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Banks and the Creation of Money

Bank Balance Sheets

Key Concept Notes for an AP Macro Class

|How do banks “create” money? |

|By lending out deposits that are used multiple times, just like the Consumption Multiplier Effect (1/1-MPC or 1/MPS) |

| |

|Where do the loans come from? |

|From depositors who take cash and place it in accounts at banks |

| |

|How are the amounts of potential loans calculated? |

|By understanding and applying the bank balance sheet system, also known as a “T-Account” that consists of “assets” and |

|“liabilities” for banks |

| |

|Bank Liabilities (the right side of the T Account Sheet): |

|#1 = Demand Deposits (also known as “Checkable Deposits”)(DD) |

|These are cash deposits from the public. |

|These are a liability because they belong to the depositors and can be |

|withdrawn by the depositors. |

|#2 = Owners Equity (also known as “Stock Shares”) |

|These are the values of stocks held by the public ownership of bank |

|shares. |

| |

|Key concept for AP concerning Liabilities: |

|If the demand deposit comes in from someone’s “cash” holdings, then |

|that demand deposit is already part of the Money Supply (M-1). The cash |

|is simply being placed into a bank account. |

| |

|If the demand deposit comes in from the purchase of bonds (by the Fed) |

|then this creates new cash and therefore creates new Money Supply (M-1). |

|Bank Assets (the left side of the T Account Sheet): |

|#1= Required Reserves (RR) |

|These are the percentages of demand deposits that must be held in the |

|vault so that some depositors have access to their money. Textbooks |

|show that actual demand deposits can be as low as 3%, but they vary |

|based on the bank and the amount of the demand deposit. |

|AP will use 5%, 10%, or 20% for reserves…. |

|#2 = Excess Reserves (ER) |

|These are the source of new loans. These amounts will be applied to the |

|Monetary Multiplier/Reserve Multiplier |

|NOTE: DD = RR plus ER |

|#3 = Bank Property Holdings (Buildings and Fixtures) |

|These are usually stated as a money value of the bank’s property… |

|#4 = Securities (Federal Bonds) |

|These are the bonds previously purchased by the bank, or new bonds |

|sold to the bank by the Federal Reserve. These bonds can be |

|purchased from the bank, turned into cash that immediately becomes |

|available as “excess reserves”. |

|#5 = Customer Loans |

|This can be amounts held by banks from previous transactions, owed to |

|the bank by prior customers. |

|Money Creation (Using Excess Reserves) |

|Banks want to create profit. They can generate profit by lending the excess reserves and collecting interest payments. Since each|

|loan will go out |

|into customer’s and business’ accounts, more loans are created in decreasing amounts. Each successive bank must pull some of the |

|money out for required reserves. A rough estimate of the number of loan amounts created by any first loan is the “monetary |

|multiplier”. |

| |

|The Monetary Multiplier (also known as): |

| Checkable Deposits Multiplier |

| Reserve Multiplier |

| Loan Multiplier |

| |

|The formula is simple: 1divided by the reserve requirement (ratio) |

|An example = RR = 10% = 1/.1 = Monetary Multiplier of 10. |

|Excess Reserves are multiplied by the Multiplier to create new loans for the entire banking system and this creates new Money |

|Supply. |

Summary of Items to Know

|Bank Balance Sheet = |

|Assets and Liabilities in a T Account |

|Liabilities = |

|Demand Deposits |

|Owner’s Equity (Stock Shares) |

|Assets = |

|Required Reserves |

|Excess Reserves |

|Bank Property (Buildings and Fixtures) |

|Securities (Bonds) |

|Loans |

|Assets must Equal Liabilities |

|DD = RR + ER |

|Money is Created through the Monetary Multiplier |

|ER x 1/RR (Multiplier)= New Loans throughout the banking system |

|The Money Supply is affected |

|Cash from a citizen becomes a DD, but does NOT change the Money Supply |

|The ER from this cash becomes an “immediate” loan amount. |

|ER x Multiplier become New Loans and DO change the Money Supply |

|The Fed Buying bonds creates new loans and changes the Money Supply |

|IF the Fed buys the bonds on the open market, this also becomes a new |

|Demand Deposit amount. (2009 FRQ) |

|IF the Fed buys bonds from accounts already held by a particular bank, |

|then the amount only becomes new Excess Reserves (2011 FRQ) |

|Supplemental Note about Bonds |

|Bond “prices” move opposite to the changes in interest rates. (2011 FRQ) |

|Higher interest rates will push bond prices downward. (Less Money Supply) |

|Lower interest rates will push bond prices upward. (More Money Supply) |

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