Money creation

1. Money CreationMoney Creation
Ms. RossMs. Ross
Spring 2007Spring 2007

2. Jack and the Jack and the
BeanstalkBeanstalk
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!

3. Jack and the Jack and the
BeanstalkBeanstalk
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.

4. 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.

5. 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.

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

7. Post Money Creation Post Money Creation
Activity:Activity:
Although the US Mint produces coins Although the US Mint produces coins
and the Bureau of Engraving and Printing and 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!

8. 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.

9. 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.

10. 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.

11. 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.

12. 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

13. 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.

14. 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.

15. 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.