Banks and Money Creation

What happens to the money you deposit in the bank?• Financial Intermediaries• Act as the go-between for borrowers and

lenders• Take deposits from households and

business and make loans to other households and businesses• commercial banks• Savings and loans associations• Savings banks• Credit unions• Money market mutual fund companies

The role of financial intermediaries

• Remember the three basic problems?• Financial intermediaries dress these

problems by• creating liquidity•Minimizing the cost of borrowing•Risk reduction

The Fractional Reserve System• Banks must hold a required percentage

of the deposits as reserves.• This percentage is called the required

reserve ratio.• Any part of the deposit that banks hold

above the required reserve is called excess reserves.

• The bank may lend excess reserves or use them to buy government securities.

• The bank makes a loan by creating a checkable deposit for the borrower, which results in an increase in the money supply.

Money Creation$100

$10 $ 90

$9 $81 $8.10 $72.90

Does this look familiar?

The Money Multiplier

• When banks lend out a portion of the deposit, it creates an increase in the money supply in the same way that the spending multiplier works with the MPC.

• The amount of money banks lend out depends on the reserve ratio.

• Deposit expansion multiplier = 1/ rr

• The total increase in the money supply may be less than predicted by the multiplier if:•Borrowers do not spend all the money they borrow•Banks do not lend out all their excess reserves•People hold part of their money as cash

The Money Multiplier

• Different required reserves ratios will have different effects on the multiplier process.

• With a reserve ration of 1, all money deposited would be required reserves, so the money expansion would not happen.

• We have a fractional reserve system in the U.S. , therefore the banking system can create money because the reserve ratio is not 1.

The Money Multiplier

• To find the TOTAL amount of money created:

• Expansion of the money supply = excess reserves (multiplier)

Be sure to read any multiplier questions to determine exactly which value the question want you to find: the initial change or the final change.

The Money Multiplier

Activity 4-3