Download Chapter 11 How Banks Create Money

Chapter 11
How Banks Create Money
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-1
Learning Objectives
• Describe the simplified balance sheets of a
single bank and the banking system.
• Explain the money-creating abilities of a
single bank that is part of a multibank
system.
• Explain the money-creating abilities of the
banking system as a whole through
multiple-deposit expansion, and compare
this with the money-creating abilities of the
single bank.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-2
Learning Objectives (cont.)
• Define the monetary (or credit) multiplier.
• Discuss some of the limitations on the
banking system’s ability to create deposits
and expand the money supply.
• Describe how the banks’ lending activities
may contribute to financial instability and to
increased fluctuations in the level of
economic activity.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-3
Balance Sheet
• A statement of assets and claims that
summarises the financial position of a
firm at a point in time
• Each side balances:
–
Assets are items of economic and financial value
–
Assets = Liabilities + Net Worth
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-4
Formation of a Bank
• Transaction (1): The birth of a bank
–
new owners sell $250 000 worth of shares in
the bank
Assets
$
Cash
250 000
Liabilities & Net Worth
$
Capital Stock
250 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-5
Formation of a Bank (cont.)
• Transaction (2): Becoming a going
concern
–
Acquisition of property and equipment
Assets
$
Liabilities & Net Worth
$
Cash
10 000 Capital Stock
Property 240 000
250 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-6
Formation of a Bank (cont.)
• Transaction (3): Accepting deposits
–
Citizens and businesses deposit $100,000
–
Change in composition not total supply of
money
Assets
Liabilities & Net Worth
$
$
Cash
110 000 Deposits
100 000
Property 240 000 Capital Stock
250 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-7
Formation of a Bank (cont.)
• Transaction (4): Setting aside required
reserves
–
Assume reserve ratio is 20%
–
Bank must keep $20 000 (required reserves)
bank’s
required
reserve
Reserve ratio =
bank’s deposit liabilities
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-8
Formation of a Bank (cont.)
–
Bank decides to keep $110 000 (actual
reserves), which is $90 000 more than
required (excess reserves)
–
Bank’s required reserves are 20% of $100 000
Assets
$
Liabilities & Net Worth
$
Cash
0 Deposits
100 000
Reserves 110 000 Capital Stock
250 000
Property 240 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-9
Formation of a Bank (cont.)
• Transaction (5): Drawing a cheque
–
A citizen who has substantial deposits in the
bank draws a cheque for $50 000 to buy goods
–
The seller of the goods deposits the cheque in
another bank
–
The banking system as a whole has not lost or
gained
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-10
Formation of a Bank (cont.)
Transaction (5): Drawing a cheque (cont.)
Assets
$
Reserves 60 000
Property 240 000
Liabilities & Net Worth
$
Deposits
50 000
Capital Stock
250 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-11
Creating Money
• Transaction (6): Granting a loan
–
A company borrows $50 000 from the bank
–
Money is created
–
Balance sheet after loan is negotiated:
Assets
Liabilities & Net Worth
$
$
Reserves 60 000 Deposits
100 000
Loans
50 000 Capital Stock
250 000
Property 240 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-12
Creating Money (cont.)
Balance sheet after cheque drawn on loan
has been cancelled:
Assets
Liabilities & Net Worth
$
$
Reserves 10 000 Deposits
50 000
Loans
50 000 Capital Stock
250 000
Property 240 000
Now, bank has no excess reserves
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-13
Creating Money (cont.)
• Transaction (7): Buying government
bonds
–
Bank buys $50 000 of government bonds
instead of lending $50 000
–
Money is created
Assets
Liabilities & Net Worth
$
$
Reserves 60 000 Deposits
100 000
Bonds
50 000 Capital Stock
250 000
Property 240 000
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-14
The Banking System
• Multiple banks: multiple-deposit
expansion
• Money is created by a multiple of the
banking system’s excess reserves
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-15
Multiple-Deposit
Expansion
• Assume initially: 20% reserve
requirement
• Bank A
–
–
Accepts a deposit for $100

Does not alter money supply

Excess reserves of $80
A loan of $80 is negotiated
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-16
Multiple-Deposit
Expansion (cont.)
• Balance Sheet: Bank A
Assets
$
Reserves +100
–80
Loans
+80
Liabilities & Net Worth
$
Current Deposits
+100
+80
–80
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-17
Multiple-Deposit
Expansion (cont.)
• Loan cheque of $80 is drawn on Bank
A and deposited in Bank B
• Bank B
–
Gains $80 in reserves and deposits
–
Excess reserves of $64
–
Loans $64
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-18
Multiple-Deposit
Expansion (cont.)
• Bank B
Assets
$
Reserves
–80
–64
Loans
+80
Liabilities & Net Worth
$
Current Deposits
+80
+64
–64
• Loan cheque of $64 is drawn on Bank B
and deposited in Bank C, and so on…
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-19
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
B
C
D
E
F
G
H
I
J
K
L
M
N
Other banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
21.97
Required
reserves
$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
Excess
reserves
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Total amount of money created by the banking system
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
New money
created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
11-20
Multiple-Deposit
Expansion (cont.)
• Total banking system has created $400
• How?
–
Via the monetary multiplier
monetary multiplier
m =
1
=
1
reserve ratio
R
where m is the monetary multiplier
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-21
Possible Leakages
• Currency drains
–
Loan may be paid in cash and remain in circulation
• Transfer of deposits to non-bank financial
institutions
• Excess reserves
–
Individual banks may choose to have larger reserves than
required (say 25% instead of 20%)
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-22
Willingness to Borrow
• For the full multiplier effect to take
place:
–
Borrowers must be willing and able to utilise the
loans
–
Borrowing is likely to be low during a recession
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-23
Banks and Financial
Instability
• Banks may contribute to business
fluctuations
• Can exacerbate recession, by holding
back on credit expansion
• May amplify inflationary pressures, by
increasing lending and credit creation
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-24
Next Chapter:
Monetary Policy
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
11-25