No Such Thing as a Free Lunch: Principles of Economics (Part 121)

Those who are of the opinion that money will do everything may reasonably be expected to do everything for money.

Edward Wood, 1st Earl of Halifax

The Money Supply and the Federal Reserve System

(Part D)

by

Charles Lamson

The Creation of Money

Bankers seek to earn income by lending money out at a higher interest rate than they pay depositors for use of their money.

In modern times, the chances of a run on a bank are fairly small; and, even if there is a run, the central bank protects the private banks in various ways. Therefore, banks usually make loans up to the point where they can no longer do so because of the reserve requirement restrictions.

A bank's required amount of reserves is equal to the required reserve ratio times the total deposit in the bank. If a bank has deposits of $100 and the required ratio is 20 percent, the required amount of reserves is $20. The difference between a bank's actual reserves and its required reserves is its excess reserves:

excess reserves ≡ actual reserves - required reserves

If banks make loans up to the point where they can no longer do so because of the reserve requirement restriction, this means that banks make loans up to the point where their excess reserves are zero.

To see why, note that when a bank has excess reserves, it has credit available, and it can make loans. Actually, a bank can make loans only if it has excess reserves. When a bank makes a loan, it creates a demand deposit for the borrower. This creation of a demand deposit causes the bank's excess reserves to fall because the extra deposits created by the loan use up some of the excess reserves the bank has on hand. An example will help demonstrate this.

Assume there is only one private bank in the country, the required reserve ratio is 20 percent, and the bank starts off with nothing, as shown in panel 1 of Figure 2. Now suppose dollar bills are in circulation and someone deposits 100 of them in the bank. The bank deposits the $100 with the central bank, so it now has $100 dollars in reserves, as shown in panel 2. The bank now has assets (reserves) of $100 and liabilities (deposits) of $100. If the required reserve ratio is 20 percent, the bank has excess reserves of $80.

How much can the bank lend and still meet the reserve requirement? For the moment, let us suppose anyone who gets a loan keeps the entire proceeds in the bank or pays them to someone else who does. Nothing is withdrawn as cash. In this case, the bank can lend $400 and still meet the reserve requirement. Panel 3 shows the balance sheet of the bank after completing the maximum amount of loans it is allowed with a 20 percent reserve ratio. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans (which are made as deposits) equal $500 in deposits. With $500 in deposits and a required reserve ratio of 20 percent, the bank must have reserves of $100 (20 percent of $500) and it does. The bank can lend no more than $400 because its reserve requirement must not exceed $100. When a bank has no excess reserves and can make no more loans, it is said to be loaned up.

Remember, the money supply (M1) equals cash in circulation plus deposits. Before the initial deposit, the money supply was $100 ($100 cash and no deposits). After the deposit and the loans, the money supply is $500 (no cash outside of bank vaults and $500 in deposits). It is clear, then, that when loans are converted into deposits, the supply of money can change.

The bank whose T-accounts are presented in Figure 2 is allowed to make loans of $400 based on the assumption that loans that are made stay in the bank in the form of deposits. Now suppose I borrow from the bank to buy a personal computer, and I write a check to the computer store. If the store also deposits its money in the bank, my check merely results in a reduction in my account balance and an increase to the store's account balance within the bank. No cash has left the bank. As long as the system is closed in this way remember that we have so far assumed that there is only one bank---the bank knows that it will never be called on to release any of its $100 in reserves. It can expand its loans up to the point where its total deposits are $500.

Of course, there are many banks in the country, a situation that is depicted in Figure 3. As long as the banking system as a whole is closed, it is still possible for an initial deposit of $100 to result in an expansion of the money supply to $500, but more steps are involved when there is more than one bank.

To see why, assume Mary makes an initial deposit of $100 in bank 1, and the bank deposits the entire $100 with the Fed (panel 1 of Figure 3). All loans that a bank makes are withdrawn from the bank as the individual borrowers write checks to pay for merchandise. After Mary's deposit, bank 1 can make a loan of up to $80 to build, because it needs to keep only $20 of its $100 deposit as reserves. (We are assuming a 20 percent required reserve ratio.) In other words, bank 1 has $80 in excess reserves.

Bank 1's balance sheet at the moment of the loan to Bill appears in panel 2 of Figure 3. Bank 1 now has loans of $80. It has credited Bill's account with the $80. So its total deposits are $180 ($80 in loans plus $100 in reserves). Bill then writes a check for $80 for a set of shock absorbers for his car. Bill wrote his check to Sam's Car Shop, and Sam deposits Bill's check in bank 2. When the check clears, bank 1 transfers $80 in reserves to bank 2. Bank 1's balance sheet now looks like the top of panel 3. Its assets include reserves of $20 and loans of $80; its liabilities are $100 in deposits. Both sides of the T-account balance: The bank's reserves are 20 percent of its deposit, as required by law, and it is fully loaned up.

Now look at bank 2. Because bank 1 has transferred $80 in reserves to bank 2, it now has $80 in deposits and $80 in reserves (panel 1, bank 2). Its reserve requirement is also 20 percent, so it has excess reserves of $64 on which it can make loans.

Now assume bank 2 loans the $64 to Kate to pay for a textbook and Kate writes a check for $64 payable to the Manhattan College Bookstore. The final position of bank 2, after it honors Kate's $64 check by transferring $64 in reserves to the bookstore's bank, is reserves of $16, loans of $64, and deposits of $80 (panel 3, bank 2).

The Manhattan College Bookstore deposits Kate's check in its account with bank 3. Bank 3 now has excess reserves, because it has added $64 to its reserves. With a reserve ratio of 20 percent, bank 3 can loan out $50.20 (80 percent of $64, leaving 20 percent in required reserves to back the $64 deposit).

As the process is repeated over and over, the total amount of deposits created is $500, the sum of the deposits in each of the banks. Because the banking system can be looked on as one big bank, the outcome here for many banks is the same as the outcome in Figure 2 for one bank.

The Money Multiplier

In practice, the banking system is not completely closed---there is some leakage out of the system. Still, the point here is:

Do not confuse the money multiplier with the spending multiplier as we discussed in the last several posts. They are not the same thing.

In the example we just examined, reserves increase by $100 when the $100 in cash was deposited in a bank, and the amount of deposits increased by $500 ($100 from the initial deposit, $400 from the loans made by the various banks from their excess reserves). The money multiplier in this case is $500/$100 = 5. Mathematically, the money multiplier can be defined as:

money multiplier ≡ 1/ required reserve ratio

*CASE & FAIR, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 483-485*

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