess reserves are an asset. Gottheil — Principles of Economics, 6e

  29. How Banks Create Money 9. How are loans recorded on a bank’s balance sheet? • Loans are an asset. Gottheil — Principles of Economics, 6e

  30. How Banks Create Money 10. How are demand deposits recorded on a bank’s balance sheet? • Demand deposits are a liability. Gottheil — Principles of Economics, 6e

  31. How Banks Create Money 11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits? • Yes Gottheil — Principles of Economics, 6e

  32. How Banks Create Money 11. Suppose that a bank’s assets are made up of required reserves of $10,000, excess reserves of $5,000 and loans of $85,000. If the legal reserve requirement is 10 percent, can we determine how much money the bank holds in demand deposits? • With required reserves of $10,000 and a legal reserve requirement is 10 percent, then demand deposits equal $100,000. Gottheil — Principles of Economics, 6e

  33. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Some excess reserves that may have otherwise been loaned out will instead be converted to required reserves. Gottheil — Principles of Economics, 6e

  34. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Banks with no excess reserves will have to borrow reserves until enough loans are repaid or enough new deposits are made. Gottheil — Principles of Economics, 6e

  35. Reversing the Money Creation Process 1. What will happen if the Federal Reserve increased the legal reserve requirement for banks? • Either way, increasing the legal reserve requirement will reduce loanable reserves in the banking system, and thus reduce the money supply. Gottheil — Principles of Economics, 6e

  36. Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? • Required reserves will increase. Gottheil — Principles of Economics, 6e

  37. Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? • Excess reserves will decrease. Gottheil — Principles of Economics, 6e

  38. Reversing the Money Creation Process 2. What will happen to a bank’s assets if the Federal Reserve increased the legal reserve requirement? • Loans will decrease. Gottheil — Principles of Economics, 6e

  39. Why Banks Sometimes Fail 1. What will happen if too many borrowers are unable to repay their loans? • A bank may fail. Gottheil — Principles of Economics, 6e

  40. Why Banks Sometimes Fail 2. If a bank fails, what will happen to the depositors? • If deposits are insured by the federal government, then the government will step in and pay depositors up to the maximum insurable amount. Gottheil — Principles of Economics, 6e

  41. Why Banks Sometimes Fail 2. If a bank fails, what will happen to the depositors? • If deposits are not insured by the federal government, then depositors may lose their money. Gottheil — Principles of Economics, 6e

  42. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Fearing that they may lose their money, and having lost confidence in the banking system, some depositors will demand their money back from their deposits. Gottheil — Principles of Economics, 6e

  43. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Too many depositors withdrawing their money from their demand deposit accounts will overwhelm the fractional reserve system, and may cause it to fail. Gottheil — Principles of Economics, 6e

  44. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Many people will lose their money, loanable funds for investment will be eliminated, and a recession may result. Gottheil — Principles of Economics, 6e

  45. Why Banks Sometimes Fail 3. If rumors spread that some borrowers are defaulting on their loans, how will some depositors respond? • Prior to modern banking regulation and practices, many recessions were caused by financial panics and banking system failures. Gottheil — Principles of Economics, 6e

  46. Safeguarding the System Federal Deposit Insurance Corporation (FDIC) • A government insurance agency that provides depositors in FDIC-participating banks 100 percent coverage on their first $100,000 of deposits. Gottheil — Principles of Economics, 6e

  47. Safeguarding the System Banks participating in the FDIC insurance program must pay insurance premiums in return for FDIC protection. Gottheil — Principles of Economics, 6e

  48. Safeguarding the System The FDIC was created in 1933, too late for the tens of thousands of people who had been financially wiped out by bank failures in the Great Depression. Gottheil — Principles of Economics, 6e

  49. Federal Deposit Insurance and Moral Hazard Fully insuring deposits leads to a costly side effect known as moral hazard. Gottheil — Principles of Economics, 6e

  50. Federal Deposit Insurance and Moral Hazard Once a bank is insured, it has an incentive to take on more risky loans than it otherwise would if it were not insured. Gottheil — Principles of Economics, 6e

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