Banks and Money Creation

Banks have played a central role in the money supply process and to understand the supply process we need to examine the 'books' of banks. We begin with a simple balance sheet for the ACM bank. The assets banks are allowed to own are restricted by the Fed. In our simple example we will assume the bank's assets consist of cash (reserves), loans, and government securities. Banks will hold government securities and loans because they earn interest. Banks also hold cash as reserves against their deposit accounts which earns no interest, so you would expect banks pursuing a profit to make every effort to minimize their holdings of cash. In the example below, the bank's assets total $5,500,000.

The banks' primary liabilities are the balances on the checking and savings accounts held by their customers. In the example below, the ACM's liabilities total $5,000,000, which gives it a net worth of $500,000. As we go through our example you will note that the two sides of the balance sheet must always be equal - the result of double-entry book keeping. The Fed, meanwhile, links the assets and liabilities when it sets the required reserve rate for the banks specifying the amount of cash a bank must keep on hand as reserves to support the demand deposits (checking accounts). In this example we are assuming the Fed is requiring the bank to hold 20 percent of the amount of its deposit accounts as cash (reserves). To "support" the $5,000,000 in checking account balances, the bank will be required to hold $1,000,000 as required reserves. Given this is all of the cash the bank has, there are no excess reserves.

Stage 1: ACM's Initial Balance Sheet

ACM's "Books:" Initial Situation

* If banks have inadequate reserves (excess reserves < 0) then they can borrow money to satisfy the necessary reserve requirements. They can borrow from the Federal Reserve at the discount window or from other banks in the federal funds market.

Stage 2: ACM's books after a $100,000 infusion of cash

Now let's see what happens when Marie walks into ACM with $100,00 in cash that she brought from France. The bank will take Marie's $100,000 and add it to its assets, but it will send Marie away with an extra $100,000 in her checking account. Because the checking deposits have risen by $100,000, the bank will be required to hold 20 percent of this amount as additional reserves. The $20,000 increase in required reserves will bring required reserves to $1,020,000 so the bank now has $80,000 in excess reserves. because the bank earns no interest on the excess cash, the bank moves to "eliminate" the excess reserves.

ACM's "Books:" After $100,000 Deposit

You can see double-entry accounting has resulted in an increase of $100,000 on both sides of the balance sheet.

• bank accepts $100,000 in cash (actual reserves rise to $1,100,000) and adds $100,000 to the account of the depositor (checking deposits rise to $1,100,000)
• with 20% required reserve rate, bank needs to hold $1,020,000 as required reserves (.2*$5,100,000). The bank has excess reserves of $80,000

Stage 3: ACM's books after elimination of excess reserves

The ACM bank will now attempt to transform the $80,000 into income-earning assets. Here we assume the bank loans out $80,000 in cash - maybe some mortgages or car loans - so the loan balance increases by $80,000 and reserves falls by an equal amount. The bank is now left with the required $1,020,000 in cash, so excess reserves are $0. As for the $80,000, someone has the cash and we can expect they will deposit it in a bank - bank KAB receives a deposit of $80,000.

ACM's "Books:" After Eliminating Excess Reserves

• bank lends out $80,000 of excess reserves in form of cash (reserves fall by $80,000 and loans rise by $80,000)
• $80,000 will work its way back into the banking system as another infusion of cash - this time an infusion of $80,000 into Bank KAB.

Stage 4: KAB's books after deposit $80,000

We are now back where we started - with an infusion of $80,000 into a bank. KAB bank's assets rise by $80,000 in cash which is offset by an $80,000 entry in the checking account balance. You can expect this bank to follow the same procedure to rid itself of the excess reserves, and since the required reserve rate is 20 percent, it will need to hold $16,000 as additional required reserves.

KAB's "Books:" After $80,000 Deposit

• bank takes in $80,000 as cash and credits checking accounts for the $80,000
• the bank must hold $16,000 as additional required reserves (.2*$80,000) which gives it $64,000 of excess reserves

Stage 5: KAB's books after elimination of excess reserves

The bank will now attempt to transform the $64,000 into income earning assets. In this example we have assumed the bank loans out the $64,000 so the loan balance increases by $64,000 and the level of reserves falls by an equal amount. The $64,000, meanwhile, will eventually be deposited it in a bank. Bank MRM will receive a deposit of $64,000 which is where we will drop the story and move quickly to our conclusion.

ACM's "Books:" After Eliminating Excess Reserves

• bank takes excess reserves of $64,000 and loans out this cash (excess reserves and actual reserves decline by $64,000 and loans increase by $64,000)
• the $64,000 in cash eventually works its way back into banking system as additional cash infusion

Conclusion: Money creation in banking system

It's now time to retrace the flow of $s through the banking system. Below you will find the changes we could expect in the balance sheets of the banking system's banks. In bank ACM where the process began, the bank's loans increased by $80,000, its cash by $20,000, and its checking account balances by $100,000. Bank KAB, meanwhile, will see its loans increase by $64,000, its required reserves increase by $16,000 and its checking account balances by $80,000. The $64,000 loan made by KAB will be deposited into an account at bank MRM where 20 percent ($12,800) will be kept as reserves against checking balances of $64,000 and 80 percent ($51,200) will be loaned out which will find its way into bank AJM.

Following the Money: A Scorecard

To see the cumulative effect, we can simple reorganize the table above and create a Composite of the Banking System table to show the changes in reserves, deposits, and loans in each of the banks. What we see is that the $100,000 cash deposit has been transformed into bank reserves of $100,000, deposits of $500,000, and loans of $400,000. Because the deposit balances are part of the money supply, we have seen a $100,000 increase in cash has produced a $500,000 increase in the money supply

Composite of the Banking System

Because of the fractional reserve system, banks can multiply the high-powered money that the Fed puts into the system. In this example there are no excess reserves and the banks will take a $100,000 increase in high-powered money and transform it into a $500,000 increase in demand deposits so the money multiplier would be 5. We are now ready to put the pieces together - the Fed and the banks. It is time to look at how the Fed can influence the money supply.