The following worksheet should teach you :

1. How a Cash Deposit at a bank effects:

a. the bank's balance sheet
b. M1 (the money supply) - HINT: there is no effect

2. How Money is Created when a bank grants a loan

a. Know the balance sheet changes when the loan is granted (see below)

b. Know the balance sheet changes when the check is cleared (see below)

3. How much money can be created by the banking system when there is an increase in excess reserves

Print the following to use while going through the worksheet:

• moneycreblank.htm

Banks create money during their normal operations of accepting deposits and making loans. In this example we'll use M1 as our definition of money. (M1 = currency in our pockets and balances in our checking accounts.) When a bank makes a loan it creates money. For example when I got a loan to buy my boat, my credit union called an told me that the loan was approved and that I should come in and get the check. I told them to just deposit it in my checking account. So they did. they turned on their computers, typed in my account number, and added the loan to my checking account balance. I now had more money (M1). The bank created this money when they gave me the loan.

To learn how banks create money during their normal activities of accepting deposits and making loans lets assume that a $10 bill is deposited in the First National Bank (FNB). We will use the balance sheets of banks to see the effects. Our balance sheets will only show the CHANGES made to them. Our study guide has problems where they show actual (but hypothetical) amounts in the bank's T-account.

Major Point: An initial increase in funds available to the banking industry results in a MULTIPLE increase in the money supply.

There is a Three Step Process per Round:

1. An increase in demand deposits or other liabilities of a bank increases the bank’s reserves.
2. Bank can make loans equal to its excess reserves. Loans made by increasing demand deposits.
3. The loan check is spent, deposited in a different bank, and CLEARS. First bank now has no excess reserves, but second does and can therefore make a loan.

Formulas:

Total Reserves = Cash in vault + Deposits at Fed.

Required Reserves = RR x Liabilities

• Liabilities are the Demand Deposits or DD
• RR is the Required Reserve ration set by the Fed
• NOTE: a common error is that students calculate the Required Reserves by: RR x Reserves. DON'T DO THIS!. To calculate the Required Reserves: RR x Liabilities
• total reserves are also called "actual reserves"

Excess Reserves = Total Reserves - Required Reserves

Excess Reserves are used by banks to:

1. make loans
2. pay back depositors when they remove their funds from their accounts (like write a check)

Change in Money Supply = initial Excess Reserves x Money Multiplier

Money Multiplier = 1 / RR

These two formulas are very important!

Given:

Required Reserve Ratio = 20%

FNB = First National Bank
SNB = Second National Bank
TNB = Third National Bank

ER = excess reserves
DD = Demand Deposits (checking account deposits = liabilities)

All banks initially have no excess reserves

Banks make loans equal to their excess reserves

$10 cash is deposited in a checking (DD) account at FNB

Show:

The CHANGES in the balance sheets of each bank as a result of this $10 cash deposit and the increased loan making ability of the banks.

I strongly suggest that you print out a blank copy of the table below, if you haven't already done so, (see: moneycreblank.htm) and fill it in as you go through this lecture. You should actually do the calculations.

Step 1: $10 deposited in FNB

The $10 bill becomes cash in the bank's vault so it becomes part of the bank's reserves. the deposit in the customer's checking account is a liability to the bank. Note that the balance sheet still balances.

Now calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed = 10

Required Reserves = RR x Liabilities = .20 x 10 = 2

Excess Reserves = Total Reserves - Required Reserves = 10 - 2 = 8

 

Step 2: FNB makes loan equal to its excess reserves

We will assume that when the bank makes a loan for $8 (the amount of its excess reserves above) it credits the borrower's checking account. THIS IS NEWLY CREATED MONEY !

Note that the balance sheet still balances: the $8 loan is an asset to the bank and the $8 credited to the borrower's checking account (DD) is an additional liability.

Now calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 10

Required Reserves = RR x Liabilities = .20 x 18 = 3.60

Excess Reserves = Total Reserves - Required Reserves = 10 - 3.60 = 6.40

You may notice that the FNB still has excess reserves BUT Excess Reserves are used by banks to:

1. make loans
2. buy government securities AND
3. pay back depositors when they remove their funds from their accounts (like write a check)

and since the FNB just made a loan it can figure that the borrower will probably spend it, so they better keep some excess reserves available to pay back depositor's when they remove their funds from their accounts (like write a check)

 

Step 3: Loan is spent, deposited in SNB, and the check clears

Sure enough, the borrower did spend the loan by writing a check which was deposited in the SNB.

When the check clears, the FNB sends the SNB $8 of its reserves. So the reserves of the FNB go down by $8 to $2, and the reserves at the SNB go up by $8. Since all banks either directly or indirectly have deposits at the Fed, checks can clear rapidly simply by having the fed transfer the funds ($8 from the account of the FNB to the account of the SNB).

Now calculate the changes in the bank's (FNB) excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 2

Required Reserves = RR x Liabilities = .20 x 10 = 2

Excess Reserves = Total Reserves - Required Reserves = 2 - 2 = 0
(With no more excess reserves, the FNB cannot make any more loans.)

 

Round Two

Step 1: Check from round one deposited in SNB

Now the SNB has $8 more reserves (this was transferred from the FNB to cover the check from a depositor of that bank.) and therefore $6.40 in additional excess reserves. It also has $8 in additional liabilities, when an $8 check from a customer of the FNB is spent and then deposited in the SNB.

To calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 8

Required Reserves = RR x Liabilities = .20 x 8 = 1.60

Excess Reserves = Total Reserves - Required Reserves = 8 - 1.60 = 6.40

Step 2: SNB makes loan equal to its excess reserves

And the process continues . . . . The SNB can now make a loan equal to its new excess reserves ($6.40). This will be NEW MONEY, increasing the Money Supply.

You may notice that the FNB still has excess reserves BUT Excess Reserves are used by banks to:

1. make loans
2. buy government securities AND
3. pay back depositors when they remove their funds from their accounts (like write a check)

and since the FNB just made a loan it can figure that the borrower will probably spend it, so they better keep some excess reserves available to pay back depositor's when they remove their funds from their accounts (like write a check)

 

Step 3: Loan is spent, deposited in TNB, and the check clears

The loan is spent and after covering the check (transferring reserves to the bank where the check was deposited - the TNB) the SNB has no additional excess reserves.,

Round Three

Step 1: Check from round two deposited in TNB

But the TNB now has new excess reserves.

The $ 6.40 loan from the SNB was spent and then deposited in the TNB (DD + $6.40). when the check clears the SNB transfers $ 6.40 from its reserves to the TNB. With these new reserves and new liabilities, the TNB now has $5.12 in new excess reserves.

To calculate the changes in the bank's excess reserves:

Total Reserves = cash in vault + Deposits at Fed. = 6.40

Required Reserves = RR x Liabilities = .20 x 6.40 = 1.28

Excess Reserves = Total Reserves - Required Reserves = 6.40 - 1.28 = 5.12

The TNB can now make a loan equal to $5.12. this would be NEW MONEY.

1. How much money was created in round one? ____$ 8____

2. How much money was created in round two? ____$ 6.40_

3. How much money can be created in round three? ____$ 5.12_

If the process continued with each additional bank making loans equal to its excess reserves, the maximum possible change in the money supply will be:

Total Change in Money Supply = initial excess reserves X money multiplier

4. What is the money multiplier? _____5______

money multiplier = 1/RR - 1/.2 = 5

5. What is the maximum total increase in the money supply that can occur as a result of the initial $10 cash deposit? ____$ 40_____

Change in the MS = ER x money multiplier = $8 x 5 = $40

6. What are the limitations on this money creation process?

The formula above gives us the MAXIMUM possible change in the money supply. The chapter’s discussion of bank credit is in terms of the maximum money-creating potential that would probably not ever be reached due to these modifications introduced at the end of this chapter:

_____1) banks may hold ER _______________________

_____2) people may hold money_________________________

_____3) the required reserve ratio_______________________

To print the completed worksheet: moneycredone.htm