Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides...

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIverSlides prepared by Muni Perumal

10-1

Chapter 10

How banks create money


10-2

Learning objectives• Describe the simplified balance sheets of

a single bank and the banking system• Explain the money-creating abilities of a single bank

that is part of a multibank system• Explain the money-creating abilities of the

banking system as a whole through multiple-deposit expansion, and compare this with the money-creating abilities of the single bank


10-3

Learning objectives (cont.)• Define the monetary (or credit) multiplier• Discuss some of the limitations on the banking

system’s ability to create deposits and expand the money supply

• Describe how the banks’ lending activities may contribute to financial instability and to increased fluctuations in the level of economic activity


10-4

Balance sheet• A statement of assets and claims that summarises

the financial position of a firm at a point in time• Each side balances:

– Assets are items of economic and financial value

– Assets = Liabilities + Net worth


10-5

Formation of a bank• Transaction (1): The birth of a bank

– New owners sell $250 000 worth of shares in the bank

Assets $

Liabilities & Net worth $

Cash 250 000 Capital stock 250 000


10-6

Formation of a bank (cont.)• Transaction (2): Becoming a going concern

– Acquisition of property and equipment

Assets $


Cash 10 000 Property 240 000

Capital stock 250 000


10-7

Formation of a bank (cont.)• Transaction (3): Accepting deposits

– Citizens and businesses deposit $100 000

– Change in composition not total supply of money

Assets $


Cash 110 000 Property 240 000

Deposits 100 000 Capital stock 250 000


10-8

Formation of a bank (cont.)• Required reserve ratio

– The ratio of reserves to deposits to meet official liquidity requirements

• Transaction (4): Setting aside required reserves– Assume reserve ratio is 20%

– Bank must keep $20 000 (required reserves)

Reserve ratio = banks required reservebanks deposit liabilities


10-9

Formation of a bank (cont.)– Bank decides to keep $110 000 (actual reserves),

which is $90 000 more than required (excess reserves)

– Bank’s required reserves are 20% of $100 000

Assets $


Cash 0 Reserves 110 000 Property 240 000



10-10

Formation of a bank (cont.)• Transaction (5): Drawing a cheque

– A citizen who has substantial deposits in the bank draws a cheque for $50 000 to buy goods

– The seller of the goods deposits the cheque in another bank

– The banking system as a whole has not lost or gained


10-11

Formation of a bank (cont.)

Assets $


Reserves 60 000 Property 240 000


Transaction (5): Drawing a cheque (cont.)


10-12

Creating money

• Transaction (6): Granting a loan– A company borrows $50 000 from the bank

– Money is created

– Balance sheet after loan is negotiated:

Assets $


Reserves 60 000 Loans 50 000 Property 240 000



10-13

Creating money (cont.)Balance sheet after cheque drawn on loan has been cancelled:

Now, bank has no excess reserves

Assets $


Reserves 10 000 Loans 50 000 Property 240 000



10-14

Creating money (cont.)• Transaction (7): Buying government bonds

– Bank buys $50 000 of government bonds instead of lending $50 000

– Money is created

Assets $


Reserves 60 000 Bonds 50 000 Property 240 000



10-15

The banking system• Multiple banks: multiple-deposit expansion• Money is created by a multiple of the banking

system’s excess reserves


10-16

Multiple-deposit expansion

• Assume initially: 20% reserve requirement • Bank A

– Accepts a deposit for $100 Does not alter money supply Excess reserves of $80

– A loan of $80 is negotiated


10-17

Multiple-deposit expansion (cont.)• Balance sheet: Bank A

Assets $


Reserves +100 –80 Loans +80

Current deposits +100 +80 –80


10-18

Multiple-deposit expansion (cont.)• Loan cheque of $80 is drawn on Bank A

and deposited in Bank B• Bank B

– Gains $80 in reserves and deposits

– Excess reserves of $64

– Loans $64


10-19

Multiple-deposit expansion (cont.)• Bank B

• Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on …

Assets $


Reserves –80 –64 Loans +80

Current deposits +80 +64 –64


10-20

Multiple deposit expansion process

BankAcquired reserves

and depositsRequiredreserves

Excessreserves

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57

ABCDEFGHIJKLMNOther banks

$100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97

$20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40

$80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57

$400.00$400.00Total amount of money created by the banking system

New moneycreated


10-21

Multiple-deposit expansion (cont.)• Total banking system has created $400• How?

– Via the monetary multiplier

– Where m is the monetary multiplier

1

R

1

reserve ratiomonetary multiplier =

m =


10-22

Multiple-deposit contraction

• The multiple credit expansion process is reversible and leads to a multiple reduction in the level of deposits — and hence the supply of money — if reserves are withdrawn


10-23

Current Australian system• The reserve ratio is based on the level

of prime assets that are to be held by banks against their liabilities

• Indicated in the prime asset ratio (PAR)• Currently, the PAR is not set at a specific level• Arrived by a process of negotiation between

APRA and each bank


10-24

Possible leakages• Currency drains

– Loan may be paid in cash and remain in circulation

• Transfer of deposits to non-bank financial institutions• Excess reserves

– Individual banks may choose to have larger reserves than required (say 25% instead of 20%)


10-25

Willingness to borrow• For the full multiplier effect to take place:

– Borrowers must be willing and able to utilise the loans

– Borrowing is likely to be low during a recession


10-26

Banks and financial instability• Banks may contribute to business fluctuations• Can exacerbate recession, by holding back

on credit expansion• May amplify inflationary pressures, by increasing

lending and credit creation, during recovery and business cycle peaks

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides...

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