Chapter 26

Money Creation and

the Banking System

08/29/22
©1999 South-Western College Publishing
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 Commercial Banking
System
• Privately owned, profit
seeking
• 2 major functions, accept
deposits and make loans
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Who were the first bankers?
Goldsmiths in the
Middle Ages

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 Why are banks called
Depository Institutions?
Because they accept
deposits from the public

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 What is a Fractional
Reserve Banking System?
A banking system that
provides people
immediate access to their
deposits, but allows banks
to hold only a fraction of
those deposits in reserve
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How do banks make profit?
They pay depositors a
lower interest and lend a
fraction of the deposits
out at a higher interest

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 What determines a
Bank’s Profit?
The spread between
interest paid to deposits
and interest received
from loans
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 What is a Bank’s
Balance Sheet?
The bank’s statement of
liabilities (what it owes)
and assets (what it owns)

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 Assets and Liabilities of a Bank

ASSETS LIABILITIES

•DEPOSITS
•RESERVES •BORROWING
•LOANS
•BONDS ASSETS - LIABILITIES
•BUILDINGS EQUALS
•EQUIPMENT NET WORTH

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 Find out about
cyberspace banking:
http://www.sfnb.com
http://www.ots.treas.gov/ebanking.
html

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 What determines how
much a Bank can lend?
The legal reserve
requirement determines
what fraction of a bank’s
deposits they can lend
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What is a Legal Reserve
Requirement?
The percentage of demand
deposits banks and other
financial intermediaries
are required to keep in
cash reserves
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 What are
Excess Reserves?
Deposits that a bank has
above its required reserves

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 How do Banks
multiply money?
Because each bank can
legally lend its excess
reserves, there is a
multiple process that take
place as money circulates
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 The money multiplier
process
Assume all excess
reserves are loaned out
Use a reserve ratio of 10%
( .10)
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 What is the Potential
Money Multiplier?
The increase in the money
supply that is potentially
generated by a change in
demand deposits
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 What is the money
multiplier with a reserve
requirement of 1/10?

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 $100
$90
$81 original deposit
$74
$63
...
total money

$1,000
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What is the Money
Multiplier formula?
1/Required reserve ratio

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 If the required reserve ratio is
1/10 and all banks are exactly
meeting their reserve
requirement - how do we
calculate the money multiplier?

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One divided by one tenth equals 10

. 1 Multiplier
1 . 10
=

1X 10
= 10
1
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 Does this multiplication
process work in reverse?
Yes! For every dollar
taken out of
circulation, there is a
multiple effect on the
money supply
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 Can a Bank fail?
If its liabilities are
greater than its assets,
a bank can fail

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 How do we Safeguard
the Banking System?
The Federal Deposit Insurance
Corporation (FDIC)

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 What is the FDIC?
A government insurance
agency that provides
depositors 100%
coverage on their first
$100,000 of deposits
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 What else does
the FDIC do?
It audits and examines banks
to detect any weaknesses in
its operation

©1999 South-Western College Publishing

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 Despite the FDIC, can
banks still fail?
Yes! There were many
bank failures as
recently as the 1980’s
and 1990’s
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Bank Failures in the 80’s
and 90’s
• Effects of inflation from the
70’s and 80’s
• Bad loans, energy industry
• Expanded deposit insurance

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http://www.fdic.gov/learning/index.html
http://www.bog.frb.fed.us
http://www.ffiec.gov/nic
http://www.chi.frb.org
http://www.bankweb.com/bankweb.html
http://www.bankrate.com
http://www.bankwatch.com
http://www.bankinfo.com
©1999 South-Western College Publishing 2
29 9
• What is a Fractional Reserve Banking
System?
• How do banks make profit?
• What is a Legal Reserve Requirement?
• What are Excess Reserves?
• How do Banks multiply money?
• What is the money multiplier formula?
• What is the FDIC?

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END
©1999 South-Western College Publishing
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