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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|withdrawn by the depositors.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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