Money CreationMoney Creation

Ms. RossMs. Ross

Spring 2007Spring 2007

Jack and the BeanstalkJack and the Beanstalk

Suppose Jack purchased 100 beans at Suppose Jack purchased 100 beans at market. When he plants those beans at market. When he plants those beans at home, the resulting beanstalk produces home, the resulting beanstalk produces five times as many beans as he planted. five times as many beans as he planted. How many beans grew on the beanstalk?How many beans grew on the beanstalk?

500!500!

Jack and the BeanstalkJack and the Beanstalk

Is there a way for money to be created in Is there a way for money to be created in the same way?the same way?

Who or what can create money this way?Who or what can create money this way? Today we are going to explore the Today we are going to explore the

process by which banks can create process by which banks can create money.money.

Reserve RequirementReserve Requirement

When people deposit money in a bank, banks When people deposit money in a bank, banks hold on to some of the deposited money as hold on to some of the deposited money as reserves but lend the rest of it.reserves but lend the rest of it.

Banks make money by charging a higher rate Banks make money by charging a higher rate of interest on the loans they make than the rate of interest on the loans they make than the rate they pay on deposits.they pay on deposits.

In this activity, we will assume that banks will In this activity, we will assume that banks will hold only the required reserve ratio and lend hold only the required reserve ratio and lend the rest out.the rest out.

Reserve RequirementReserve Requirement

Today the reserve requirement is 10 Today the reserve requirement is 10 percent.percent.

That minimum has been set by the That minimum has been set by the Federal Reserve.Federal Reserve.

To make today’s activity work more To make today’s activity work more easily, we will assume a reserve easily, we will assume a reserve requirement of 20 percent.requirement of 20 percent.

AssessmentAssessment

You were recently walking by the U.S. You were recently walking by the U.S. Mint in Philadelphia and you heard one Mint in Philadelphia and you heard one tourist say the following: “All the money in tourist say the following: “All the money in the United States is created in this mint the United States is created in this mint and the U.S. Mint in Denver. It is sure and the U.S. Mint in Denver. It is sure amazing to think that every dollar you amazing to think that every dollar you have ever saved or spent was created in have ever saved or spent was created in either this building or the one in Denver.”either this building or the one in Denver.”

Post Money Creation Post Money Creation Activity:Activity:

Although the US Mint produces coins and Although the US Mint produces coins and the Bureau of Engraving and Printing the Bureau of Engraving and Printing prints Federal Reserve Notes, money is prints Federal Reserve Notes, money is created when one bank’s loans becomes created when one bank’s loans becomes another bank’s deposits and that bank another bank’s deposits and that bank uses much of the deposit to make uses much of the deposit to make another loan!another loan!

Money CreationMoney Creation

Since money includes all currency in Since money includes all currency in circulation plus the total deposits in circulation plus the total deposits in depository institutions, the process of depository institutions, the process of lending and depositing in successive lending and depositing in successive banks creates money. banks creates money.

This process of successive loans and This process of successive loans and deposits is called deposits is called money creation.money creation.

Money CreationMoney Creation

The money creation process is limited by The money creation process is limited by the amount of reserves banks choose to the amount of reserves banks choose to hold and can be affected by the amount hold and can be affected by the amount actually deposited in depository actually deposited in depository institutions.institutions.

However, reserve requirement delineate However, reserve requirement delineate an upper limit on the amount by which an upper limit on the amount by which money can be created through the money can be created through the successive deposit and loan process.successive deposit and loan process.

Money MultiplierMoney Multiplier

The simple money multiplier is the The simple money multiplier is the amount that an initial $1 increase in amount that an initial $1 increase in deposits will eventually add to the money deposits will eventually add to the money supply if banks lend all but their required supply if banks lend all but their required reserves and all of the borrowed money reserves and all of the borrowed money is deposited into a depository institution.is deposited into a depository institution.

Money MultiplierMoney Multiplier

The money multiplier can be found by The money multiplier can be found by dividing the required reserve ratio into dividing the required reserve ratio into one.one.

Money Multiplier = Money Multiplier = 1/required reserve 1/required reserve ratioratio

1/0.20 = 51/0.20 = 5 The money multiplier for our activity is 5.The money multiplier for our activity is 5.

Money MultiplierMoney Multiplier

With the $100,000 initial deposit, what is With the $100,000 initial deposit, what is the total amount the money supply could the total amount the money supply could expand in our example?expand in our example?

$100,000 X 5 = $500,000$100,000 X 5 = $500,000

Money CreationMoney Creation

If the Fed raised the required reserve If the Fed raised the required reserve ratio from 20 to 25 percent, how would ratio from 20 to 25 percent, how would the activity have been different?the activity have been different?

The money multiplier would be 1/0.25 = The money multiplier would be 1/0.25 = 4. Only $400,000 would have been 4. Only $400,000 would have been created by the process.created by the process.

Money CreationMoney Creation

In reality, the Fed changes the required In reality, the Fed changes the required reserve ratio very infrequently. reserve ratio very infrequently.

The last change occurred in 1992.The last change occurred in 1992.

Money CreationMoney Creation

If money is created when banks make loans, If money is created when banks make loans, how is money destroyed?how is money destroyed?

Money is destroyed when loans are repaid. Money is destroyed when loans are repaid. However, banks can use the proceeds from the However, banks can use the proceeds from the repaid loan to make another loan.repaid loan to make another loan.

Therefore, money is usually recreated to Therefore, money is usually recreated to replace the money destroyed when the loan replace the money destroyed when the loan was repaid.was repaid.