Lecture 22:

How can Banks Create Money?

We are talking about M1 money
Rules
banks only maintain demand dep
accts
banks hold required reserves
banks make loans in the amount of
their excess reserves
RR = DD*rr ER = TR - RR
 The basics of credit expansion

Assets Liabilities

TR total reserves DD demand depostis

RR req. reserves
ER exc. reserves

Loans

Remember the Rule: Banks make loans in the amount of their

excess reserves. ER = TR - RR
 Illustrating the credit expansion
process(rr=.25)
assets liabilities assets liabilities

Res 100 dd 100 res + 56.25 dd + 56.25

loans +75 dd +75 loans +42.19 dd +42.19

res ?? -75 dd -75 res ?? dd - ?

res + 75 dd + 75 res + ? dd + ?

loans + 56.25 dd + 56.25

dd - 56.25
res - ?? -56.25
 The Deposit Multiplier

The deposit multiplier is the amount by

which an increase in bank reserves is
multiplied to calculate the increase in
bank deposits.
Deposit multiplier =
(Change in deposits)/(Change in reserves) =
1/(Required reserve ratio)
Creating Deposits by Making
Loans with
Many Banks
Even though each bank lends only
what it receives, the banking system
creates money.
Remember, checks written on deposits
in one bank become deposits in
another bank, so total deposits do
not change.
 The Deposit Multiplier
in the United States
The deposit multiplier in the United
States differs from the one calculated
previously because:
The U.S. required reserve ratio is less than
25 percent
U.S. banks sometimes choose to hold
excess reserves
Part of loans are held as currency and are
not available for relending.
 Summary of the Money Multiplier

1
D deposits ={ } D reserves
rr
An injecftion of reserves into the banking system
allows banks to expand the quantiy of debt money
in circulation. The rate of expansion depends on
the required reserve ratio.
 Credit Expansion Intuition

The intuition behind credit expansion

multipliers
1. bank debt circulates as money
2. banks maintain fractional reserves
3. a $1 injection of reserves results in
the creation of >$1 in bank debt as
loans are issued and fractional
reserves are maintained.
Think of this as an inverse
pyramid
Total Bank Deposits

reserves
 Multiplier problems

D Deposits D Reserves rr

400 100 .25

500 100 ?
? 100 .10
200 ? .25
 How Does Money Influence the
macro Economy??
D Policy => D Bank Reserves
=> D Money Supply
=> D interest rates
=> D consumption and
investment
=> D GDP
 The Market for Loanable Funds

interest Supply
rate

Demand

Loanable
Funds
 Consider the two situations

When there is unemployment and the

economy is in a recessionary gap
situation, an increase in the money
supply will increase real GDP
When the economy is at capacity, an
increase in the money supply is
inflationary.
this is nothing new from EIA
 The Short-Run Effects
of a Change in the
Quantity of Money
An increase in the quantity of money
causes interest rates to decrease.
This stimulates consumption and
investment, causing the aggregate
demand curve to shift.
Real GDP and the price level both
increase in the short run.
 The Long-Run Effects
of a Change in the
Quantity of Money
In the long run, the economy is at
potential GDP.
Wage increases caused by excess
demand for labor cause the SAS
curve to shift up and to the left.
The new equilibrium is at potential GDP
with a higher price level.
 What is the Historical relationship
between money growth and
inflation
Money growth and inflation follow a
close relationship through time.

However, other factors such as oil price

shocks can have an important impact
on inflation.
growth in the money supply and inflation
see Fig 13.7 page 308 for an update
growth in the money supply and inflation
see Fig 13.7 page 308 for an update