Transcript Unit 4: Chapter 13 PPT Notes

The
Fractional
Reserve
System
Creating a
Bank
13
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
Money
Creation
End Show
13-1
Copyright 2008 The McGraw-Hill Companies
Chapter Objectives
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-2
• Why the U.S. Banking System is
Called a “Fractional Reserve”
System
• Distinction Between a Bank’s
Actual Reserves and Its Required
Reserves
• How a Bank Can Create Money
Through Granting Loans
• The Multiple Expansion of Loans
and Money by the Entire Banking
System
• The Monetary Multiplier and How
to Calculate it
Copyright 2008 The McGraw-Hill Companies
The Fractional Reserve System
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Only a portion(fraction) of
checkable deposits are backed
up by cash in bank vaults or
deposits at the central bank
• Used in U.S. and most other
nations today
• Can show us how banks can
create checkable deposits by
issuing loans
Key Terms
End Show
13-3
Copyright 2008 The McGraw-Hill Companies
Fractional Reserve System
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-4
• The Goldsmiths
• Characteristics
–Banks Create Money
Through Lending
–Fractional Reserve
Banks are Subject to
“Panics” or “Runs”
Copyright 2008 The McGraw-Hill Companies
History of Fractional Reserve
Banking: Goldsmiths
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-5
• Early traders used gold to make
transactions, but it was unsafe and
inconvenient to carry gold
• 16th century – people began
depositing gold with goldsmiths, the
goldsmith would give them a receipt,
served as first type of paper money
• At first, paper receipts were fully
(100%) backed by gold, eventually
goldsmiths began issuing receipts in
excess of the amount of gold held
• Thus the beginning of fractional
reserve banking
Copyright 2008 The McGraw-Hill Companies
Characteristics of Fractional
Reserve Banking
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• 1. banks can create money
through lending
• 2. banks operating on the basis of
fractional reserves are vulnerable
to “panics” or “runs” (Ex. Great
Depression in U.S.). This explains
why bank industry is highly
regulated and why U.S. has
deposit insurance (FDIC)
Key Terms
End Show
13-6
Copyright 2008 The McGraw-Hill Companies
Fractional Reserve System
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Balance Sheet
Assets = Liabilities + Net Worth
• Transactions Needed to
Enable Banks to Create
Money Through Lending
As Follows…
Key Terms
End Show
13-7
Copyright 2008 The McGraw-Hill Companies
A Single Commercial Bank
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
• In order to understand modern
fractional reserve banking.. We must
examine a commercial bank’s balance
sheet
• Balance sheet – statement of assets
and claims on assets that summarizes
the financial position of the bank at a
certain time
• Every balance sheet must balance;
value of assets must equal amount of
claims against those assets
End Show
13-8
Copyright 2008 The McGraw-Hill Companies
Balance Sheet
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
• Claims on balance sheet divided
into two groups: liabilities (claims
of nonowners against the firm’s
assets) and net worth (the claims
of owners against the firm’s
assets)
• Assets = liabilities + net worth
Last Word
Key Terms
End Show
13-9
• This can be used to establish
how individual banks create
money
Copyright 2008 The McGraw-Hill Companies
Transaction 1: Creating a Bank
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
• Once a charter is secured to open
a bank, must sell stock to buyers
to open bank
• Founders of bank sell shares of
stock in bank—some to
themselves and some to other
people
• This cash (vault cash) is an asset
to bank, shares of stock are net
worth
End Show
13-10
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 1:
The
Fractional
Reserve
System
Creating a
Bank
• Creating a Bank
• Vault Cash
Money
Creation
Creating a Bank
The Banking
System
Monetary
Multiplier
Last Word
Balance Sheet 1: Wahoo Bank
Assets
Cash
Key Terms
End Show
13-11
Copyright 2008 The McGraw-Hill Companies
Liabilities and Net Worth
$250,000 Stock Shares
$250,000
Transaction 2: Acquiring
Property and Equipment
The
Fractional
Reserve
System
• Cash is then used by board of
directors (bank’s owners) to
acquire property and equipment
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-12
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 2:
The
Fractional
Reserve
System
Creating a
Bank
• Acquiring Property and
Equipment
Money
Creation
The Banking
System
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Cash
Property
Key Terms
End Show
13-13
Copyright 2008 The McGraw-Hill Companies
Liabilities and Net Worth
$10,000 Stock Shares
$240,000
$250,000
Transaction 3: Accepting
Deposits
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-14
• Banks have 2 functions: accept
deposits and make loans
• Citizens deposit $ into bank as
checkable deposits, these are claims
that depositors have against the
assets of the bank and are a new
liability account
• This does not result in money supply
change, but composition of money
supply has changed
• Currency held by a bank is not part of
economy’s money supply
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 3:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
• Accepting Deposits
–Receive $100,000 as a
Checkable Deposit
Accepting Deposits
The Banking
System
Balance Sheet 3: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Cash
Property
Key Terms
End Show
13-15
Copyright 2008 The McGraw-Hill Companies
Liabilities and Net Worth
$110,000 Checkable
Deposits
$240,000
Stock Shares
$100,000
$250,000
Transaction 4: Depositing Reserves
into Fed Reserve Bank
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-16
• By law, all banks and thrifts must keep
required reserves
• Required reserves – amount of funds
equal to a specified % of the bank’s
own deposit liabilities
• This percentage is known as the
reserve ratio – ratio of required
reserves the bank must keep on the
bank’s own outstanding checkabledeposit liabilities
• See formula next slide
• Ratio established by Fed
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 4:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
• Depositing Reserves in a
Federal Reserve Bank
–Required Reserves
–Reserve Ratio
Monetary
Multiplier
Last Word
Reserve
Ratio
=
Key Terms
End Show
13-17
Copyright 2008 The McGraw-Hill Companies
Commercial Bank’s
Required Reserves
Commercial Bank’s
Checkable-Deposit Liabilities
Example
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
• Let’s say reserve ratio is 20%
(1/5)
• If a bank anticipates it will grow
in future, may send additional
reserves to Fed Reserve Bank
• See balance sheet p.247
Monetary
Multiplier
Last Word
Key Terms
End Show
13-18
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 4:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
Type of Deposit
Checkable Deposits:
$0-$7.8 Million
$6-$48.3 Million
Over $48.3 Million
Noncheckable Nonpersonal
Savings and Time Deposits
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
Statutory
Limits
0%
3
10
3%
3
8-14
0
0-9
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
$110,000
Deposits
$100,000
Property
$240,000 Stock Shares
$250,000
End Show
13-19
Current
Requirement
Copyright 2008 The McGraw-Hill Companies
Excess Reserves
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Found by subtracting its required
reserves from its actual reserves
• The ability of a bank to make
loans depends of the existence of
excess reserves
• This allows us to understand how
the banking system creates
money
Key Terms
End Show
13-20
Copyright 2008 The McGraw-Hill Companies
Control
The
Fractional
Reserve
System
• A bank’s required reserves are
not enough to meet sudden,
massive cash withdrawals
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Required reserves help the Fed
control the lending ability of
commercial banks
• Control the ability of banks to
grant credit
Key Terms
End Show
13-21
Copyright 2008 The McGraw-Hill Companies
Asset and Liability
The
Fractional
Reserve
System
Creating a
Bank
• When depositing money into the
Fed, this is an asset to the
commercial bank and a liability to
the Fed Reserve Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-22
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 4:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Excess Reserves
Excess
Reserves
=
Actual
Reserves
-
Required
Reserves
• Control
–Banking Regulators
• Asset and Liability
Key Terms
–Transactions are Both
End Show
13-23
Copyright 2008 The McGraw-Hill Companies
Transaction 5: Clearing a
Check Drawn against the Bank
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-24
• Whenever a check is drawn against
one bank and deposited in another
bank, collection of that check will
reduce both the reserves and
checkable deposits of the bank on
which the check was drawn
• If a bank receives a check, their
reserves and checkable deposits will
increase by amt of check
• What one bank loses, another gains
• No loss incurred for the banking
system as a whole
Copyright 2008 The McGraw-Hill Companies
Creating a Bank
Transaction 5:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
• Clearing a Check
–$50,000 Check
Presented for Payment
The Banking
System
Clearing a Check
Balance Sheet 5: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Reserves
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
$240,000
Stock Shares
Key Terms
End Show
13-25
Copyright 2008 The McGraw-Hill Companies
$50,000
$250,000
Money Creating Transactions
of a Commercial Bank
The
Fractional
Reserve
System
• Transactions 6 and 7
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-26
Copyright 2008 The McGraw-Hill Companies
Transaction 6: Granting a Loan
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• How does lending affect the balance sheet?
• Assets and liabilities increase by size of the
loan
• When the bank makes loans, it creates
money
• By extending credit, bank has “monetized”
the IOU
• Single bank can only loan out amount equal
to its initial excess reserves b/c it faces the
possibility that checks for the entire amount
of the loan will be drawn and cleared against
it
Key Terms
End Show
13-27
Copyright 2008 The McGraw-Hill Companies
Money Creating Transactions
Transaction 6a:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
• Granting a Loan
–$50,000 Loan Deposited
to Checking Account
The Banking
System
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Reserves
Loans
Property
Key Terms
End Show
13-28
Copyright 2008 The McGraw-Hill Companies
Liabilities and Net Worth
$60,000 Checkable
Deposits
$50,000
$100,000
$240,000 Stock Shares
$250,000
Money Creating Transactions
Transaction 6b:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
• Using the Loan
–$50,000 Loan Cashed
From Checking Account
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Reserves
Loans
Property
Key Terms
W 13.1
Liabilities and Net Worth
$10,000 Checkable
Deposits
$50,000
$50,000
$240,000 Stock Shares
$250,000
A Single Bank Can Only Lend An Amount
Equal to their Preloan Excess Reserves
End Show
13-29
Copyright 2008 The McGraw-Hill Companies
Transaction 7 : Buying Gov.
Securities
The
Fractional
Reserve
System
Creating a
Bank
• When a commercial bank buys
securities from the gov, the effect
is basically the same as lending
(new money created)
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-30
• The selling of government bonds
to the public by a commercial
bank reduces the money supply
• The securities buyer pays by
check, reducing assets and
liabilities
Copyright 2008 The McGraw-Hill Companies
Money Creating Transactions
Transaction 7:
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
• Buying Government
Securities From Dealer
–Deposits Payment Into
Checking Account
The Banking
System
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Monetary
Multiplier
Assets
Last Word
Reserves
Securities
Property
Key Terms
End Show
13-31
Copyright 2008 The McGraw-Hill Companies
Liabilities and Net Worth
$60,000 Checkable
Deposits
$50,000
$100,000
$240,000 Stock Shares
$250,000
Money Creating Transactions
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
Profits, Liquidity, and the
Federal Funds Market
• Profit
–Loans
–Securities
• Liquidity
–Impact Upon Reserves
• Overnight Bank Loans
• Federal Funds Market
–Federal Funds Rate
End Show
13-32
Copyright 2008 The McGraw-Hill Companies
Profits, Liquidity, and the
Federal Funds Market
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-33
• 2 conflicting goals of a bank:
profit and safety
• Profit – commercial banks seek
to profit through lending and
buying securities
• Liquidity – bank must be on
guard for depositors who want to
transform checkable deposits
into cash and more checks
clearing against it than in its
favor
Copyright 2008 The McGraw-Hill Companies
Federal Funds Rate
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Day-to-day flow of funds rarely leave
all banks w/exact levels of required
reserves
• Funds held at Fed Reserve Banks
highly liquid
• Banks lend these excess reserves on
an overnight basis as a way of earning
interest without sacrificing liquidity
• Interest rate paid on these overnight
loans is Federal Funds Rate
Key Terms
End Show
13-34
Copyright 2008 The McGraw-Hill Companies
The Banking System
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-35
• Multiple-Deposit
Expansion
• The Banking System’s
Lending Potential
• Assumptions:
–20% Required Reserves
–All Banks “Loaned Up”
–Banks Lend All of Excess
Reserves
Copyright 2008 The McGraw-Hill Companies
The Banking System: MultipleDeposit Expansion
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
• A single bank can lend one dollar
for each dollar of excess reserves
• Banking system as a whole can in
reality lend by a multiple of its
excess reserves
• Read pages 252-253
Monetary
Multiplier
Last Word
Key Terms
End Show
13-36
Copyright 2008 The McGraw-Hill Companies
The Banking System
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-37
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
Copyright 2008 The McGraw-Hill Companies
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
The Monetary Multiplier
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
• Exists b/c the reserves and deposits
lost by one bank become the reserves
of another bank
• It magnifies excess reserves into a
larger creation of checkable-deposit
money
• Monetary multiplier = 1/required
reserve ratio
• Max. Checkable deposit creation =
excess reserves x money multiplier
Key Terms
End Show
13-38
Copyright 2008 The McGraw-Hill Companies
The Monetary Multiplier
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Monetary Multiplier or CheckableDeposit Multiplier
Monetary
Multiplier
=
or in Symbols…
Graphic
Example
1
Required Reserve Ratio
1
m =
New Reserves
$100
$80
Excess
Reserves
R
$20
Required
Reserves
Last Word
$400
Bank System Lending
Key Terms
End Show
Money Created
13-39
Copyright 2008 The McGraw-Hill Companies
$100
Initial
Deposit
The Monetary Multiplier
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-40
• Reversibility
W 13.2
–Making Loans Creates
Money
–Loan Repayment Destroys
Money
–Multiple Step Money
Expansion
–Multiple Step Destruction of
Money
Copyright 2008 The McGraw-Hill Companies
Reversibility: The Multiple
Destruction of Money
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
• This process is reversible
• Checkable-deposit money is
destroyed when loans are paid off
• Loan repayment sets off a
process of multiple destruction of
money
Monetary
Multiplier
Last Word
Key Terms
End Show
13-41
Copyright 2008 The McGraw-Hill Companies
Bank Panics of 1930-1933
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
•
•
•
•
•
The Banking
System
Monetary
Multiplier
Last Word
•
•
•
•
Key Terms
End Show
13-42
Series of Bank Panics
Before Deposit Insurance
Mass Withdrawals From Fear
Move to Cash Reduced Money Supply
Through Reduction in Loans
Multiple Contraction Slowed Lending
and the Economy
1933 National Bank Holiday for One
Week
Resulted in FDIC and 25% Drop in
Money Supply
Contributed to the Great Depression
Regulation Protects the System Today
Copyright 2008 The McGraw-Hill Companies
Key Terms
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Last Word
Key Terms
End Show
13-43
• fractional reserve banking
system
• balance sheet
• vault cash
• required reserves
• reserve ratio
• excess reserves
• actual reserves
• Federal funds rate
• monetary multiplier
Copyright 2008 The McGraw-Hill Companies
Next Chapter Preview…
The
Fractional
Reserve
System
Creating a
Bank
Money
Creation
The Banking
System
Monetary
Multiplier
Interest Rates
and Monetary
Policy
Last Word
Key Terms
End Show
13-44
Copyright 2008 The McGraw-Hill Companies