Module 25 Banking Money Creation Module 25 Essential

Module 25 Banking & Money Creation

Module 25 Essential Questions 1. 2. 3. What is the role of banks in the economy? What are the reasons for and types of banking regulation? How do banks create money?

The Monetary Role of Banks More than half of the M 1 is currency The rest is demand deposits Recall the definition of M 1 = currency + coin + traveler’s checks + checking deposits The role of Banks: because about half of the money supply is accounted for by checking deposits, the banks are crucial in the supply of money in the economy

Banks: Can’t Live With ‘Em, Can’t Live Without ‘Em Financial Intermediaries Reserve & Lend T-Accounts, Assets & Liabilities Reserve Ratio & Required Reserve Ratio

What DO Banks DO Anyway? Earn a Profit! 1. 2. 3. 4. 5. Do banks manufacture money? Banks are _________________in business to earn _______, but in the process they do make more money. Banks offer a _______ for depositors to put money and they offer ______ services to borrowers who need money. Savers are paid ______ on savings, and borrowers are __________interest on borrowing. Banks take _____assets (savings) to finance the investment

What Do Banks DO Anyway? Earn a Profit! 1. 2. 3. 4. 5. Do banks manufacture money? No. Banks are financial intermediaries in business to earn profit, but in the process they do make more money. Banks offer a safe place for depositors to put money and they offer lending services to borrowers who need money. Savers are paid interest on savings, and borrowers are charged interest on borrowing. Banks take liquid assets (savings) to finance the investment of illiquid assets (homes and capital

What Do Banks DO Anyway? : Reserve & Lend 1. 2. 3. Why do banks only hold a fraction of their deposits in reserve? What does the bank do with the rest of the deposited money? How does this increase the money supply?

What Do Banks DO Anyway? : Reserve & Lend 1. 2. 3. Why do banks only hold a fraction of their deposits in reserve? B/c customers will withdraw money from their checking and saving accounts What does the bank do with the rest of the deposited money? Only a small fraction of reserves will be withdrawn, so the bank can lend the rest and profit from making those loans. How does this increase the money supply? Once loans are made, there is now more money

What Do Banks DO Anyway? : Create Money 1. How does a bank create money? 2. What are T-accounts? 3. 4. 5. 6. What does a bank’s T-account summarize? What is the ratio of reserves to deposits called? Who determines how low this ratio may go? Why do banks hold some deposits in reserve?

What Do Banks DO Anyway? : Create Money 1. 2. How does a bank create money? By lending deposits What are T-accounts? Simple tools for analyzing a bank’s financial position. What does a bank T-account summarize? its financial position; (business’s assets and liabilities), with assets on the left and liabilities on the right. 3. 1. What is the ratio of reserves to deposits called? the reserve ratio. 2. Who determines how low this ratio may go? The Federal Reserve 3. Why do banks hold some deposits in reserve? because there is always the small risk of a bank

The Problem of Bank Runs 1. What is a Bank Run? 2. What leads to these bank runs? 3. What happens if everyone goes to the bank to withdraw their deposits at the same time? 4. Why can’t the bank give back all the money being demanded? 5. How did banks runs lead the US Gov’t to act?

The Problem of Bank Runs 1. What is a Bank Run? Depositors: money in the bank = safe & earning $ but when everyone withdraws their money at the SAME time…you have a bank run 2. What leads to these bank runs? Fear and panic about the stability of banks lead to bank runs 3. What happens if everyone goes to the bank to withdraw their deposits at the same time? it creates a bank run, and the bank runs out of money 4. Why can’t the bank give back all the money being demanded? The bank keeps only a small % of the total deposits on reserve, so a bank run can lead to a self-fulfilling prophesy of the bank’s failure. 5. How did banks runs lead the US Gov’t to act? because BRs are very damaging to communities, states & a nation, the US gov’t passed regulatory measures/laws on banks.

Bank Regulations Deposit Insurance/FDIC Capital Requirements Reserve Requirements The Discount Window

Bank Regulations 1. Deposit Insurance/FDIC The US government created the Federal Deposit Insurance Corporation. The FDIC provides deposit insurance, a guarantee that depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. Currently, the FDIC guarantees the first $250, 000 of each account. 3. Reserve Requirements The Federal Reserve establishes the required reserve ratio for banks. This policy insures that the banks will have a certain fraction of all deposits on hand in the event that customers with to withdraw money. In the United States, the required reserve ratio for checkable bank deposits is 10%. 2. Capital Requirements To reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. Bank’s capital = assets - liabilities 4. The Discount Window The Federal Reserve stands ready to lend money to banks via an arrangement known as the discount window. This helps a bank that finds itself in a short-term pinch because many depositors might be withdrawing their cash in a short period of time.

Determining the Money Supply Money supply (M 1) is currency in circulation plus checking deposits. When you make a deposit into your checking account, the bank can make a loan to a borrower and he/she has part of your money in his/her checking account. So by making a loan, the checking deposits have increased, thus increasing

How Banks Create Money Does this process sounds familiar? It should sound a lot like the spending multiplier and the impact that an increase in spending has on the growth of even more spending.

Reserves, Bank Deposits, and the Money Multiplier 1. What happens to some of the loaned funds (referred to as “leaks”) 2. What are excess reserves? 3. What is the formula for excess reserves? 4. What is the monetary base? 5. What is the money multiplier? 6. What is the formula for the money multiplier?

Reserves, Bank Deposits, and the Money Multiplier 1. 2. 3. 4. 5. 6. What happens to some of the loaned funds? (referred to as “leaks”) some loaned funds are kept by borrowers in their wallets & not deposited into another bank so it “leaks” out of the banking system (doesn’t get multiplied) What are excess reserves? A bank’s money reserves over and above what is it required to keep as reserves What is the formula for Excess Reserves? Excess reserves = total reserves – required reserves) What is the monetary base? Currency in circulation + bank reserves What is the money multiplier? Ratio of the money supply to the monetary base; shows the total number of dollars created by the banking system for each dollar added to the monetary base What is the formula for the money multiplier?

Summary Excess Reserves = total reserves – required reserves rr = reserve ratio MM = 1/rr, where rr is the reserve ratio Loan Expansion = Excess Reserves / rr For the multiplication of money: the bank holds 10% of cash in reserve and lend the remaining 90% refers to excess reserves. MM tells us how much money will be created if a bank has $1 of excess reserves.

The Money Multiplier in Reality • Monetary Base • Money Multiplier

FRQ #10 p. 291 Tracy Williams deposits $500 that was in her sock drawer into a checking account at the local bank. A. How does the deposit initially change the t-account at the local bank? How does it change the money supply? B. If the bank maintains a reserve ratio of 10%, how will it respond to the new deposit? C. If every time the bank makes a loan, the loan results in a new check able bank deposit in a different bank equal to the amount of the loan, by how much could the total money supply in the economy expand in response to Tracy’s initial cash deposit of $500? D. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan, and the bank maintains a reserve ratio of 5%, by how much could the money supply expand in response to an initial cash deposit of $500?

Module Review Questions p. 251 -252 Read Module 26 p. 253 - 262