Transcript How Banks and Thrifts Create Money

How Banks and Thrifts Create Money
• Most transactions are “created” as a
result of loans from banks or thrifts.
• Chapter demonstrates the moneycreating abilities of a single bank or thrift
and then looks at the system as a whole.
How Banks and Thrifts Create Money

This chapter the term “bank” is
used generically and applies to all
depository institutions.
Balance Sheet
• A Balance sheets summarize the financial
position of the bank at a certain time.
• The value of assets must equal the value of
claims
• Claims on a balance sheet are divided into two
groups:
– The bank owners’ claim is called net worth
– Non-owners’ claims are called liabilities
– Equation: Assets=Liabilities + Net Worth
Fractional Reserve System
• Type of system the U.S. has in which only
a fraction of the total money supply is
held in reserve as currency.
Goldsmiths
• In the 16th century goldsmiths had safes for gold and
precious metals, where they kept for consumers and
merchants
• Receipts for these deposits were issued.
• Receipts were used as money in place of gold for
convenience.
• Goldsmiths realized they could “loan” gold by
issuing receipts to borrowers
Goldsmiths
• The 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:
• Banks can create money by lending more
than the original reserves on hand
• Lending policies must be prudent to
prevent bank “panics” or “runs” by
depositors worried about their funds
• Federal Deposit Insurance Corporation
(FDIC) was created to prevent panics
Money Creation by a Single Bank in
Banking System
• Bank is formed (example - with $250,000 worth of
owners’ capital stock)
• Bank obtains property and equipment with some of
the capital funds
• Bank begins operations by accepting deposits
• Banks keep reserve deposits in its district Federal
Reserve Bank
• Ex. pg. 254
Required Reserves
Required reserves are an amount of funds
equal to a specified percentage of the
bank’s own deposit liabilities.
• Banks keep a significant portion of their
own reserves in their vaults
Reserve Ratio
• The “specified percentage” of checkable-deposit
liabilities that a commercial bank must keep as
reserves.
• The Fed has the authority to establish and vary the
reserve ration within limits legislated by Congress
(between 8% and 14%)
• First 6 million of checkable deposits held by bank
exempt from reserve requirements
Reserves
• Three percent reserve required on
checkable deposits between $6 million
and $42.1million
• No reserves are required against noncheckable non-personal (business)
savings CDs. (up to 9% can be required)
Control:
• Required reserves do not exist to protect against
“runs” because banks must keep their required
reserves.
• Required reserves exists to give the Federal Reserve
control over the amount of lending or deposits that
banks can create
• Required reserves help the Fed control credit and
money creation.
• Banks cannot loan beyond their fraction required
reserves.
Asset and Liability
• Reserves are an asset to banks
• Reserves are a Liability to the Fed
Profits, Liquidity, and the Federal Funds
Market
• Profits: Banks are in business to make a
profit
• They earn profits primarily from interest
on loans and securities they hold
• Liquidity: Banks must seek safety by
having liquidity to meet cash needs of
depositors and meet check-clearing
transactions
Profits, Liquidity, and the Federal Funds
Market
• Federal funds rate: Banks can borrow
from one another to meet cash needs in
the federal funds market, where banks
borrow from each other’s available
reserves on overnight basis
• The interest rate paid is called the
Federal Funds Rate
Need for Monetary Control
• During prosperity, banks will lend as much as possible
and reserve requirements provide a limit to the
expansion of loans
• During recession, banks may cut lending, which can
worsen recession.
• Profit-seeking bankers will be motivated to expand or
contract loans that could worsen the business cycle.
• The Fed uses monetary policy to counteract such
results in order to prevent worsening recessions or
inflation. (Cpt. 15)