The table shows the process of deposit creation in a multibank world.
We assume that legally required reserves must equal at least 20 percent of transactions deposits.
University Bank has to hold at least $20 as required reserves when you deposit $100 into your account.
The excess reserves can be used to support additional loans.
The bank can now lend up to $80.
We have to keep track of the changes in reserves, deposit balances, and loans that occur in excess reserves.
The reserves at the U.S. Federal Reserve are the same as the ones banks use.
The reserves may be held in the form of cash in the bank's vault but are usually held as credits with one of the regional Federal Reserve banks.
You can deposit cash at the bank.
The $100 of reserves created by the deposit are designated as required reserves.
The excess reserves of the bank are used to make a loan.
Money supply has increased
The antenna was bought by Campus Radio.
This depletes Campus Radio's account but increases Atlas's balance.
When the Campus Radio check clears, Eternal Savings gets $80 of reserves.
Eternal Savings gives money to Herman's Hardware.
Excess reserves are the basis of bank loans.
Further loans can be used for bank 3.
The process of using excess reserves to make a loan creates a deposit.
A deposit will be made somewhere else when the loan is spent.
Cash held in a bank's vaults, IOUs from bank customers, reserve credits at the Federal Reserve, and the bank's own deposits at the central bank are included.
On the right side of the balance sheet is a list of the bank's debts.
Deposits of bank customers are the largest liability.
Table 13.3 shows the use of balance sheets.
The University Bank's balance looks immediately after it receives your initial deposit.
On the left-hand side, your deposit is considered an asset because your coins have an immediate market value and can be used to pay off the bank's liabilities.
Required reserves are divided into 20 percent of your deposit and excess reserves are divided into 80 percent.
The bank has an obligation to return your deposit when you demand it, on the right-hand side of the balance sheet.
Assets and liabilities are equal in the bank's accounts balance.
The University Bank wants to make money and do more than balance its books.
To put its excess reserves to work, it will have to make loans.
It would lend $80 to Campus Radio.
The loan alters both sides of University Bank's balance sheet.
On the right-hand side, the bank creates a new transactions deposit for Campus Radio, which is an additional liability.
There are two things happening on the left-hand side of the balance sheet.
The bank notes that Campus Radio owes it money.
The economy's money supply has been affected by the first two steps of University Bank's balance sheet.
You deposited $100 into your checking account.
The initial transaction did not change the money supply's value.
$100 less cash was held by the public and $100 more in transactions accounts.
The excitement begins when the bank makes a loan.
The bank increases the total money supply when it makes a loan.
Like everyone else, Campus Radio can use its money to buy goods and services.
Money creation begins with this second step.
Money looks out of place when a bank makes a loan.
To understand how this works, you have to remind yourself that money is more important than currency.
Transactions deposits are money as well.
It is possible that Campus Radio uses its loan to buy an antenna.
The rest of Table 13.3 shows how balance sheets and money supply change as a result of this additional transaction.
When Campus Radio buys an antenna, the balance in its checking account at University Bank drops to zero because it has spent all of its money.
As University Bank's liabilities fall, so does the level of its required reserves, which means that University Bank can now lend only $80 rather than $100.
Eternal Savings credits Atlas's account by $80 when Atlas deposits a check from Campus Radio.
University Bank gets the reserves that support the deposit.
The required and excess reserves appear on the Eternal Savings balance sheet.
The money supply hasn't changed during step 3.
The increase in the value of Atlas Antenna's transactions account is more than offset by the decrease in the value of Campus Radio's transactions account.
The only thing that hasn't changed is the money supply's ownership.
Eternal Savings made a loan to Herman's Hardware in step 4 because of its newly acquired excess reserves.
The loan has two effects.
It creates a transactions deposit of $64 for Herman's Hardware and increases the money supply by the same amount.
It increases the required level of reserves.
It's obvious that the process of deposit creation won't end quickly.
It can continue indefinitely, like the income multiplier process in Chapter 10.
There is a required reser ve ratio.
The money multiplier process is shown in Figure 13.2.
Excess and required reserves are created when a new deposit enters the banking system.
Excess reserves can be used to make loans.
These loans are converted into deposits elsewhere.
Until all available reserves become required reserves, the process of money creation continues.
The interbank reserve movements are handled by bank clearing houses and regional Federal Reserve banks.
The effect is the same.
Chapter 14 talks about the nature and use of bank reserves more fully.
They can't be used to create new loans because of the flow of money.
New loans can be used for excess reserves.
Transactions from those loans are deposited elsewhere in the banking system.
Further loans are made after some additional leakage into required reserves occurs.
The process goes on until all excess reserves leak into the required reserves.
The total value of new loans will be the same as the initial excess reserves.
The money multiplier worked in our previous example.
We assumed that the required reserve ratio was 0.20 and that the money multiplier was equal to 5.
As a result of your original deposit, the initial level of excess reserves was $80.
The ultimate increase in the money supply was $400 when all the banks fully utilized their excess reserves at each step of the money multiplier process.
If the bank has excess reserves, it can make additional loans.
Without excess reserves, all of a bank's reserves are required, and no further liabilities can be created with new loans.
A bank with excess reserves can make more loans.
Each bank is allowed to lend an amount equal to its excess reserves.
Excess reserves and lending capacity are created when loans enter the circular flow and become deposits elsewhere.
We can gauge the lending capacity of any bank by keeping track of excess reserves.
The money multiplier process is summarized in Table 13.4.
We assume that all banks are "loaned up" without excess reserves.
Someone deposits $100 in cash into a transactions account at Bank A.
If the required reserve ratio is 20 percent, this initial deposit creates excess reserves at Bank A and adds $100 to total transactions deposits.
If Bank A uses its newly acquired excess reserves to make a loan that ends up in Bank B, two things happen: Bank B acquires $64 in excess reserves and total transactions deposits increase by another $80.
There is a series of loans and deposits.
Transactions deposits grow by an equal amount when the twenty-sixth loan is made by bank Z.
The money supply will stay the same.
Bank G acquires.
When the required reserve ratio is 0.20, a $100 cash deposit creates $400 of new lending capacity.
$100 deposit $20 required reserves are the initial excess reserves.
5 is the money multiplier.
$400 is the new lending potential.
The process of deposit creation continues as money moves through the system.
The possibility of $400 step, excess reserves and new loans can be created by the initial excess reserves of $80.
When the reserve ratio is 20 percent, the lending capacity of new loans is reduced.
The details of bank deposits and loans are hard to understand.
They show that banks can create money.
The amount of purchasing power available for buying goods and services is changed by banks when they perform these two functions.
Market participants can respond to the changes in the money supply by changing their spending behavior.
There is a simplified perspective on the role of banks in the circular flow.
Consumers spend most of their income but also save some of it.
Unemployment is a potential source of stabilization problems because of consumer saving.
If additional spending by business firms, foreigners, or governments doesn't compensate for consumer saving at full employment, a recessionary GDP gap will emerge, creating unemployment.
The banking system can play a role in encouraging such spending.
Banks couldn't transfer money from people who were saving to people who were spending it.
Purchase power can be returned to the circular flow by using these and other bank deposits as the basis of loans.
The primary economic function of banks is to transfer purchasing power from saver to spender.
They lend money to businesses for new plant and equipment, to consumers for new homes or cars, and to government entities that want more purchasing power.
There are three major constraints on the deposit creation of the banking system.
The first constraint is the willingness of consumers and businesses to continue using checks.
Banks wouldn't be able to acquire or maintain the reserves that are the foundation of bank lending activity if people preferred to hold cash.
The willingness of consumers, businesses, and governments to borrow money from banks is one of the constraints on deposit creation.
The chain of events we've observed in deposit creation depends on the willingness of Campus Radio to lend money.
Deposit creation would never begin if no one wanted to borrow money.
Deposit creation won't live up to its potential if excess reserves aren't borrowed.
The Federal Reserve System is a major constraint on deposit creation.
Reserve requirements may be imposed by the Fed to limit deposit creation.
The tools of monetary policy are discussed in Chapter 14.
Banks used to experience "runs" when depositors would rush to withdraw their funds.
When a bank is running low on cash, depositor runs usually begin.
Depositor runs became confirmation of a bank's insolvency.
The bank closing pushed the economy into a recession.
In 2001-2003, this happened in Argentina.
There was a lot of fear that the U.S. banking system would collapse during the Great Depression.
Depositors were withdrawing more cash and borrowers weren't able to repay their loans.
Banks were unable to create money as their reserves dwindled.
Bank deposits and loans disappeared suddenly.
With little cash coming in and a lot of cash flowing out, banks quickly ran out of cash reserves and had to shut their doors.
Over 9000 banks failed between 1930 and 1933.
Franklin Roosevelt declared a "bank holiday" in order to prevent the collapse of the banking system.
Laura Alonso, a retired waitress who walked recovery, said she should have known better than to trust a credit crunch here.
She withdrew her money in December, not because of the depos drawals.
Permission was granted for the post to be excerpted.
The banking system can't make loans if consumers don't keep their money in banks.
Congress created a deposit insurance to protect customer deposits.
The Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) were created in 1933 and 1934 to make sure that depositors would get their money back even if the bank failed.
The motivation for deposit runs was eliminated by the guarantee of insured deposits.
The federal government would repay deposits if a bank closed.
Public confidence in the banking system was increased by federal deposit insurance.
It did not ward off bank failures.
A major risk for bank customers was eliminated by the federal government.
Depositors no longer had to worry about the soundness of a bank's lending practices because their deposits were insured.
The opportunity for riskier loans was created by this.
Interest rates went up during the 1970s.
Banks had to offer higher rates of interest on customer deposits.
Many of their loans already had lower interest rates.
S&Ls used to lend most of their funds in long-term home mortgages.
They were stuck with high interest rates on short-term deposits and low interest rates on long-term mortgages.
This was a recipe for failure.
Increased competition from new financial institutions caused deposits to leave the S&Ls.
The downturns in oil prices and real estate made it harder for borrowers to repay their loans.
More than half of the S&Ls that existed in 1970 disappeared by 1990.
More banks failed in 1988 than in any year since the Great Depression.
The recession pushed more banks into insolvency.
Depositors in failed banks were paid off by the FDIC.
The FSLIC ran out of funds because many S&Ls failed.
Congress had to appropriate larger sums of money to bail out the banks.
Over $60 billion was spent on bank rescues in 1992.
The federal government takes control of a failing bank when it pays insured deposits.
The government tries to acquire a stronger bank.
The federal government acquires the loans of the failed bank.
In 1989 the Resolution Trust Corporation was created to manage these loans.
The RTC tried to collect outstanding loans or sell the properties that were financed with those loans.
Part of the huge outlays for bank rescues in the early 1990s were offset by the proceeds from these RTC property sales.
Banks will be competing for deposits and loans tomorrow.
Deposit insurance provided by the FDIC and the renamed Savings Association Insurance Fund will help them attract new funds.
The types of loans and investments that banks can make has been set by Congress.
It has made bank owners put more of their own money at risk.
The intent of these changes is to improve the financial stability of banks while assuring the public that their deposits are safe in the economy tomorrow even in banks with only fractional reserves.
Money serves a vital function in account deposits in a market economy.
M2 allows balances and other deposits to form a broader measure of increased output by adding a savings account.
Banks can make loans to create money.
New transactions deposits and services balances are also considered money.
Banks' ability to make loans depends on excess of deposit balances.
These are on their reserves.
Purchasing power is available in the marketplace if a bank has excess reserves.
LO2 is able to make new loans.
Government regulation limits the amount of deposits that can be created as loans are spent.
It is limited by the fact that other banks can make additional loans.
The money is used to borrow money.
The federal government's banking system comes from excess reserves when banks fail.
LO3 will pay deposits.
Transfer owners are now required to put more of their own money into their bank accounts, as well as deposit their money at risk, because of the role banks play in creating money.
How are an economy's production possibilities affected?