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Money Creation & Banking (The Monetary Multiplier (The monetary…

- - - - Loan Negotiation:
        
        When a bank makes loans, it creates money
        
        Much of the money used in the US therefore is created through the extension of credit by commercial banks.
        This checkable-deposit money may be thought of as "debts" of commercial banks and thrift institutions.
        Checkable deposits are bank debts in the sense that they are claims that banks and thrifts promise to pay "on demand".
        
        Check drawn on loan:
        
        A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves.
        When it lends, the lending bank faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it. If that happens, it will lose (to other banks) reserves equal to the amount it lends. So, to be safe, it limits its lending to the amount of its excess reserves.
        
        If a bank creates checkable-deposit money when it lends its excess reserves, is money destroyed when borrowers pay off loans? YES
        
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  - - - Buying Government Securities:
        
        The bank accepts government bonds (which are not money) and gives the securities dealer an increase in its checkable deposits (which are money).
        Of course when the securities dealer draws and clears a check for the full amount the bank loses both reserves and deposits in that amount and then just meets the legal reserve requirement.
        
        Finally, the selling of government bonds to the public by a commercial bank - like the repayment of a loan - reduces the supply of money. The securities buyer pays by check, and both "Securities" and "Checkable Deposits" decline by the amount of the sale.
        
        New money is created when banks buy government bonds from the public; money disappears when banks sell government bonds to the public.
- - - - Although the Fed pays interest on excess reserves, bank may be able to obtain higher interest rates by temporarily lending the reserves to other banks in the federal funds market; the interest rate on such loans is the federal funds rate.
- - - - To answer this question we will make 3 simplifying assumptions:
        
        Initially all banks are meeting this 20 percent reserve requirement exactly. No excess reserves exist; or, in the parlance of banking, they are "loaned" up" (or loaned out") fully in terms of the reserve requirement.
        
        If any bank can increase its loans as a result of acquiring excess reserves, an amount equal to those excess reserves will be lent to one borrower, who will write a check for the entire amount of the loan and give it to someone else, who will deposit the check in another bank. This third assumption means that the worst thing possible happens to every lending bank - a check for the entire amount of the loan is drawn and cleared against it in favour of another bank.
        
        The reserve ration for all commercial banks is 20 percent.
        
        The banking system's lending potential
        
        Bank A:
        
        Bank B:
        
        Bank C:
        
        Expansion of the Money Supply by the Commercial Banking System:
        
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- - - - The monetary multiplier exists because the reserves and deposits los by one bank become reserves of another bank. It magnifies excess reserves into a larger creation of checkable-deposit money.
        The monetary multiplier m is the reciprocal of the required reserve ratio R (the leakag into required reserves that occurs at each step in the lending process).
  - - - In this formula, m represents the maximum amount of new checkable-deposit money that can be created by a single dollar of excess reserves, given the value of R. By multiplying the excess reserves E by m, we can find the maximum amount of new checkable deposit money, D, that can be created by the banking system.
        
        Maximum Checkable-Deposit Creation = excess reserves x monetary multiplier
        
        Symbols: D = E x m
        
        Example: D = $80 x 5 = $400
  - - - Higher reserve ratios mean lower monetary multipliers and therefore less creation of new checkable-deposit money via loans; smaller reserve ratios mean higher monetary multipliers and thus more creation of new checkable-deposit money via loans.
  - - - Loan repayment, in effect, sets off a process of multiple destruction of money the opposite of the multiple creation process. Because loans are both made and paid off in any period, the direction of the loans, checkable deposits, and money supply in a given period will depend on the net effect of the two processes.
        
        If the dollar amount of loans made in some period exceeds the dollar amount of loans paid off, checkable deposits will expand and the money supply will increase.
        
        If the dollar amount of loans is less than the dollar amount of loans paid off, checkable deposits will contract and the money supply will decline.