| Exercises | On the Net I Economics Consultants I Added Perspective |
| Review | Interactive Quiz I PowerPoint Review Slides I More Study Aids |
| Research |
Chapter in a Nutshell
The fundamental idea that explains how banks create money is the fractional reserve system. Fractional reserve simply means that banks have to keep in their vaults or at the Federal Reserve Bank only a fraction of what people deposit in their banks, even though these people have the right to withdraw their deposits on demand (which is why their deposits are called demand deposits). How can banks honor a promise to return deposits to people when their deposits aren't there? The answer is that customarily people don't ask for their deposits, certainly not all, and not all at one time. That's what banks count on and, most of the time, it works.
What do banks do with the deposits, if they're not there? That's the "creation" story. When a bank receives a new deposit, it can loan out a portion of the deposit, keeping a fraction of the deposit on hand as reserves. The Federal Reserve System (the Fed) determines how large that fraction held in reserves must be. That's why they are called required reserves. When the borrower who took out the loan spends it on, say, building a house, the housebuilder now has the money and deposits it in his own bank. This second bank is now able to loan a portion of this new deposit, keeping on hand a fraction as required reserves. Its own loan provides income for someone else who deposits it in a third bank, and so on. The process repeats and the money supply expands.
This money creation process doesn't go on forever because each round of deposits is smaller as more reserves must be set aside. Stretching it out, the new deposits eventually become close to zero. How much, then, does an initial deposit create in terms of total new deposits? The answer is found by using the potential money multiplier, which is 1/LRR, where LRR is the legal reserve requirement (in percentage terms).
The money supply is unlikely to expand to the extent indicated by the potential money multiplier for two reasons. First, banks may prefer to hold reserves in excess of those required. These are called excess reserves. Second, and more important, people may simply not borrow sufficiently to exhaust the full amount of the available reserves.
The money creation process can also run in reverse gear. When someone makes a withdrawal, it means the bank's loans are more than its new and lower deposits can support. It must reduce its loans. But that creates its own round-after-round sequence of loan and deposit reductions.
Banks sometimes fail when a large portion of the loans they made are not repaid. When people learn that someone else's bank is failing, they become nervous about their own deposits and may choose to withdraw them. If many people behave this way, they may cause a "run on the bank." If an exceptionally large number of withdrawals take place in a short period of time, loans must be called in, reducing the money supply and real GDP. The Federal Deposit Insurance Corporation was created to insure depositors' deposits up to $100,000 so they would be less anxious about the security of their deposits.
However, in spite of the FDIC and regular bank audits, banks do fail. During the 1980s and the early 1990s, bank failure rates rose significantly. A variety of causes account for these increased rates of bank failure. Savings and loans associations (S&Ls) also went through a difficult period during the 1980s as banks began to compete with them in the home mortgage market. Savings and loans failures were so extensive in the 1980s that a special government-sponsored corporation, the Resolution Trust Corporation, had to be established to handle the claims of depositors and creditors of the failed S&Ls.
In the absence of intervention by a central bank like the Fed, banking practice would tend to exacerbate the phases of the business cycle. During recession, a bank is less likely to lend for fear of not being repaid. The money supply shrinks as outstanding loans are called in, causing the interest rate to rise and the quantity of investment to fall, just when investment is needed the most. During prosperity, banks are more inclined to lend, which causes the money supply to grow more rapidly than otherwise, resulting in lower interest rates and more borrowing. With the economy near or at full employment, it creates an upward pressure on the price level. The Fed can counteract these outcomes by using some of its monetary tools.
After studying this chapter, you should be able
to:
· Explain the concept of a fractional reserve banking system.
· Describe how banks can create money by making loans based on new deposits.
· Calculate the amount of money a banking system can create given a new deposit and the legal reserve
requirement.
· Explain why banks may keep excess reserves.
· Show how the money supply shrinks when loans are repaid.
· Present reasons for bank failures.
· Justify the need for deposit insurance and bank audits.
· Recount events associated with the savings and loan crisis of the 1980s.
· Explain how a central bank can help to stabilize the banking system and manipulate the money supply
to dampen the business cycle.
• The Federal Deposit Insurance Corporation (FDIC) (http://www.fdic.gov/) insures demand deposit accounts in participating banks.
[Return to Start]Steve Scariano graduated from the University of Toronto with a degree in journalism. After a brief stint with CJAD radio in Montreal, Steve was hired by CNN as a researcher in its news department. His first project is to write a primer for the network's business correspondents on banks and the banking system in the United States.
While Steve, a native Canadian, studied economics in college, he is unfamiliar with the intricacies of the U.S. banking system. He can write succinctly, but he desperately needs a refresher course on money and banking if he is to do the job well. He has heard great things about Economic Consultants, and he asked CNN to hire the firm to assist him. CNN has agreed. You are assigned the task of preparing a report for Steve that addresses the following issues:
• FDIC's Learning Bank
(http://www.fdic.gov/learning/index.html)
The Federal Deposit Insurance Corporation (FDIC) educates the public about banks, banking, and the FDIC.
• The Federal Reserve
(http://www.bog.frb.fed.us/)
The Federal Reserve provides a detailed description of its operations.
• The Federal Reserve System's National Information
Center (NIC)
(http://www.ffiec.gov/nic/)
The NIC has news, data, and information about banks.
• The Fed: Our Central Bank
(http://www.chi.frb.org/pubs-speech/publications/BOOKLETS/
fed_central/fed_central.html)
The Chicago Federal Reserve bank publishes this pamphlet on the workings of the Federal Reserve.
• Bank Web Directory of Banks
(http://www.bankweb.com/bankweb.html)
BankWeb Directory of Banks maintains a directory for over 1,500 banks in the United States.
• American Banker
(http://www.americabanker.com/)
American Banker is a journal providing banking and financial services information.
• Bank Watch
(http://www.bankwatch.com/)
Thomason BankWatch provides research and analysis on over 1,000 financial institutions in more than 85
countries.
• bankinfo.com
(http://www.bankinfo.com/)
bankinfo.com is a daily online magazine for the banking and financial services industry.
• ABA Banking Journal
(http://www.banking.com/aba/)
ABA Banking Journal is an online magazine devoted to the banking industry.
• Faulkner & Gray
(http://www.faulknergray.com/banking/index.htm)
Faulkner & Gray publishes a number of banking journals and newsletters, many of which are available
online.
• Bank Rate Monitor
(http://www.bankrate.com/)
Bank Rate Monitor surveys more than 2,500 institutions to provide more than 1,600 pages of bank interest
rates.
Added Perspective: More on the Net
• Visit a few cyberspace banks, such as U.S. Bank (http://www.usbank.com/online/) and Security First Network Bank (http://www.sfnb.com/). How are their services different from those of your local bank? Also review Office of Thrift Supervision materials on electronic banking (http://www.ots.treas.gov/ebanking.html). The ots regulates federally chartered savings and loans.
• Visit the FDIC (http://www.fdic.gov/). What is the latest information on moral hazard?
[Return to Start]Test your understanding of the chapter's concepts with the interactive quiz. The quiz contains twenty multiple-choice questions, like those found on a typical exam. Questions include detailed feedback for each answer, so that you may know instantly why you have answered correctly or incorrectly. In addition, you may email yourself and/or your instructor the results of the quiz, with a listing of correct and incorrect answers. Finally, check your results versus other students around the world -- previous scores to quizzes are displayed online.
How to Take the Quiz
Start the quiz, type in your name
(required), your email address (optional), and the email address of your instructor (optional). Answer
the questions (as many or as few as you like, but you need to answer at least one question). Then hit
the submit button and see your results. At the results page, click on the link in the "description"
column to see feedback on your answers. Scroll down the page to see quiz results from students around
the world.
(c) 1999 South-Western College Publishing,
All Rights Reserved
webmaster