Chapter 13 - The money creation process

Overview:    New money is created in the U.S. economy when commercial banks and thrifts make loans. It matters not whether the borrower takes the loan in cash or as a new checkable deposit.  However, most loans are taken as deposits, and we will see later that loans taken in cash diminish the multiplier effect.  So, for purposes of discussion, we will assume that all loans result in new checkable deposits                                                       

Recall that the primary responsibility of the Federal Reserve (Fed) is to control the growth of the U.S. money supply.  In order to do this, the Fed must find a way to control the banking system's legal ability to make loans.  The Fed attempts to control the loan making ability of the banking system by controlling reserves in the banking system.  Therefore, the secret to understanding the money creation system is to understand bank reserves.

                            Reserves  =  Vault cash  +  Reserves on deposit at Fed

            Required Reserves  =  Reserve Ratio  x  Checkable Deposits

                Excess Reserves  =  Reserves  -  Required Reserves

Because a bank cannot go below its required reserve level in order to make a loan, the bank's potential for making loans and creating new money is defined by its excess reserves.   However, the banking system (all depository institutions) has the potential for creating new money in multiples of the excess reserves in the banking system.   This money multiplier is calculated as the reciprocal of the reserve ratio.

This multiplied growth in new deposits (new electronic money) results from the fact that when one bank makes a loan and creates a checkable deposit, new money is created. But when a check is drawn on that account and paid, that bank loses those reserves.  But, those reserves are not lost to the banking system.  They simply move from one bank to another.

We are careful to say "potential" because there are leakages from this multiplied money creation process:

    1.    Currency drains (cash leakages) -  Some part of the loans made by the banking system will be taken as cash rather than new checkable deposits.  To the extent that this cash remains in circulation, the lending potential of the banking system will be diminished.

    2.    Excess reserves - We assume that, since excess reserves earn nothing for banks, that they will make every effort to make every loan they can. But, in fact, banks may hold some excess reserves and this will reduce the overall credit expansion potential of the banking system.

  Chapter 13  – Practice problems

1.       If First National Bank has Reserves of $40,000. Excess Reserves of $10,000. and Checkable Deposits of $240,000,  The Reserve Ratio must be ______%.

  2.       If the Banking System has Checkable Deposits of $100,000, Reserves of $35,000, and the Reserve Ratio is 20%, the Banking System’s potential for expanding the money supply is  $____________.

  3.          Second National Bank has Checkable Deposits of $40,000. and Excess Reserves of $4,000.  If the Reserve Ratio is 10%, this bank holds Reserves of  $ _________.

4.       The Banking System has Excess Reserves of $4 Million and Checkable Deposits of $800 Million.  If the Reserve Ratio is 10%, the Banking System holds Reserves of $ _________.

  5.       Fifth National Bank has $50 Million in Reserves and $30 Million in Excess Reserves.  If the Reserve Ratio is 20%, this bank has checkable deposit liabilities equal to $ _______.

  6.       Sam Smith deposits $40,000. in his checking account at First Federal Savings and Loan.  If the Reserve Ratio is .25, the Banking System’s potential for creating new electronic money increases by $ __________ as a result of this transaction.

  7.          Assume the Acme Widget Company deposits $100,000. in cash in Bank A.  If no Excess Reserves exist at the time of this deposit and the Reserve Ratio is 10%, Bank A has the potential to increase the money supply by  $ _________.