Banking (2024)

• Banks (def):
• Institutions that borrow from people (take in deposits) and use that money to make loans to other individuals

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• The Fractional Reserve System
• Banks can’t lend out all their deposits
• They must hold a percentage of their deposits as reserves → required reserve ratio
• The deposits the bank has in excess of their reserve requirements → excess reserves

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• Simple Money Multiplier
• measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no money

1

Reserve ratio

RoundBank GetsBank Keeps Bank Loans

(reserve ratio: 20%) (person borrows)

• Key Accounting Terms
• assets: things that a bank owns
• liabilities: things that a bank owes
• 2 groups:
• checking deposits—claims of non-owners against the banks assets
• net worth—claims of owners of the firm against the bank’s assets (i.e. stock)

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Assets = liabilities + net worth

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• reserves: currency & deposits a bank keeps on hand or at the Fed to manage the normal cash inflows (deposits) and outflows (w/drawls & loans)
• reserve ratio: the ratio of reserves to total deposits
• money multiplier: the measure of the money ultimately created per dollar deposited in the banking system

Description:

• owners of bank secure a state or national charter
• Raise start-up capital by issuing stock = $250,000

Description:

• Property & equipment acquired
• office space-$220,000; office equipment-$20,000
• Change noted in blue

Description:

• Bank receives $100,000 of deposits (required reserves = 20%)

Description:

Simplification: all reserves are deposited at the Branch Federal Reserve

• Bank anticipates a future increase in checkable deposits
• For convenience, bank sends reserves beyond its required reserve level (20%)—this is what will eventually allow bank to issue loans & earn interest income

Description:

• Clem Bradshaw writes a check against his Wahoo checking account to Ajax
• When the check is processed, both Wahoo’s reserves and checkable deposits are reduced

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Description:

• Gristly Meat Packing Co. wants to expand & applies for a $50,000 loan at Wahoo
• Wahoo approves the loan & CEO of Gristly gives Wahoo a promissory note (i.e. an IOU)
• Wahoo creates a $50,000 checkable deposit (liability) to pay for the loan (asset)

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• Back in “Transaction 3,” a checkable deposit was created as a result of currency being taken out of circulation
• This is a change in the composition of the money supply but no change in total supply of money

• When banks lend, it creates checkable deposits that are money—think back to the goldsmith
• The bank has monetized an IOU
• The IOU is not money (NOT a medium of Exchange)
• Checks written against a checkable deposit are money (IS a medium of exchange)

• Gristly will be spending its $50k very quickly
• It contracts out to Quickbuck Construction to build their new factory.
• Gristly writes a $50k check against its account at Wahoo and gives it to Quickbuck.
• Quickbuck deposits this check at the Fourth Nat’l Bank of Omaha
• The check is processed just as it was in “transaction 5”
• Wahoo loses reserves and deposits
• Fourth Nat’l gains reserves and deposits

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Q: Could the Wahoo bank have lent more than the $50k to Gristly?

A: NO!—Wahoo was “fully loaned up” as indicated by its balance sheet

• Be able to calculate the excess reserves
• What if Wahoo had lent Gristly $55k?
• Collection of the check against Wahoo would have lowered its reserves to 5,000 but checkable deposits = $50k
• This brings the reserve ratio to 10% ($5k/$50k)—well below the required 20%

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RULE: A single commercial bank in a multibank system can only loan an amount equal to its pre-loan excess reserves.

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Q: If Banks create checkable-deposit money when they lend from their excess reserves, is money destroyed when borrowers repay their loans?

A: Yes—when loans are paid off, the lending process works in reverse

• Checkable deposits decline by the amount of the loan repayment

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Description:

When the banks buy government bonds the effect is the same as lending—new money is created

• Assume Wahoo’s balance sheet is as it was in transaction 5
• Instead of making a loan, Wahoo buys a $50k government

security (i.e. bond)

• Bond purchases increase the supply of money the same way that lending does
• Bank accepts the bond which is not money
• Gives the securities broker an increase in checkable deposits which is money
• When the securities dealer draws and clears his/her check, Wahoo’s balance sheet acts just as it did in transaction 6b
• The selling of government bonds reduces the money supply—just like the repayment of a loan

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• A new checkable deposit of $1,000 is made in Bank 1. The required reserve ratio is 10 percent of checkable deposits, and banks do not hold any excess reserves. That is, banks loan out the other 90 percent of their deposits. Assume that all money loaned out by one bank is redeposited in another bank. To see how the new deposit creates money and increases the money supply, find the following values.

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• The original deposit increased total bank reserves by _____. Eventually this led to a total of $10k expansion of bank deposits, _____ of which was b/c of the original deposit while _____ was b/c of bank lending activities.
• If the required reserve had been 15%, the amount of deposit expansion would have been (more / less) than in this example.
• If the required reserve had been 5%, the amount of deposit expansion would have been (more / less) than in this example.
• If banks had not loaned out all of their excess reserves the amount of deposit expansion would have been (more / less) than in this example
• If all loans had not been redeposited, the amount of deposit expansion would have been (more / less) than in this example

3.Another way to represent the multiple expansion of deposits is through T-accounts. A T-account shows offsetting assets and liabilities. For the bank, assets include loans, deposits with the Federal Reserve, and Treasury securities. Liabilities include deposits. Use the T-account below to show how the new $1,000 deposit described in the previous example would be listed in a T-account.

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• Will an increase in the reserve requirement increase or decrease the money supply? Explain.

The money supply will be decreased. Banks must hold more of their deposits as reserves so loans and money creation are decreased

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(B)What will happen to deposits, required reserves, excess reserves, and the money supply if deposits are withdrawn from the banking system?

Deposits decrease; required reserves decrease; excess reserves decrease, and the money supply decreases.

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(C)What could happen at each stage of the money creation process to prevent the money supply from increasing the full amount predicted by the deposit expansion multiplier?

People could hold their loan proceeds as cash; banks hold excess reserves.