The Fractional Reserve System 13 The process by

The Fractional Reserve System 13 “The process by which banks create money is so simple that the mind is repelled. ” John Kenneth Galbraith My favorite economist Money Creation Monetary Multiplier Last Word Key Terms Money Creation End Show 13 -1 Copyright 2008 The Mc. Graw-Hill Companies

Chapter Objectives • Why the U. S. Banking System is Called a “Fractional Reserve” System • Distinction Between a Bank’s Actual Reserves and Its Required Reserves • How a Bank Can Create Money Through Granting Loans • The Multiple Expansion of Loans and Money by the Entire Banking System • The Monetary Multiplier and How to Calculate it

Creating Money Fractional Reserve Banking System – Only part (a fraction) of checkable deposits are backed up by cash in bank vaults or in bank’s accounts at the Fed. – Size of the “fraction” held in reserves is regulated by Fed. • Characteristics of a Fractional Reserve System – Banks Create Money Through Lending – Fractional Reserve Banks are Subject to “Panics” or “Runs”

Creating Money How banks create money (increase money supply) § Banks are required to keep a certain percentage of checking account balances on hand in their vault or in their account at the Federal Reserve Bank. § The reserve requirement is a percentage established by the Federal Reserve.

Creating Money How banks create money (increase money supply) § For example, if the reserve requirement is 10%, and Wachovia Bank has $10 million deposited into checking accounts at their banks, Wachovia must always have at least $1 million ($10 million x 10%) on hand in vault cash or in their cash account at the Fed. § Banks can then make loans to consumers and businesses with the other 90% of their checking deposits, thereby creating money in the money supply.

Creating Money Excess Reserves = Loanable Funds Actual Reserves What banks have in vaults and accounts at Fed. - - Required Reserves = What banks are required = to have in vaults and Fed accounts. Excess Reserves Amount that banks can loan out.

How banks create money (increase money supply) Assume a 10% reserve requirement, banks loan all excess reserves (“loaned up”), and borrowers deposit entire amount back into a bank (no leakages). Injection into the money supply by the Federal Reserve Bank (we’ll discuss this in Ch 14). Final impact on money supply New Deposits Required Reserves (10%) Loanable Funds $ 100, 000 $ 10, 000 $ 90, 000 9, 000 81, 000 8, 100 72, 900 7, 290 65, 610 6, 561 59, 049 5, 905 53, 145 $1, 000 $100, 000 $900, 000

How banks create money (increase money supply) With fractional reserve banking, the initial injection into the banking system has a multiplier effect on the money supply. Amount of the impact depends on the reserve requirement. Money (deposit) multiplier = reciprocal of reserve requirement If reserve requirement is 10%, money multiplier = 1/. 10 = 10. Deposit of $100, 000 can impact the money supply by 10 x $100, 000 = $1 million. In order to increase the impact a deposit would have on the money supply, would we raise or lower the reserve requirement? If reserve requirement is 5%, money multiplier = 1/. 05 = 20. Deposit of $100, 000 can impact the money supply by 20 x $100, 000 = $2 million.

The Monetary Multiplier or Checkable. Deposit Multiplier Monetary Multiplier = m = Graphic Example 1 Required Reserve Ratio (20%) 1 R =5 New Reserves $100 $80 Excess Reserves $400 Bank System Lending Money Created $20 Required Reserves $100 Initial Deposit

The Monetary Multiplier • Reversibility – Making Loans Creates Money – Loan Repayment Destroys Money

Bank Panics of 1930 -1933 • Series of Bank Panics • Before Deposit Insurance (FDIC) • Mass Withdrawals From Fear Las Wo t rd – More than 9, 000 banks failed in one year • Move to Cash Reduced Money Supply Through Reduction in Loans (money destruction) • Multiple Contraction Slowed Lending and the Economy • 1933 National Bank Holiday for One Week • Resulted in FDIC and 25% Drop in Money Supply • Contributed to the Great Depression • Regulation Protects the System Today (your author said this, not me!)

Key Terms • fractional reserve banking system • vault cash • required reserves • reserve ratio • excess reserves • actual reserves • monetary multiplier