CHAPTER 32 Money Creation

Transcription

1 CHAPTER 32 Money Creation A. Short-Answer, Essays, and Problems 1. What is the history behind the idea of a fractional reserve banking system? Early traders used gold in making transactions. They realized that it was inconvenient and not safe to move gold for every transaction. So they deposited their gold with a goldsmith. The goldsmiths had safes for gold and precious metals, which they often kept for consumers and merchants. They issued receipts for these deposits. Receipts came to be used as money in place of gold because of their convenience. The goldsmiths became aware that the stored gold was never fully redeemed. The goldsmiths realized they could loan gold by issuing paper receipts to borrowers, who agreed to pay back gold plus interest. Such loans originated fractional reserve banking, because the actual gold in the vaults became only a fraction of the receipts held by borrowers and owners of gold. 2. What are the two significant characteristics of the fractional reserve banking system? The two significant characteristics are: (1) banks can create money by lending more than the original reserves on hand. The smaller the amount of reserves viewed as necessary, the larger the amount of money that could be created. (2) The lending policies of fractional reserve banks must be prudent to prevent bank panics or runs by depositors worried about their funds on deposit at the institutions. The reserves must be able to cover the bank runs. 3. Describe bank runs. How can bank runs be avoided? A bank run is a situation where large numbers of depositors run to their banks to withdraw their money. These panic runs are often fueled by rumors that banks are about to go bankrupt. Bank runs are highly unlikely if the banker s reserves and lending policies are prudent. Another way to avoid bank panics is by having an insurance system, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, which insures checkable deposits up to a certain limit in the event that a bank goes bankrupt. 4. Why are financial institutions required to keep reserves? Reserves are required to constrain the amount of bank lending (money creation) that can occur. Without required reserves, theoretically banks would have unlimited power to lend and thereby, expand the money supply without any limit. 5. Explain what is meant by fractional reserve banking. Fractional reserve banking is the system that exists in the United States whereby financial institutions are required to keep only a fraction of their customer checkable deposits in reserve. They may lend out or invest the remainder in qualified securities. This system allows banks to create money through the loans that they make. 6. Describe the basic features of a commercial bank s balance sheet. On the left side of the balance sheet of a commercial bank is a statement of the bank s assets. On the right side of the balance sheet are the claims of the owners of the bank, called net worth, and claims of the nonowners, called liabilities. This relationship would be written in equation form as: assets = liabilities + net worth.

2 Chapter What are the major assets and the major claims (liabilities) on a commercial bank s balance sheet? Major assets include reserves, loans, and government securities. Major claims are customer checkable deposits. In Chapter 32, the only major assets mentioned were reserves and loans. 8. What is the relationship between bank assets, liabilities and net worth? must equal the total of the bank s liabilities and net worth. These must balance so that the claims of owners (net worth) and nonowners (liabilities) on the bank s assets are balanced by the assets they hold. 9. What happens to the money supply when a bank accepts deposits of currency from the public and places it in checkable deposits (or checking accounts)? The composition of the money supply changes, but there has been no change in the economy s total supply of money. In this case, bank money or checkable deposits have increased and currency held by the public has decreased by an equal amount. 10. The main purpose of required reserves is to promote bank liquidity and protect depositors. Evaluate this statement. This statement is incorrect. The amount of reserves held by banks represents only a fraction of their liabilities. These reserves would be little assistance for banks in the case of a run on the bank. Rather, required reserves allow the Federal Reserve to control the lending ability of commercial banks. Required reserves are also useful for clearing checks. [text: E p. 658; MA p. 302] 11. Arrange the following items in the form of a commercial bank s balance sheet, and explain how each might come into being. Stock shares, $300,000; Reserves, $60,000; Property, $290,000; Checkable deposits, $150,000; Securities, $40,000; Loans, $60,000 Reserves $ 60,000 Loans 60,000 Securities 40,000 Property 290,000 Checkable deposits $150,000 Stock shares 300,000 (a) Reserves could come from deposits or cash capital of owners. (b) Loans represent what the bank has temporarily given to borrowers who must repay the money at a later date. (c) Securities represent government notes which the bank has purchased and which can be redeemed for money. (d) Property represents the real and personal property owned by the bank such as the building, equipment, and so forth. (e) Checkable deposits are customers checkable deposits. (f) Stock shares are the value of the owners equity. 12. Use the following bank transactions to develop the bank s balance sheet. To start the bank, owners issue $500,000 in stock to shareholders. Next, they purchase $200,000 worth of equipment and office space to establish the physical location of the bank. Finally, they open the bank and receive $750,000 in checkable deposits. With these reserves, they make $600,000 worth of loans. Reserves $450,000 Property 200,000 Checkable deposits $750,000 Stock shares 500,000

3 Money Creation 13. Define the reserve ratio. The required reserve ratio is the fraction or percentage of reserves which must be held against deposits by financial institutions regulated by the Federal Reserve Board of Governors. 14. How does the reserve requirement change for banks and thrifts as the size of the bank changes? The reserve ratio becomes greater. In 2009, banks with less than 10 million dollars in checkable deposits kept no required reserves at the Fed. Banks with about $10 to $55 million in checkable deposits had to keep 3 percent of them as required reserves at the Fed. Banks with over $55 million had to keep 10 percent of their checkable deposits as required reserves held by the Fed. Clearly, as the size of a bank increases based on the amount of checkable deposits, the amount of required reserves will increase at some set amount. 15. Does the Fed pay interest on required reserves and excess reserve balances held at the Federal Reserve bank? Yes, the Fed pays interest on required reserves and excess reserve balances held at the Federal Reserve bank. This change is a recent one and was made in late Why are reserves listed in the assets column of a bank s balance sheet? Reserves are a claim on the Federal Reserves assets, since the Federal Reserve is the bank that holds the funds. This works much like checkable deposits for depositors at a bank, which are a claim against the bank s assets. In the way that checkable deposits are an asset for the depositor, reserves are an asset for a bank. 17. Give an equation that shows the relationship between actual, required, and excess reserves. Actual reserves = required plus excess reserves; or alternatively, excess reserves = actual minus required reserves. 18. Is the purpose of required bank reserves to enhance liquidity and protect commercial bank depositors from losses? Explain. No the purpose of reserves is not for liquidity or loss protection, but for control by the Fed. The purpose is to give the Fed some control over banks and their ability to lend money. 19. How are bank customers protected against bank failures? Explain. Bank deposits are protected through periodic examinations of banks by regulatory agencies. In addition, insurance is provided through such institutions as the Federal Deposit Insurance Corporation (FDIC). It provides protection for individuals for a loss of up to $250,000. A similar insurance program is provided for thrift depositors through the National Credit Union Administration (NCUA).

4 Chapter Using the balance sheet below and assuming a required reserve ratio of 33%, answer the following: (a) What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By expanding its loans by this amount in part (b), its checkable deposits would expand to what amount (if all loans were made to checking account customers)? (d) If checks clear against the bank equal to the amount loaned in (b), how much would remain in reserves and in checkable deposits? Reserves $ 60,000 Loans 60,000 Securities 40,000 Property 290,000 Checkable deposits $150,000 Stock shares 300,000 (a) $10,000 because required reserves are $50,000 (1/3 of $150,000) while actual reserves are $60,000. (b) $10,000 (= $60,000 50,000). (c) $160,000 (= $150, ,000). (d) $50,000 in reserves, $150,000 in checkable deposits. 21. Using the balance sheet below and assuming a required reserve ratio of 20%, answer the following: (a) What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By expanding its loans by this amount in part (b), its checkable deposits would expand to what amount (if all loans were made to checking account customers)? (d) If checks clear against the bank equal to the amount loaned in (b), how much would remain in reserves and in checkable deposits? Reserves $ 40,000 Loans 70,000 Securities 50,000 Property 400,000 Checkable deposits $100,000 Stock shares 460,000 (a) $20,000 because required reserves are $20000 (20% of $100,000) while actual reserves are $40,000. (b) $20,000 (= $40,000 20,000). (c) $120,000 (= $100, ,000). (d) $20,000 in reserves, $100,000 in checkable deposits. 22. Suppose the First National Bank has the following simplified balance sheet. The reserve ratio is 20%. (all figures in thousands) Reserves $40 Securities 90 Loans 70 Checkable $200 deposits Assume that households and businesses deposit $5000 in this bank and that this currency is added to the bank s reserves. In column (1) show the bank s balance sheet after this occurs. Is there a change in the money supply? In column (2) show what would happen if the bank now loans all of its excess reserves to a depositor. Is there a change in the money supply? (all figures in thousands) Reserves $40 $45 $45 Securities Loans Checkable $200 $205 $209 deposits No, currency has been reduced dollar-for-dollar with the $5000 increase in checkable deposits.

5 Money Creation Yes, the $4000 excess reserves increase checkable deposit money by $ Suppose the Second National Bank has the following simplified balance sheet. The reserve ratio is 25%. (all figures in thousands) Reserves $50 Securities 80 Loans 70 Checkable $200 deposits Assume that households and businesses deposit $10,000 in this bank and that this currency is added to the bank s reserves. In column (1) show the bank s balance sheet after this occurs. Is there a change in the money supply? In column (2) show what would happen if the bank now loans all of its excess reserves to a depositor. Is there a change in the money supply? (all figures in thousands) Reserves $50 $60 $60.0 Securities Loans Checkable $200 $210 $217.5 deposits No, currency has been reduced dollar-for-dollar with the $10,000 increase in checkable deposits. Yes, the $7500 excess reserves increase checkable deposit money by $ Jack deposits his money at Bank 1, while Maria deposits her money at Bank 2. Balance sheets for each bank are listed below. Bank 1 Reserves $200,000 Property 600,000 Checkable deposits $ 400,000 Stock shares 1,000,000 Bank 2 Reserves $150,000 Property 250,000 Checkable deposits $300,000 Stock shares 700,000 (a) What will the banks balance sheets look like when Jack writes a $50,000 check to Maria and the check clears? (b) The reserve ratio is 20%. What are each bank s excess reserves after the check clears in (a)? (c) How many additional loans can each bank make when Jack writes Maria another check for $100,000? (a) See balance sheets below. Bank 1 Reserves $150,000 Property 600,000 Checkable deposits $ 350,000 Stock shares 1,000,000

6 Chapter 29 Reserves $200,000 Property 250,000 Bank 2 Checkable deposits $350,000 Stock shares 700,000 (b) Bank 1 has excess reserves of $80,000 [$150,000 ($350, )]. Bank 2 has excess reserves of $130,000 [$200,000 ($350, )] (c) The check reduces Bank 1 s reserves to $50,000 which is exactly 20% of their remaining $250,000 checkable deposits. This means that Bank 1 cannot make any more additional loans. The check increases Bank 2 s reserves to $300,000 and checkable deposits to $450,000. At the current reserve ratio that means Bank 2 must hold $90,000 in reserves, and so Bank 2 has $210,000 available for additional loans. 25. When a check is drawn against bank A and deposited in another bank, the first bank loses reserves as the check is cleared. Yet the check collection involves no loss of reserves by the banking system. Explain what significance this has for the lending ability of the system as a whole. The system does not lose reserves as long as checks are being redeposited in other banks. The reserves simply move from one bank to another within the system. This means that the reserves are still available within the system to support loans and since reserves must be only a fraction of checkable deposits, they can support a multiple of the reserve amount in terms of loan and deposit values. Reserves are sometimes called high-powered for that reason. 26. What is the effect on the money supply when a commercial bank buys government securities from the public? The effect is the same as bank lending. The bank buying the securities issues a check that in turn gets deposited in a bank. The checkable deposits of that bank have increased its lending ability by increasing its excess reserves. 27. What is the effect on the money supply when a commercial bank sells government securities to the public? The effect is the same as a repayment of a loan. The bank selling the securities receives a check that in turn draws down the checkable deposits at the bank that is responsible for the check. The checkable deposits of that bank have decreased its lending ability by decreasing its excess reserves. 28. Banks pursue two conflicting goals. Explain what they are and why the conflict. The one goal is profit and the other goal is safety or liquidity. Banks seek to make profits and to do so they need to make loans to customers and buy securities. Banks also seek safety and the way that they do so is with liquidity. Liquid assets such as cash and excess reserves are the safe assets of a bank. If, on the one hand, a bank is too cautious and makes few loans, it will make few profits. If, on the other hand, a bank is too lax, it can make many loans, a number of which may go bad, thus hurting bank assets and profits. Banks must seek a balance between profits and liquidity. 29. What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the Federal funds market? First, banks are in business to make a profit just as are other businesses. They earn profits primarily on loans and by buying and selling securities. Second, banks must seek safety by having liquidity to meet the cash needs of depositors and to meet transactions as checks clear. Banks can borrow from one another to meet short-term needs for cash or reserves in the federal funds market. In this market banks borrow available reserves from other banks on an overnight basis. The rate paid is called the federal funds rate.

7 Money Creation 30. How do banks partly reconcile the goals of profits and liquidity? They can lend temporary excess reserves held at the Federal Reserve Banks to other commercial banks. They lend the excess reserves on an overnight basis in the Federal funds markets. Banks that are short of required reserves borrow from banks that have excess reserves. The interest rate charged on these overnight loans is the Federal funds rate. 31. What is meant by the Federal funds market and what is the Federal funds rate? When financial institutions find themselves temporarily short of reserves, they can borrow from other institutions reserves on an overnight or very short-term basis. The supply and demand for such reserve funds is known as the Federal funds market and the rate at which these funds are borrowed is the Federal funds rate. 32. Answer the next questions based on the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 30%. All figures are in millions of dollars. Reserves $200 Securities 500 Loans 100 Property 500 Checkable deposits $600 Stock shares 700 (a) What is the amount of excess reserves in this commercial banking system? (b) What is the maximum amount that the money supply can be expanded? (c) If the reserve ratio fell to 25%, what is now the maximum amount that the money supply can be expanded? (a) Required reserves are $600 million.30 = $180 million. Actual reserves are $200 million, so excess reserves are $20 million. (b) The monetary multiplier is 1 /.3 or Maximum expansion of the money supply is $20 million 3.33, or million. (c) If the reserve ratio was 25%, then excess reserves would be $50 million [$200 million (.25 $600 million)]. The monetary multiplier would be 1 /.25 or 4, so the maximum expansion of the money supply is $200 million [4 $50 million]. 33. Answer the next questions based on the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 25%. All figures are in billions of dollars. Reserves $100 Securities 200 Loans 100 Property 600 Checkable deposits $300 Stock shares 700 (a) What is the amount of excess reserves in this commercial banking system? (b) What is the maximum amount that the money supply can be expanded? (c) If the reserve ratio fell to 25%, what is now the maximum amount that the money supply can be expanded? (a) Required reserves are $300 billion.25 = $75 billion. Actual reserves are $100 billion, so excess reserves are $25 billion. (b) The monetary multiplier is 1/.25 or 4. Maximum expansion of the money supply is $25 billion 4, or $100 billion.

8 Chapter 29 (c) If the reserve ratio was 20%, then excess reserves would be $40 billion [$100 billion (.20 $300 billion)]. The monetary multiplier would be 1 /.20 or 5, so the maximum expansion of the money supply is $200 billion [5 $40 billion]. 34. Answer the next questions based on the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 20%. All figures are in billions of dollars. Reserves $ 60 Securities 140 Loans 100 Property 400 Checkable deposits $200 Stock shares 500 (a) What is the amount of excess reserves in this commercial banking system? (b) What is the maximum amount that the money supply can be expanded? (c) If the reserve ratio fell to 10%, what is now the maximum amount that the money supply can be expanded? (a) Required reserves are $200 billion.20 = $40 billion. Actual reserves are $60 billion, so excess reserves are $20 billion. (b) The monetary multiplier is 1/.20 or 5. Maximum expansion of the money supply is $20 billion 5, or $100 billion. (c) If the reserve ratio was 10%, then excess reserves would be $40 billion [$60 billion (.10 $200 billion)]. The monetary multiplier would be 1/.10 or 10, so the maximum expansion of the money supply is $400 billion [10 $40 billion]. 35. If the balance sheet below were for the entire banking system instead of just a single bank, by how much could loans be expanded? Assume a reserve ratio of 33%. Reserves $ 60,000 Securities 60,000 Loans 40,000 Property 290,000 Checkable deposits $150,000 Stock shares 300,000 The system as a whole could support up to $30,000 in new loans. If there were no leakages, the $10,000 in excess reserves would be in the system as if the system were one gigantic bank. As long as those reserves are in the system they must equal 33% of new loans. $10,000 is 33% of $30,000. Therefore, $30,000 worth of new loans can be created in the system with $10,000 of excess reserves. (The money multiplier is 1/.333 or 3; 3 times $10,000 = $30,000.) Checkable deposits would then become $180,000 and actual reserves of $60,000 would just meet the legal requirement. 36. If the balance sheet below were for the entire banking system instead of just a single bank, by how much could loans be expanded? Assume a reserve ratio of 20%. Reserves $ 40,000 Securities 70,000 Loans 50,000 Property 400,000 Checkable deposits $100,000 Stock shares 460,000 The system as a whole could support up to $100,000 in new loans. If there were no leakages, the $20,000 in excess reserves would be in the system as if the system were one gigantic bank. As long as those reserves are in the system they must equal 20% of new loans. $20,000 is 20% of $100,000. Therefore, $100,000 worth of new loans can be created in the system with $20,000 of excess reserves. (The money multiplier is 1/.20 or 5; 5 times $20,000 = $100,000.) Checkable deposits would then become $200,000 and actual reserves of $40,000 would just meet the legal requirement.

9 Money Creation 37. Define the monetary multiplier. Because banks need only keep a fraction of their checkable deposits in reserve, the deposit multiplier is the multiple found by the ratio of the potential amount of checkable deposits that can be supported by a given amount of reserves. The multiplier, m, is the reciprocal of the required reserve ratio R. (m = 1/R). For example, if the required reserve ratio is 10%, then m = 1/.10 = Give an equation that shows the relationship between excess reserves, maximum checkable-deposit expansion, and the monetary multiplier. The maximum deposit expansion = excess reserves times monetary multiplier; or symbolically, D = E times m where D is the maximum potential deposit expansion, E is excess reserves, and m is the monetary multiplier. 39. How can money be destroyed in the same way that checkable deposits expand the money supply? A loan repayment or a withdrawal has the opposite effect on the money supply as a checkable deposit. This effect is multiplied from the loss of additional loans that could be made on the withdrawn checkable deposits or from the repaid loan funds. Essentially and generally, if the dollar amount of loans repaid is greater than the dollar amount of loans made, checkable deposits decrease and the money supply decreases. 40. (Last Word) What led to the bank runs of the early 1930s? In the 1930s there was no depositors insurance and the beginning of the Great Depression caused several weak banks to fail, resulting in loss of their depositors money. This bred general concern about the stability of the banking system and people began to go to their banks en mass, demanding their checkable deposits in cash. Banks could not meet the demands given the reserves they held and the factional reserve system then in place. This run on the banks caused more than 9000 banks to fail in the first 3 years of the 1930s. 41. (Last Word) What effect did the bank panics of have on the money supply? Explain. Bank panics in led to a multiple contraction of the money supply, which worsened the Depression. Many of the failed banks were healthy, but they suffered when worried depositors panicked and withdrew funds at the same time. More than 9000 banks failed in three years. As people withdrew funds, this reduced banks reserves and, in turn, their lending power fell significantly. Contraction of excess reserves leads to multiple contraction in the money supply. The money supply was reduced by 25 percent to 33 percent in that period. President Roosevelt declared a bank holiday, closing banks temporarily while Congress started the Federal Deposit Insurance Corporation (FDIC), which restored some public confidence in banks and ended the bank panics.