Download CHAPTER 32: MONEY CREATION Introduction The Fractional

CHAPTER 32: MONEY CREATION
Introduction
The Federal ~eserve System plays a crucial role in the U.S. economy, controlling the money
supply and usmg monetary policy to stabilize the economy. As part of this process, banks create
~oney through the fractional reserve system. Chapter 32 explains the process by which banks
~ncrease the money supply and the role of the money multiplier in determining the total increase
m the money supply. This knowledge lays the foundation for understanding how monetary
policy works. Material from Chapter 32 usually appears in a few multiple-choice questions on
the AP macroeconomics exam, as well as occasionally occurring as a complete free-response
question on money creation.
The Fractional Reserve System
The U.S. banking system is known as a fractional reserve system, meaning that banks are
required to keep a fraction of all checkable deposits in reserve at the bank (or at the Federal
Reserve bank) and that the rest of the deposits can be loaned out to other customers. As a result,
the reserves at banks are only a fraction of the total money supply.
The banking system creates money by issuing loans. Because the money is loaned and re-Ioaned,
it can create a significantly larger money supply than the original deposit. If the bank retains a
large proportion of its deposits, fewer dollars are available to be loaned, so the growth of the
money supply will be low. If the fraction of deposits held by the bank is low and the bank keeps
loaning large proportions of the subsequent deposits, the money supply can grow rapidly. The
ability to change these fractional reserves gives the Federal Reserve considerable flexibility in
changing the money supply.
On the other hand, a fractional reserve system carries significant risks for panics and bank runs.
If the bank has loaned a significant amount of the original deposits and those deposit-holders
return to withdraw those funds, the bank does not have the funds available to repay those funds
on demand. The money hasn't disappeared; it will be repaid with interest. But depositors who
don't get their money back right away can start a panic, causing other customers to rush to
retrieve their funds . The Federal Deposit Insurance Corporation (FDIC) was created to prevent
such bank runs by insuring deposits up to $100,000. (That limit was temporarily raised to
$250,000 in late 2008 to restore confidence during a serious financial crisis.) When depositors
know their accounts are insured by the government, they have confidence that their money is
protected and runs are unlikely.
Bank Balance Sheets
Banks perform two primary functions for customers: they provide a safe place for savings, and
they loan out money to customers. A bank's balance sheet lists the assets (what the bank owns,
the cash on hand, and the money owed to the bank), liabilities (the bank's expenses and debts),
and net worth. The balance sheet must remain balanced.
Assets
=
Liabilities + Net Worth
A new bank is created with $250,000 of stock bought by shareholders, which is a liability for the
bank because it must be repaid to the stockholders. From the stock proceeds, $240,000 is spent
on property and capital, and $10,000 remains in cash, which are the assets of the bank. The
balance sheet is balanced.
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Asseu
Accepting Deposits
Balance Sheet 3: Wahoo Bank
liabilities and net worth
$1 10 ,000
240.000
C hcc kob le
de poSi t s
Stock shares
$1 00 ,000
250.000
If depositors make $100,000 in deposits into checking accounts, those deposits show up on both
sides of the balance sheet- as cash the bank is holding as an asset and as a liability of checkable
deposits the bank owes the depositors. However, the economy's money supply has not changed,
Remember, M I consists of currency held by the public and demand deposits at the bank. When
the deposits were made, the form of the money changed from currency to checkable deposits, but
the quantity of money did not change.
The Reserve Requirement
The reserve requirement (or reserve ratio) is the percentage of checkable deposits that the bank
must hold in reserve and cannot loan out. It can hold that reserve as vault cash at the bank or
keep it at the regional Federal Reserve Bank. If $1 00,000 is deposited at the bank and the reserve
requirement is 10 percent, the bank is required to hold $10,000 in cash, and it can loan out the
other $90,000 to customers. The Federal Reserve determines the reserve requirement.
Actual reserves are the total amount of reserves the bank holds. Excess reserves are the amount
of reserves the bank holds beyond the required reserves; these are the funds that can be loaned out
to other customers.
Actual Reserves = Required Reserves + Excess Reserves
While it may appear that the purpose of a reserve requirement is to ensure liquidity so that funds
will be available when depositors attempt to withdraw their funds, this is not the real purpose of a
reserve requirement. The purpose of the reserve requirement is to control the money supply.
When a bank makes loans to customers, it increases the money supply; when the loan is repaid, it
decreases the money supply. The Federal Reserve can change the reserve requirement, which
changes the money supply, to address recession or inflation. The reserve requirement limits how
far the money supply can grow in order to prevent significant inflation in the economy.
Government Securities
Banks can also buy and sell government bonds to affect the money supply. If the bank buys
bonds from a securities dealer, it increases the money supply because it receives a non-money
asset (the bond) and pays with money. If the bank sells bonds, it reduces the money supply by
releasing a non-money asset into the economy and taking in money.
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Chapter 32: Money Creation
Bear in Mind
It is i~portant to note the difference between the change in money supply resulting from a new
deposlt of cash versus the bank buying securities. A customer deposit causes no change in the
money supply because the money is only changing form from currency to a demand deposit, both
forms o.f M I . However, if a bank buys a bond, the money supply does increase. The bank puts
money mt.o the economy to buy the bond, while absorbing a non-money asset into its accounts.
In answenng exam questions, it is important to pay careful attention to the initial action in order
to determine whether money is created in that initial action or whether money is created later in
the process through loans.
The Federal Funds Market
Banks are like any other firm-they seek profit. Banks make profit by paying a low interest rate
on deposits and using those deposits to make loans for which they charge a higher interest rate, or
by using those deposits to buy securities, which earn a higher interest rate. So banks have an
incentive to loan out as much of their excess reserve as possible. The bank has another objective,
though. It has to maintain liquidity for depositors who want to make withdrawals. So it can't
loan out so much of the excess reserve that if depositors unexpectedly write a large number of
checks at the end of the day, the bank would be left with less than the required reserve. To
resolve this issue, banks make overnight loans to each other to ensure they meet their reserve
requirements each night. Banks with excess reserves at the end of the day can make overnight
loans to banks that need it, charging an interest rate called the federal funds rate.
Multiple-Deposit Expansion
We can see how banks create money through loans by starting with a few assumptions. All of the
banks must meet the reserve requirement (10 percent in our example), and the banks start with no
excess reserves. Further, we will assume that every time a bank makes a loan, the recipient writes
a check for the entire amount, which is fully redeposited in another bank. Finally, we assume that
banks will loan out all excess reserves.
Customer A
Customer B
Customer C
Customer D
Customer E
Deposits
$1 ,000
Required
Reserves
$100
Excess
Reserves
$900
Loans
$900
$900
$90
$810
$810
$81
$729
$810
Total
Increase in
Money Supply
$ 0
$900
$900
$1,710
$1,710
Let's assume Customer A takes $1 ,000 from under his mattress and deposits it into his checking
account at the bank. Did the money supply change? No . The money only changed form, from
currency to a checkable deposit. If the bank must hold 10 percent in cash to meet the reserve
requirement, it must hold $100 and, therefore, has $900 available in new excess reserves that it
can loan to customers.
Customer B takes out a $900 loan to buy a computer from Customer C. At this point, the bank
creates $900 in new money. How? Customer A still has his $1,000 in demand deposits at the
bank, but now Customer B has a $900 loan from the bank to buy the computer-the $900 has
been used twice.
Chapter 32: Money Creation
227
Customer B buys the computer from Customer C, who deposits the $900 in his checking account
at a bank. Did this action create more money? No, the money just changed location, from a
customer check based on the loan to a new deposit in Customer C's checking account. Of the
new $900 deposit, the bank is required to reserve $90 (so banks now hold a total of $190 in
required reserves), leaving $810 in excess reserves available for loans.
Customer D comes to the bank to borrow $810, to pay Customer E for car repairs. [n creating the
loan from the excess reserves, the bank has created another $810 in new money, for a total of
$1,710 of new money created by the banking system from the original $1,000 deposit. When
Customer E deposits the $810 payment from Customer D, the bank must again keep the 10
percent required reserve ($81) and can again loan the $729 in new excess reserves. This process
continues with deposit after deposit and loan after loan .
Important Implications of Money Creation
A few important questions arise from this understanding of the multiple-deposit expansion of the
money supply. What happens if depositors try to remove funds that have been loaned? How
large will the money supply grow under this system? And why is the reserve requirement
important for limiting the growth of the money supply?
First, once the excess reserves have been loaned and reloaned, what if Customer A comes back to
the bank and wants to withdraw his $1,000 deposit? It isn ' t there. Nearly all of it has been
loaned out to Customer B. If Customer A can't get his money and makes panicked calls to his
friends , Customers C and E, they may rush to their banks to try to get their deposits as well-a
classic run on the banks. [n modem banking, Customer A is only one of hundreds of thousands
of people who have deposits at each bank, and it is extremely unlikely that everyone would show
up at once to withdraw their deposits. Even if they did, the FD[C provides government protection
of deposits, up to a limit, in case the banks actually collapsed.
The Growth of the Money Supply
An important implication is that with every loan, the money supply keeps growing. How large
will it grow? To find out, we need to calculate the money multiplier.
Money Multiplier
=
Reserve Requirement
[fthe reserve requirement is 10 percent, the money multiplier is I / 0.1, or 10. If the reserve
requirement is 20 percent, the money multiplier is I / 0.2, or 5. The larger the reserve
requirement of deposits that the bank must hold, the smaller the multiplier becomes.
Bear in Mind
You cannot use a calculator on the AP economics exams, and you can count on questions that
reqUIre you to calculate the money mUltiplier. An easy trick of the trade to calculate the
multiplier is to think about the denominator (the reserve requirement) as a fraction of a dollar.
For example, if the reserve requirement is 10 percent, the denominator is 0.1 O-which looks like
10 cents. What ~ust yo~ multiply your dime by to get to a dollar? Ten. Your multiplier is 10. If
the reserve reqUIrement IS 25 percent, your denominator is 0.25-a quarter. You must multipl a
quarter by 4 to get to a dollar, so your multiplier is 4.
y
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Chapter 32: Money Creation
Now that we.know the multiplier, we can calculate the maximum potential growth of the money
supply resultmg from an initial deposit.
Potential Money Creation
=
Excess Reserves x Money Multiplier
~n. ~ur earlie~ example, the initial $ I ,000 deposit with a 10 percent reserve requirement left an
InItIal $9.00 m excess reserves. With a money multiplier of 10, the amount of money created by
the bankmg system through loans is $9,000. Added to the $1,000 initial deposit, the total money
supply is $10,000. Now we can begin to see the full impact of changes in the multiplier. If the
reserve requirement had been 20 percent with a multiplier of 5, the money supply could have
grown only by $4,000 for a total of $5,000, because the banks could not have loaned as much.
Had the reserve requirement been 50 percent with a multiplier of 2, the money supply could have
grown only by $ I ,000 for a total of $2,000.
The money multiplier is a concept very similar to the spending multiplier and marginal propensity
to consume. With the M PC, one person's spending is another person's income, so an initial
change in spending eventually leads to a much larger change in real GDP as the money is spent
and respent. In the same way, an initial deposit into the banking system is loaned and reloaned,
spent and respent, so that an initial deposit into the banking system results in a much larger effect
on the money supply.
Limitations on Growth of the Money Supply
Another implication of this mUltiple-deposit expansion system is the importance of the reserve
requirement in controlling the growth of the money supply. Assume for a moment that there was
no reserve requirement at all. If banks were free to loan out all deposits made to the bank, how
far would the money supply grow') It would grow infinitely. There would be no means to limit
the perpetual reloaning of funds, causing massive inflation. Therefore, a reserve requirement is
essential for limiting the growth of the money supply and the rate of inflation.
Will the money supply always grow to its potential? Generally not. Remember our opening
assumptions-that banks loan out all of their excess reserves and customers redeposit all of their
funds at their banks. In reality, consumers hold cash in their wallets and in their homes for
purchases, and money not deposited at the bank cannot be used to further expand the money
supply. Further, banks may not fully loan funds if they are concerned about meeting their reserve
requirement or if customers simply choose not to take out as many loans during an economic
downturn. So while we know the maximum potential growth of the money supply, the actual
money supply may change less.
Multiple-Choice Questions
1.
A fractional reserve system requires banks to keep a fraction of demand deposits in
(A)
government securities.
(8)
loans to customers.
(C)
vault cash or deposits at a Federal Reserve bank.
(D)
collateral assets, such as home mortgages.
(E)
savings accounts or time deposits.
Chapter 32: Money Creation
229
2.
Banks create money in the U.S. monetary system by
(A)
printing it.
(B)
making loans.
(C)
selling government securities.
(D)
increasing interest rates.
(E)
increasing the reserve requirement.
3.
If a customer deposits $2,000 and the bank is allowed to loan $1,200 of the deposit, the
reserve requirement is
(A)
40 percent.
(B)
6 percent.
(C)
167 percent.
(D)
60 percent.
(E)
8 percent.
4.
Assume the reserve requirement is 15 percent and a bank initially has no excess reserves.
If a customer deposits $1,000, how much of that deposit can be loaned?
(A)
$15
(B)
$150
(C)
$7,000
(D)
$850
(E)
$1 ,015
5.
When a customer deposits $200 cash into his checking account at the bank, the
money supply
(A)
increases by $200.
(B)
decreases by $200 times the mUltiplier.
(C)
decreases by $200.
(D)
increases by $200 times the multiplier.
(E)
does not change .
6.
The balance sheet below shows the current financial status of Horvath National Bank. If
the reserve requirement is 20 percent and the bank does not sell any securities, by how
much could it increase loans?
Assets
Liabilities
Total Reserves
$35,000
$100,000
Demand Deposits
Loans
$10,000
Securities
$55,000
(A)
(B)
(C)
(D)
(E)
7.
230
$0
$10,000
$70,000
$25,000
$\5,000
The federal funds rate is the
(A)
interest rate banks charge each other for short-term loans.
(B)
total money supply in the United States.
(C)
rate of growth of the money supply.
(D)
percentage of deposits banks must hold in cash.
(E)
ratio of loans to deposits.
Chapter 32: Money Creation
8.
Assume a bank has no excess reserves and the reserve requirement is 20 percent. If a
customer deposits $20,000 in currency into his checking account, what is the maximum
amoun~ by.which banks will increase the money supply through multiple-deposit
expansIon In the banking system?
(A)
$4,000
(B)
$20,000
(C)
$40,000
(D)
$100,000
(E)
$80,000
9.
If members of the public choose to hold money in currency rather than depositing it into
banks, the growth of the money supply will be
(A)
less than the potential growth of the money supply.
(B)
infinite.
(C)
unaffected, because currency is only a different form of M I.
(D)
determined by the marginal propensity to consume.
(E)
determined by the reserve requirement.
Free-Response Question
Sandy receives a graduation gift of $1 ,000 in $100 bills from her grandmother. Sandy deposits
the $1,000 into her checking account at the First Federal Bank.
(a)
What is the initial impact of Sandy's deposit on the money supply? Explain.
(b)
If the reserve requirement is 20 percent, calculate the following:
(i)
the maximum amount First Federal can loan from the initial deposit. Explain
how you calculated this amount.
(ii)
the maximum potenti al increase in the total money supply as a result of the
deposit. Explain how you calculated this amount.
(c)
Identify two reasons why the money supply might not grow to its maximum
potential.
(d)
If the reserve requirement were 100 percent, what would be the maximum potential
increase in the money supply as a result of Sandy' s deposit? Explain.
(e)
If the reserve requirement were 0 percent, explain the following.
(i)
the maximum potential increase in the money supply as a result of Sandy's
deposit
(ii)
the effect on the purchasing power of the dollar
Multiple-Choice Explanations
(C)
The fractional reserve system means that a percentage of all deposits into
I.
checkable accounts must be held in reserve by the bank and not loaned.
2.
(B)
Each time a bank makes a loan from its excess reserves, money is created.
3.
(A)
If the bank is allowed to loan $1 ,200 of the $2,000 deposit, it must be required to
keep $800 of the deposit. 8 / 20 = 40 / 100 = a 40 percent reserve ratio
4.
(D)
The bank is required to hold IS percent of the $1,000, or $150, in required
reserve. The other $850 in excess reserves can be loaned out by the bank.
5.
(E)
When cash is deposited into a checking account, the money supply does not
change, because both currency and demand deposits are components of the M I money
supply. The money changed form from cash to checking deposits, but the amount of
money did not change.
Chapter 32: Money Creation
231
6.
7.
8.
9.
(E)
Checkable deposits are $100,000, so with a 20 percent reserve requirement, the
required reserve is $20,000. Of the $35,000 in actual reserves, $20,000 is required, so the
other $15,000 is excess reserves available for loans.
(A)
Banks must sometimes borrow from other banks overnight in order to meet their
reserve requirements. The interest rate on these short-term loans is the federal funds rate.
(E)
If the deposit is $20,000 and the reserve requirement is 20 percent, the bank must
hold $4,000 in required reserves, leaving $16,000 in excess reserves. The multiplier
(I / Reserve Requirement) is 5 (I /0.2) . The greatest possible expansion of the money
supply is the excess reserve times the multiplier ($16,000 x 5), or $80,000.
(A)
If money is not deposited into the bank, it cannot continue the multiple-deposit
expansion, so the money supply will not grow as large as it could have if all of the money
had been deposited.
Free Response Explanation
12 points (2 + 4 + 2 + 2 + 2)
(a)
2 points:
• I point is earned for stating that Sandy's deposit does not change the money supply.
• I point is earned for explaining that currency and demand deposits are just different
forms of the M I money supply, so only the composition of the money supply changed,
not the amount of money.
(b)
4 points:
• I point is earned for stating that First Federal could loan $800 of the initial deposit.
• I point is earned for explaining that the bank has required reserves of $200 (0.20 x
$1,000), so excess reserves are $800 ($1 ,000 - $200).
• I point is earned for stating that the money supply will increase by $4,000.
• I point is earned for explaining that the multiplier is 5 (I / 0.2), which is mUltiplied by the
excess reserves of $800 for a total money creation of $4,000.
(c)
2 points:
• I point is earned for each of two reasons from the following list:
o The banks decide to hold some excess reserves and not loan them out.
o The public holds on to some currency and does not redeposit it at the bank.
o Consumers are not willing to borrow money from banks.
(d)
2 points:
• I point is earned for stating that the maximum increase in the money supply is zero.
• I point is earned for explaining that because the bank cannot loan any of the deposit back
out, the money supply cannot grow.
(e)
2 points:
• I point is earned for stating that the money supply would grow infinitely.
• I point is earned for explaining that the purchasing power of the dollar would fall,
because inflation resulting from the higher money supply would lower the value of
money .
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Chapter 32: Money Creation