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Notes on Banking and Money Creation

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Notes on Banking and Money Creation Notes on Banking and Money Creation Basics: How Do Banks Get Money? • From the public as _______. The public wants safety and sometimes a return in the form of interest rates. • Since the deposits are the property of the ______, banks must record them as “__________” for the bank and are labeled as “______ ________”. They are also known as “___________________” but that term is being used less with the demise of “checkbooks”. • Demand Deposits (DD) are considered a liability to the bank because the bank is liable to give the deposits back to individuals upon demand. • Banks, once in operation, can invest funds in the form of ______________, purchased from the Fed. The bonds earn the bank _____________. The bond amounts are “______” for banks. What Do Banks Do With the Money? • _____ it to the public in order to profit from the ________ charges on the loans. This money creates a “_______ Multiplier” or “______ Multiplier”. Do Banks Lend All of the Money? • Not all of the Demand Deposits. Since some of the public comes to the bank each day and wants to withdraw some of the Demand Deposits, banks must keep some cash “in the vault”. This “_______” is used to satisfy withdrawal requests. • Banks that belong to the Federal Reserve System must keep a “_________ Reserve” percentage set by the Fed. The Required Reserve is approximately ___% of Demand Deposits, and since almost all banks in the US are part of the Fed System, this has become the national standard. • The remaining amount becomes the “______ Reserves”. The Excess Reserves are then used by the banks as loans to the public. • Banks can lend ___ of the Bond Assets they hold and do not have to put any percentage into the ________ Reserves. What Happens to the Loans? • When a person borrows from a bank it will be assumed that the money is _____ somewhere. The next assumption is that the funds end up in a bank account as someone else’s _______ Deposits in a second bank. The second bank then pulls out the Required Reserves. The remaining Excess Reserves become a new loan which another person can use and the money ends up in a third bank. The process “___________”. • Note however, that with each new loan, some is removed and held as Required Reserves. The loan amount will shrink with each new loan. How many times can the process occur? • No one knows at which point any given amount of deposits shrink to a point where borrowing will end, but estimates are made using the “_____ Multiplier”. The formula is based on the amount being drained out by the Reserve Requirement. The greater the Reserve Requirement, the quicker the loan amount will shrink and end the line of loans. • The general formula is given as: 1/rr, with “rr” standing for the Required Reserve percentage, known here as the reserve ratio. If the rr is 10%, then every original loan of 1 dollar will create __ dollars of loans in the banking system (____). A 5% rr gives a multiplier of __ (_____) and a reserve of 20% lowers the multiplier to only __ (____). AP and Bank T-Accounts • Banks keep all of the accounting for this lending system in a T-Account of Assets and Liabilities. • The Assets and Liabilities are always equal to show bank solvency. • The T-Account is a chart, with Assets on the Left and Liabilities on the Right. Assets Liabilities The Components and Definitions for T-Accounts Liabilities: 1. __________________________ from the public = ___ 2. _____________ or __________ = Values of the bank stocks as held by the public Assets: 1. ______________________ = The percentage of DD in the Vault = ___ 2. _______________ = The remaining % of DD, used for loans = ___ 3. ______________ or ________________ = Usually a statement of the bank’s property values 4. __________________ or ______ or ____________ = Previously purchased bonds held by the bank as investments. 5. ______ or _______________ = Previously loaned funds now owed back to the bank. Assets Liabilities 1. 1. 2. 2. 3. 4. 5. Remember: DD = RR + ER Bonds can move two ways: 1. The Fed sells to the banks and increases the amount. 2. The Fed buys from the banks and decreases the amount. Other Cause and Effect Factors to Remember • Changes in the Money Supply will move the _________ line on the Money Market Graph. • Changes in the Money Supply will change _______________________. • Changes in the Money Supply can create ___________ or dis-___________. • Change in inflation can change _______________. • Changes in interest rates also affect the international ____________ markets. (We will learn this in Unit 7.) • Changes in interest rates affect the prices of bonds in an ____________ relationship. o Higher interest rates will push bond prices ___________. (______ Money Supply) o Lower interest rates will push bond prices ___________. (______ Money Supply) Banks and the Money Supply The Money Multiplier process creates new money for the economy. The following are three scenarios College Board has used in the past for FRQ questions. Scenario #1: A private citizen takes cash that they possess and put it into a bank account. • The cash placed into the bank is already part of the ____________________ • The deposit is counted as a bank ___________________ • A percentage must be placed into __________________ • The remainder is placed into ________________ • The bank will want to lend ___ of the ___________, if possible • The amount in ___________ is multiplied by the _____________________ • This will be assumed to become _________________ in the banking system • This will be counted as the change in the _________________ Scenario #2: • The Fed buys bonds back from the public. • The public now has new ______ • This new cash is new __________ • Assume that the public puts the cash into ___________________ • A set percentage is placed into _________________ • The remainder becomes _________________ • __________________ are multiplied by the Money Multiplier (_____) • This amount becomes new _____________ and is new _______________ • The total change in the Money Supply is the amount of __________________ plus the new _____________________ Scenario #3: • The Fed buys bonds back from the member banks • The bank now has new __________________ • No money is needed to be placed into _________________, since this is not owed to the public • All of these __________________ are multiplied by the __________________ • This amount becomes new ________________________ • This amount is the change in the __________________ Notes on Banking and Money Creation Basics: How Do Banks Get Money? • From the public as deposits. The public wants safety and sometimes a return in the form of interest rates. • Since the deposits are the property of the public, banks must record them as “Liabilities” for the bank and are labeled as “Demand Deposits”. They are also known as “Checkable Deposits” but that term is being used less with the demise of “checkbooks”. • Demand Deposits (DD) are considered a liability to the bank because the bank is liable to give the deposits back to individuals upon demand. • Banks, once in operation, can invest funds in the form of Federal Bonds, purchased from the Fed. The bonds earn the bank interest rates. The bond amounts are “Assets” for banks. What Do Banks Do With the Money? • Lend it to the public in order to profit from the interest charges on the loans. This money creates a “Lending Multiplier” or “Money Multiplier”. Do Banks Lend All of the Money? • Not all of the Demand Deposits. Since some of the public comes to the bank each day and wants to withdraw some of the Demand Deposits, banks must keep some cash “in the vault”. This “reserve” is used to satisfy withdrawal requests. • Banks that belong to the Federal Reserve System must keep a “Required Reserve” percentage set by the Fed. The Required Reserve is approximately 10% of Demand Deposits, and since almost all banks in the US are part of the Fed System, this has become the national standard. • The remaining amount becomes the “Excess Reserves”. The Excess Reserves are then used by the banks as loans to the public. • Banks can lend all of the Bond Assets they hold and do not have to put any percentage into the Required Reserves. What Happens to the Loans? • When a person borrows from a bank it will be assumed that the money is spent somewhere. The next assumption is that the funds end up in a bank account as someone else’s Demand Deposits in a second bank. The second bank then pulls out the Required Reserves. The remaining Excess Reserves become a new loan which another person can use and the money ends up in a third bank. The process “multiplies”. • Note however, that with each new loan, some is removed and held as Required Reserves. The loan amount will shrink with each new loan. How many times can the process occur? • No one knows at which point any given amount of deposits shrink to a point where borrowing will end, but estimates are made using the “Money Multiplier”. The formula is based on the amount being drained out by the Reserve Requirement. The greater the Reserve Requirement, the quicker the loan amount will shrink and end the line of loans. • The general formula is given as: 1/rr, with “rr” standing for the Required Reserve percentage, known here as the reserve ratio. If the rr is 10%, then every original loan of 1 dollar will create 10 dollars of loans in the banking system (1/.1). A 5% rr gives a multiplier of 20 (1/.05) and a reserve of 20% lowers the multiplier to only 5 (1/.2).
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