1.2 Module 34: Banking and Money Creation

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The Monetary Role of Banks

A little less than half of M1, the narrowest definition of the money supply, consists of currency in circulation—$1 bills, $5 bills, and so on. It’s obvious where currency comes from: it’s printed by the U.S. Treasury. But the rest of M1 consists of bank deposits, and deposits account for the great bulk of M2, the broader definition of the money supply. By either measure, then, bank deposits are a major component of the money supply. And this fact brings us to our next topic: the monetary role of banks.

What Banks Do

A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers. Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets. Except in the case of a bank run—which we’ll get to shortly—all of a bank’s depositors won’t want to withdraw their funds at the same time. So a bank can provide its depositors with liquid assets yet still invest much of the depositors’ funds in illiquid assets, such as mortgages and business loans.

Banks can’t, however, lend out all the funds placed in their hands by depositors because they have to satisfy any depositor who wants to withdraw his or her funds. In order to meet these demands, a bank must keep substantial quantities of liquid assets on hand. In the modern U.S. banking system, these assets take the form either of currency in the bank’s vault or deposits held in the bank’s own account at the Federal Reserve. The latter can be converted into currency more or less instantly. Currency in bank vaults and bank deposits held at the Federal Reserve are called bank reserves. Because bank reserves are in bank vaults and at the Federal Reserve, not held by the public, they are not part of currency in circulation.

To understand the role of banks in determining the money supply, we start by introducing a simple tool for analyzing a bank’s financial position: a T-account. A business’s T-account summarizes its financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right.

Figure 34-1 shows the T-account for a hypothetical business that isn’t a bank—Samantha’s Smoothies. According to Figure 34-1, Samantha’s Smoothies owns a building worth $30,000 and has $15,000 worth of smoothie-making equipment. These are assets, so they’re on the left side of the table. To finance its opening, the business borrowed $20,000 from a local bank. That’s a liability, so the loan is on the right side of the table. By looking at the T-account, you can immediately see what Samantha’s Smoothies owns and what it owes. Oh, and it’s called a T-account because the lines in the table make a T-shape.

A T-account summarizes a business’s financial position. Its assets, in this case consisting of a building and some smoothie-making machinery, are on the left side. Its liabilities, consisting of the money it owes to a local bank, are on the right side.

Samantha’s Smoothies is an ordinary, nonbank business. Now let’s look at the T-account for a hypothetical bank, First Street Bank, which is the repository of $1 million in bank deposits.

Figure 34-2 shows First Street Bank’s financial position. The loans First Street Bank has made are on the left side because they’re assets: they represent funds that those who have borrowed from the bank are expected to repay. The bank’s only other assets, in this simplified example, are its reserves, which, as we’ve learned, can take the form either of cash in the bank’s vault or deposits at the Federal Reserve. On the right side we show the bank’s liabilities, which in this example consist entirely of deposits made by customers at First Street Bank. These are liabilities because they represent funds that must ultimately be repaid to depositors.

First Street Bank’s assets consist of $1,000,000 in loans and $100,000 in reserves. Its liabilities consist of $1,000,000 in deposits—money owed to people who have placed funds in First Street’s hands.

Notice, by the way, that in this example First Street Bank’s assets are larger than its liabilities. That’s the way it’s supposed to be! In fact, as we’ll see shortly, banks are required by law to maintain assets larger by a specific percentage than their liabilities.

In this example, First Street Bank holds reserves equal to 10% of its customers’ bank deposits. The fraction of bank deposits that a bank holds as reserves is its reserve ratio.

In the modern American system, the Federal Reserve—which, among other things, regulates banks operating in the United States—sets a required reserve ratio, which is the smallest fraction of bank deposits that a bank must hold. To understand why banks are regulated, let’s consider a problem banks can face: bank runs.

The Problem of Bank Runs

A bank can lend out most of the funds deposited in its care because in normal times only a small fraction of its depositors want to withdraw their funds on any given day. But what would happen if, for some reason, all or at least a large fraction of its depositors did try to withdraw their funds during a short period of time, such as a couple of days?

If a significant share of its depositors demanded their money back at the same time, the bank wouldn’t be able to raise enough cash to meet those demands. The reason is that banks convert most of their depositors’ funds into loans made to borrowers; that’s how banks earn revenue—by charging interest on loans.

Bank loans, however, are illiquid: they can’t easily be converted into cash on short notice. To see why, imagine that First Street Bank has lent $100,000 to Drive-a-Peach Used Cars, a local dealership. To raise cash to meet demands for withdrawals, First Street Bank can sell its loan to Drive-a-Peach to someone else—another bank or an individual investor. But if First Street Bank tries to sell the loan quickly, potential buyers will be wary: they will suspect that First Street Bank wants to sell the loan because there is something wrong and the loan might not be repaid. As a result, First Street Bank can sell the loan quickly only by offering it for sale at a deep discount—say, a discount of 50%, or $50,000.

The upshot is that if a significant number of First Street Bank’s depositors suddenly decided to withdraw their funds, the bank’s efforts to raise the necessary cash quickly would force it to sell off its assets very cheaply. Inevitably, this leads to a bank failure: the bank would be unable to pay off its depositors in full.

What might start this whole process? That is, what might lead First Street Bank’s depositors to rush to pull their money out? A plausible answer is a spreading rumor that the bank is in financial trouble. Even if depositors aren’t sure the rumor is true, they are likely to play it safe and get their money out while they still can. And it gets worse: a depositor who simply thinks that other depositors are going to panic and try to get their money out will realize that this could “break the bank.” So he or she joins the rush. In other words, fear about a bank’s financial condition can be a self-fulfilling prophecy: depositors who believe that other depositors will rush to the exit will rush to the exit themselves.

A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Bank runs aren’t bad only for the bank in question and its depositors. Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs. The upcoming Economics in Action describes an actual case of just such a contagion, the wave of bank runs that swept across the United States in the early 1930s. In response to that experience and similar experiences in other countries, most modern governments established a system of bank regulations, which we’ll look at next.

!world_eia!IT’S A WONDERFUL BANKING SYSTEM

Next Christmastime, it’s a sure thing that at least one TV channel will show the 1946 film It’s a Wonderful Life, featuring Jimmy Stewart as George Bailey. The movie’s climactic scene is a run on Bailey’s bank, as fearful depositors rush to take their funds out.

When the movie was made, such scenes were still fresh in Americans’ memories. There was a wave of bank runs in late 1930, a second wave in the spring of 1931, and a third wave in early 1933. By the end, more than a third of the nation’s banks had failed. To bring the panic to an end, in 1933, the newly inaugurated president, Franklin Delano Roosevelt, closed all banks for a week to give bank regulators time to shut down unhealthy banks and certify healthy ones.

Panicky IndyMac depositors lined up to pull their money out of the troubled California bank in 2008.

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Since then, regulation has protected the United States and other wealthy countries against most bank runs. In fact, the scene in It’s a Wonderful Life was already out of date when the movie was made. But the last 15 years have seen several waves of bank runs in developing countries. For example, bank runs played a role in an economic crisis that swept Southeast Asia in 1997–1998 and in the severe economic crisis in Argentina, which began in late 2001.

Notice that we said “most bank runs.” There are some limits on deposit insurance. As a result, there can still be a rush to pull money out of a bank perceived as troubled. In fact, that’s exactly what happened to IndyMac, a California-based lender that had made a large number of questionable home loans. In 2008, as questions about Indy-Mac’s financial soundness were raised, depositors began pulling out funds, forcing federal regulators to step in and close the bank. Unlike in the bank runs of the 1930s, however, most depositors got all their funds back—and the panic at IndyMac did not spread to other institutions.

Bank Regulation

Should you worry about losing money in the United States due to a bank run? No. After the banking crises of the 1930s, the United States and most other countries put into place a system designed to protect depositors and the economy as a whole against bank runs. This system has three main features: deposit insurance, capital requirements, and reserve requirements. In addition, banks have access to the discount window, a source of cash when it’s needed.

The FDIC guarantees that bank deposits up to a certain amount will be paid even if a bank runs short or fails.

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1. Deposit InsuranceAlmost all banks in the United States advertise themselves as a “member of the FDIC”—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 per depositer, per insured bank.

Deposit insurance doesn’t just protect depositors if a bank actually fails. The insurance also eliminates the main reason for bank runs: since depositors know their funds are safe even if a bank fails, they have no incentive to rush to pull them out because of a rumor that the bank is in trouble.

2. Capital RequirementsDeposit insurance, although it protects the banking system against bank runs, creates a well-known incentive problem. Because depositors are protected from loss, they have no incentive to monitor their bank’s financial health, allowing risky behavior by the bank to go undetected. At the same time, the owners of banks have an incentive to engage in overly risky investment behavior, such as making questionable loans at high interest rates. That’s because if all goes well, the owners profit; and if things go badly, the government covers the losses through federal deposit insurance.

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. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. The excess of a bank’s assets over its bank deposits and other liabilities is called the bank’s capital. For example, First Street Bank has capital of $100,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets.

3. Reserve RequirementsAnother regulation used to reduce the risk of bank runs is reserve requirements, rules set by the Federal Reserve that specify the minimum reserve ratio for banks. For example, in the United States, the required reserve ratio for checkable bank deposits is 10%.

4. The Discount WindowOne final protection against bank runs is the fact that the Federal Reserve, which we’ll discuss more thoroughly later, stands ready to lend money to banks in trouble, an arrangement known as the discount window. The ability to borrow money means a bank can avoid being forced to sell its assets at fire-sale prices in order to satisfy the demands of a sudden rush of depositors demanding cash. Instead, it can turn to the Federal Reserve and borrow the funds it needs to pay off depositors.

Determining the Money Supply

Without banks, there would be no checkable deposits, and so the quantity of currency in circulation would equal the money supply. In that case, the money supply would be determined solely by whoever controls government minting and printing presses.

But banks do exist, and through their creation of checkable bank deposits, they affect the money supply in two ways.

1. Banks remove some currency from circulation: dollar bills that are sitting in bank vaults, as opposed to sitting in people’s wallets, aren’t part of the money supply.
2. Much more importantly, banks create money by accepting deposits and making loans—that is, they make the money supply larger than just the value of currency in circulation.

Next we cover how banks create money and what determines the amount of money they create.

How Banks Create Money

Money creation begins when cash is deposited into a checkable bank account.

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To see how banks create money, let’s examine what happens when someone decides to deposit currency in a bank. Consider the example of Silas, a miser, who keeps a shoebox full of cash under his bed. Suppose Silas realizes that it would be safer, as well as more convenient, to deposit that cash in the bank and to use his debit card when shopping. Assume that he deposits $1,000 into a checkable account at First Street Bank. What effect will Silas’s actions have on the money supply?

Panel (a) of Figure 34-3 shows the initial effect of his deposit. First Street Bank credits Silas with $1,000 in his account, so the economy’s checkable bank deposits rise by $1,000. Meanwhile, Silas’s cash goes into the vault, raising First Street Bank’s reserves by $1,000 as well.

When Silas deposits $1,000 (which had been stashed under his bed) into a checkable bank account, there is initially no effect on the money supply: currency in circulation falls by $1,000, but checkable bank deposits rise by $1,000. The corresponding entries on the bank’s T-account, depicted in panel (a), show deposits initially rising by $1,000 and the bank’s reserves initially rising by $1,000. In the second stage, depicted in panel (b), the bank holds 10% of Silas’s deposit ($100) as reserves and lends out the rest ($900) to Mary. As a result, its reserves fall by $900 and its loans increase by $900. Its liabilities, including Silas’s $1,000 deposit, are unchanged. The money supply, the sum of checkable bank deposits and currency in circulation, has now increased by $900—the $900 now held by Mary.

This initial transaction has no effect on the money supply. Currency in circulation, part of the money supply, falls by $1,000; checkable bank deposits, also part of the money supply, rise by the same amount.

But this is not the end of the story because First Street Bank can now lend out part of Silas’s deposit. Assume that it holds 10% of Silas’s deposit—$100—in reserves and lends the rest out in cash to Silas’s neighbor, Mary. The effect of this second stage is shown in panel (b). First Street Bank’s deposits remain unchanged, and so does the value of its assets. But the composition of its assets changes: by making the loan, it reduces its reserves by $900, so that they are only $100 larger than they were before Silas made his deposit. In the place of the $900 reduction in reserves, the bank has acquired an IOU, its $900 cash loan to Mary.

The money supply increases when banks lend out a portion of their cash deposits.

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So by putting $900 of Silas’s cash back into circulation by lending it to Mary, First Street Bank has, in fact, increased the money supply. That is, the sum of currency in circulation and checkable bank deposits has risen by $900 compared to what it had been when Silas’s cash was still under his bed. Although Silas is still the owner of $1,000, now in the form of a checkable deposit, Mary has the use of $900 in cash from her borrowings.

And this may not be the end of the story. Suppose that Mary uses her cash to buy a television and a tablet from Acme Electronics. What does Anne Acme, the store’s owner, do with the cash? If she holds on to it, the money supply doesn’t increase any further. But suppose she deposits the $900 into a checkable bank deposit—say, at Second Street Bank. Second Street Bank, in turn, will keep only part of that deposit in reserves, lending out the rest, creating still more money.

Assume that Second Street Bank, like First Street Bank, keeps 10% of any bank deposit in reserves and lends out the rest. Then it will keep $90 in reserves and lend out $810 of Anne’s deposit to another borrower, further increasing the money supply.

Table 34-1 shows the process of money creation we have described so far. At first the money supply consists only of Silas’s $1,000. After he deposits the cash into a checkable bank deposit and the bank makes a loan, the money supply rises to $1,900. After the second deposit and the second loan, the money supply rises to $2,710. And the process will, of course, continue from there. (Although we have considered the case in which Silas places his cash in a checkable bank deposit, the results would be the same if he put it into any type of near-money.)

This process of money creation may sound familiar. Recall the multiplier process that we described earlier: an initial increase in real GDP leads to a rise in consumer spending, which leads to a further rise in real GDP, which leads to a further rise in consumer spending, and so on. What we have here is another kind of multiplier—the money multiplier. Next, we’ll learn what determines the size of this multiplier.

Reserves, Bank Deposits, and the Money Multiplier

In tracing out the effect of Silas’s deposit in Table 34-1, we assumed that the funds a bank lends out always end up being deposited either in the same bank or in another bank—so funds disbursed as loans come back to the banking system, even if not to the lending bank itself.

In reality, some of these loaned funds may be held by borrowers in their wallets and not deposited in a bank, meaning that some of the loaned amount “leaks” out of the banking system. Such leaks reduce the size of the money multiplier, just as leaks of real income into savings reduce the size of the real GDP multiplier. (Bear in mind, however, that the “leak” here comes from the fact that borrowers keep some of their funds in currency, rather than the fact that consumers save some of their income.)

But let’s set that complication aside for a moment and consider how the money supply is determined in a “checkable-deposits-only” monetary system, where funds are always deposited in bank accounts and none are held in wallets as currency. That is, in our checkable-deposits-only monetary system, any and all funds borrowed from a bank are immediately deposited into a checkable bank account. We’ll assume that banks are required to satisfy a minimum reserve ratio of 10% and that every bank lends out all of its excess reserves, reserves over and above the amount needed to satisfy the minimum reserve ratio.

Now suppose that for some reason a bank suddenly finds itself with $1,000 in excess reserves. What happens? The answer is that the bank will lend out that $1,000, which will end up as a checkable bank deposit somewhere in the banking system, launching a money multiplier process very similar to the process shown in Table 34-1.

In the first stage, the bank lends out its excess reserves of $1,000, which becomes a checkable bank deposit somewhere. The bank that receives the $1,000 deposit keeps 10%, or $100, as reserves and lends out the remaining 90%, or $900, which again becomes a checkable bank deposit somewhere. The bank receiving this $900 deposit again keeps 10%, which is $90, as reserves and lends out the remaining $810. The bank receiving this $810 keeps $81 in reserves and lends out the remaining $729, and so on.

As a result of this process, the total increase in checkable bank deposits is equal to a sum that looks like:

We’ll use the symbol rr for the reserve ratio. More generally, the total increase in checkable bank deposits that is generated when a bank lends out $1,000 in excess reserves is the:

As we have seen, an infinite series of this form can be simplified to:

Given a reserve ratio of 10%, or 0.1, a $1,000 increase in excess reserves will increase the total value of checkable bank deposits by $1,000/0.1 = $10,000. In fact, in a checkable-deposits-only monetary system, the total value of checkable bank deposits will be equal to the value of bank reserves divided by the reserve ratio. Or to put it a different way, if the reserve ratio is 10%, each $1 of reserves held by a bank supports $1/rr = $1/0.1 = $10 of checkable bank deposits.

The Money Multiplier in Reality

In reality, the determination of the money supply is more complicated than our simple model suggests because it depends not only on the ratio of reserves to bank deposits but also on the fraction of the money supply that individuals choose to hold in the form of currency. In fact, we already saw this in our example of Silas depositing the cash under his bed: when he chose to hold a checkable bank deposit instead of currency, he set in motion an increase in the money supply.

To define the money multiplier in practice, it’s important to recognize that the Federal Reserve controls the sum of bank reserves and currency in circulation, called the monetary base, but it does not control the allocation of that sum between bank reserves and currency in circulation. Consider Silas and his deposit one more time: by taking the cash from under his bed and depositing it in a bank, he reduces the quantity of currency in circulation but increases bank reserves by an equal amount—leaving the monetary base, on net, unchanged. The monetary base, which is the quantity the monetary authorities control, is the sum of currency in circulation and reserves held by banks.

The monetary base is different from the money supply in two ways.

1. Bank reserves, which are part of the monetary base, aren’t considered part of the money supply. A $1 bill in someone’s wallet is considered money because it’s available for an individual to spend, but a $1 bill held as bank reserves in a bank vault or deposited at the Federal Reserve isn’t considered part of the money supply because it’s not available for spending.
2. Checkable bank deposits, which are part of the money supply because they are available for spending, aren’t part of the monetary base.

Figure 34-4 shows the two concepts schematically. The circle on the left represents the monetary base, consisting of bank reserves plus currency in circulation. The circle on the right represents the money supply, consisting mainly of currency in circulation plus checkable or near-checkable bank deposits. As the figure indicates, currency in circulation is part of both the monetary base and the money supply. But bank reserves aren’t part of the money supply, and checkable or near-checkable bank deposits aren’t part of the monetary base. In normal times, most of the monetary base actually consists of currency in circulation, which also makes up about half of the money supply.

The monetary base is equal to bank reserves plus currency in circulation. It is different from the money supply, consisting mainly of checkable or near-checkable bank deposits plus currency in circulation. Each dollar of bank reserves backs several dollars of bank deposits, making the money supply larger than the monetary base.

Now we can formally define the money multiplier: it’s the ratio of the money supply to the monetary base. In normal times the money multiplier in the United States, using M1 as our measure of money, has fluctuated between 3.0 and 1.5. During the recession of 2007–2009, it fell to about 0.7. Even in normal times, that’s a lot smaller than 1/0.1 = 10, the money multiplier in a checkable-deposits-only system with a reserve ratio of 10% (the minimum required ratio for most checkable deposits in the United States).

The reason the actual money multiplier is so small arises from the fact that people hold significant amounts of cash, and a dollar of currency in circulation, unlike a dollar in reserves, doesn’t support multiple dollars of the money supply. In fact, currency in circulation normally accounts for more than 90% of the monetary base. However, in April 2013, currency in circulation was $1,107 billion, compared with a monetary base of $3,061 billion—just about 36%. What had happened?

Notice that earlier we said “in normal times.” As we’ll see in upcoming modules, a very abnormal situation developed after Lehman Brothers, a key financial institution, failed in September 2008. Banks, seeing few opportunities for safe, profitable lending, began parking large sums at the Federal Reserve in the form of deposits—deposits that counted as part of the monetary base. As a result, currency in circulation in April 2013 made up only 36% of the monetary base, and the monetary base was actually larger than M1, with the money multiplier therefore less than 1.

Module 34 Review

Check Your Understanding

Assume that the required reserve ratio is 5% to answer the following.