Money Creation by Banks

1
Lesson 9-2 Money Creation by Banks
2
The Banking System and Money Creation   Banks and
Other Financial Intermediaries   A financial
intermediary is an institution that amasses funds
from one group and makes them available to
another.   Pension funds, insurance companies,
and mutual funds are all financial
intermediaries.   A bank is a financial
intermediary that accepts deposits, makes loans,
and offers checking accounts.      
3
Non-bank financial intermediaries have become
more and more like banks and have assumed a
larger and larger share of the nations total
financial assets. Banks are tightly regulated
but non-bank financial intermediaries are less
tightly regulated.
4
Bank Finance and a Fractional Reserve System   A
balance sheet is a financial statement showing
assets, liabilities, and net worth.   Assets are
anything that is of value.   Liabilities are
obligations to other parties.   Net worth equals
assets less liabilities.   Banks make profits by
earning more interest on loans than they have to
pay to pay depositors along with other costs.  
5
Banks must hold some of depositors cash in
reserves, but they may lend out the rest.   A
system in which banks hold reserves whose value
is less than the sum of claims out-standing on
those reserves is called a fractional reserve
banking system.
6
Money Creation Required reserves plus excess
reserves equal total reserves.   Required
reserves are the quantity of reserves banks are
required to hold.   Excess reserves are any
reserves banks hold in excess of required
reserves.   The required reserve ratio is the
ratio of reserves to checkable deposits banks are
required to maintain.   When a bank has no excess
reserves, it is loaned up. Bank transactions can
be presented on a bank statement.  
7
 When a depositor deposits cash into his checking
account, the money supply does not
change.   There is less cash in circulation and
more money in checkable accounts than
before.   Money deposited in banks is divided
between required reserves and loans.   New loans
generate more cash in circulation or more
checkable deposits.   Part of the new money is
returned to some bank somewhere as additional
deposits that are divided between required
reserves and loans and the process starts over
again.
8
Eventually, all of the initial new deposit is
used up in required reserves. The total amount of
money in checkable accounts has expanded, thereby
increasing the money supply.   If the initial
action had been to withdraw money from a
checkable account, the process would have
continued as above but in a negative direction.
9
The Deposit Multiplier   The deposit multiplier
(md ) equals the ratio of the maximum possible
change in checkable deposits divided by the
change in reserves that created it.   R rrD
where R equals reserves, rr equals required
reserve ratio, and D equals checkable
deposits.   .R rr .D. 1/rr .D/.R md .
10
The Regulation of Banks   Banks are among the
most heavily regulated of financial
institutions.   Regulations help protect
depositors against corrupt business
practices.   Regulations help prevent crises of
confidence.   Regulations help control the
quantity of money.  
11
Deposit Insurance   Deposit insurance is provided
by the Federal Deposit Insurance Corporation
(FDIC).   Having insurance may make banks take
greater risks than they would otherwise.   Regulat
ions to Prevent Bank Failure   Banks are severely
limited in what they can do.   Regulators
routinely perform audits.   The FDIC has the
power to close a bank whose net worth has fallen
below the required level.