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).

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 Demand Deposits/Checkable Deposits from the public = DD 2 Owner’s Equity or Stock Shares = Values of the bank stocks as held by the public

Assets: 1 Required Reserves = The percentage of DD in the Vault = RR 2 Excess Reserves = The remaining % of DD, used for loans = ER 3 Bank Property or Building and Fixtures = Usually a statement of the bank’s property values 4 Government Securities or Bonds or Bond Holdings = Previously purchased bonds held by the bank as investments. 5 Loans or Customer Loans = Previously loaned funds now owed back to the bank.

Assets Liabilities 1. RR 1. DD 2. ER 2. Owner’s Equity 3. Building and Fixtures 4. Bonds 5. Loans

Remember: DD = RR + ER Bonds can move two ways: The Fed sells to the banks and increases the amount. 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 Supply line on the Money Market Graph. • Changes in the Money Supply will change nominal interest rates. • Changes in the Money Supply can create inflation or dis-inflation. • Change in inflation can change real wages. • Changes in interest rates also affect the international currency markets. (We will learn this in Unit 7.) • Changes in interest rates affect the prices of bonds in an inverse relationship. o Higher interest rates will push bond prices downward. (Less Money Supply) o Lower interest rates will push bond prices upward. (More Money Supply)

Banks and the Money Supply

The Money Multiplier process creates new money for the economy. The following are three likely 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 M1 Money Supply. • The deposit is counted as a bank liability/Demand Deposit • A percentage must be placed into Required Reserves • The remainder is placed into Excess Reserves • The bank will want to lend all of the Excess Reserve, if possible • The amount in Excess Reserve is multiplied by the Money Multiplier (1/rr) • This will be assumed to become NEW Demand Deposits in the banking system • This will be counted as the change in the Money Supply

Scenario #2: • The Fed buys bonds back from the public. • The public now has new cash • This new cash is new Money Supply • Assume that the public puts the cash into Demand Deposits • A set percentage is placed into Required Reserves • The remainder becomes Excess Reserves • Excess Reserves are multiplied by the Money Multiplier (1/rr) • This amount becomes new Demand Deposits and is new Money Supply • The total change in the Money Supply is the amount of bonds purchased plus the new Demand Deposits

Scenario #3: • The Fed buys bonds back from the member banks • The bank now has new Excess Reserves • No money is needed to be placed into Required Reserves, since this is not owed to the public • All of these Excess Reserves are multiplied by the Money Multiplier • This amount becomes new Demand Deposits • This amount is the change in the Money Supply