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Money Creation by Banks

The Banking System and Money Creation

Banks and Other Financial Intermediaries
A financial intermediary is an institution that
amasses funds from one group and makes them
available to another.
Pension funds, insurance companies, and mutual
funds are all financial intermediaries.
A bank is a financial intermediary that accepts
deposits, makes loans, and offers checking accounts.

Non-bank financial intermediaries have become

more and more like banks and have assumed a
larger and larger share of the nations total financial
Banks are tightly regulated but non-bank financial
intermediaries are less tightly regulated.

Bank Finance and a Fractional Reserve System

A balance sheet is a financial statement showing
assets, liabilities, and net worth.
Assets are anything that is of value.
Liabilities are obligations to other parties.
Net worth equals assets less liabilities.
Banks make profits by earning more interest on loans
than they have to pay to pay depositors along with
other costs.

Banks must hold some of depositors cash in

reserves, but they may lend out the rest.
A system in which banks hold reserves whose value
is less than the sum of claims out-standing on those
reserves is called a fractional reserve banking

Money Creation
Required reserves plus excess reserves equal total
Required reserves are the quantity of reserves
banks are required to hold.
Excess reserves are any reserves banks hold in
excess of required reserves.
The required reserve ratio is the ratio of reserves to
checkable deposits banks are required to maintain.
When a bank has no excess reserves, it is loaned up.
Bank transactions can be presented on a bank

When a depositor deposits cash into his checking

account, the money supply does not change.
There is less cash in circulation and more money in
checkable accounts than before.
Money deposited in banks is divided between
required reserves and loans.
New loans generate more cash in circulation or more
checkable deposits.
Part of the new money is returned to some bank
somewhere as additional deposits that are divided
between required reserves and loans and the process
starts over again.

Eventually, all of the initial new deposit is used up in

required reserves. The total amount of money in
checkable accounts has expanded, thereby increasing
the money supply.
If the initial action had been to withdraw money from a
checkable account, the process would have continued
as above but in a negative direction.

The Deposit Multiplier

The deposit multiplier (md ) equals the ratio of the
maximum possible change in checkable deposits divided
by the change in reserves that created it.
R = rrD where R equals reserves, rr equals required
reserve ratio, and D equals checkable deposits.
.R = rr .D.
1/rr = .D/.R = md .

The Regulation of Banks

Banks are among the most heavily regulated of
financial institutions.
Regulations help protect depositors against corrupt
business practices.
Regulations help prevent crises of confidence.
Regulations help control the quantity of money.

Deposit Insurance
Deposit insurance is provided by the Philippine
Deposit Insurance Corporation (PDIC).
Having insurance may make banks take greater risks
than they would otherwise.
Regulations to Prevent Bank Failure
Banks are severely limited in what they can do.
Regulators routinely perform audits.
The PDIC has the power to close a bank whose net
worth has fallen below the required level.