How Banks Expand the Money Supply
Learning Objectives
By the end of this section, you will be able to:
- Utilize the money multiplier formulate to determine how banks expand the money supply
- Analyze and create T-account balance sheets
- Evaluate the risks and benefits of money and banks
Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. In this section we will take an orthodox approach to money and see how banks can expand on a given amount of deposits to create more money than initially existed. Before we can do that, however, we need to understand a bit of accounting.
A Bank’s Balance Sheet
A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own with an expectation that it will produce income for you in the future. For example, you might own shares in a corporation that you expect to pay dividends in the future. If you own a home, this is also considered an asset because you could rent it out or sell it for cash in the future. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, the home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability), which is also called equity.
In the case of a company’s balance sheet, net worth is called shareholders’ equity, the net value of the company as an asset to the owners (the shareholders) of the company. A bank’s balance sheet operates in the same way. A bank’s net worth is called bank capital. Its assets include cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called “reserves”), loans that it makes to customers, and bonds.
[link] illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under “Assets” and “Liabilities,” we sometimes call it a T-account.
The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank (also called bank capital or shareholders’ equity) is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth.
When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank marks up both a liability and an asset. The money deposited goes into the bank’s vault (or the electronic equivalent in reserves at the Federal Reserve), and that money is the bank’s asset. The bank could, likewise, use that money to buy other assets, like government bonds. But the account of the depository also gets marked up by the amount of a deposit, and the account is the bank’s liability. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in Figure 1, the Safe and Secure Bank holds $10 million in deposits.
Loans are the first category of bank assets in Figure 1. When a bank makes a loan, the borrower agrees to repay the amount of the loan (the principle) plus interest. Since, to the bank, this is an expected future income, then the loan itself is an asset to the bank; and, of course, a liability to the borrower. On the other side of this transaction, however, the bank is giving the borrower money when it makes the loan, and we can think of this as adding the money to the borrower’s checking account. Since the money in a checking account is a liability to the bank and an asset to the account holder, then we actually have to sets of asset-liability relationships, the loan itself and checking account, that mirror each other and that would be in the same amounts except for the interest owed on the loan. In a later section of this chapter, you’ll see that the accounting involved in bank loans has important implications for our understanding of banking, and indeed money in general.
The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.
The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.
We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in Figure 1, net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive.
For some concrete examples of what banks do, watch this video from Paul Solman’s “Making Sense of Financial News.”
Money Expansion by a Single Bank
Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in Figure 2. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either.
The Federal Reserve requires Singleton Bank to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.
This change in business plan alters Singleton Bank’s balance sheet, as Figure 3 shows. Singleton’s assets have changed. It now has $1 million in reserves and a loan to Hank’s Auto Supply of $9 million. The bank still has $10 million in deposits.
Singleton Bank lends $9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer will not allow let Hank to walk out of the bank with $9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 4 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest
Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which one can easily use as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously as Hank’s Auto Supply writes checks to pay its bills the deposits will draw down. However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million.
Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack’s Chevy Dealership as Figure 5 shows.
If Jack’s deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 6 shows.
How is this money creation possible? In the orthodox economics view, it is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.
Watch this video to learn more about how banks create money.
The Money Multiplier and a Multi-Bank System
In a system with multiple banks, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank’s Auto Supply into First National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand.
In a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier. This tells us by how many times a loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks.
Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is:
We then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation.
Using the Money Multiplier Formula
Using the money multiplier for the example in this text:
Step 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10.
Step 2. We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:
Cautions about the Money Multiplier
The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.
The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan.
Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as “mattress savings,” or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.
Watch a video of Jem Bendell discussing “The Money Myth.”
Money and Banks—Benefits and Dangers
Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.
However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The 2008–2009 Great Recession illustrated this pattern.
The Many Disguises of Money: From Cowries to Bit Coins
The global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards.
The latest creation and perhaps one of the purest forms of fiat money is the Bitcoin. Bitcoins are a digital currency that allows users to buy goods and services online. Customers can purchase products and services such as videos and books using Bitcoins. This currency is not backed by any commodity nor has any government decreed that it is legal tender, yet customers use it as a medium of exchange and can store its value (online at least). It is also unregulated by any central bank, but is created online through people solving very complicated mathematics problems and receiving payment afterward. Bitcoin.org is an information source if you are curious. Bitcoins are a relatively new type of money. At present, because it is not sanctioned as a legal currency by any country nor regulated by any central bank, it lends itself for use in illegal as well as legal trading activities.
Summary
We define the money multiplier as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. The network of banks making loans, people making deposits, and banks making more loans creates much of the money in an economy.
Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe.
References
Bitcoin. 2013. www.bitcoin.org.
National Public Radio. Lawmakers and Regulators Take Closer Look at Bitcoin. November 19, 2013. http://thedianerehmshow.org/shows/2013-11-19/lawmakers-and-regulators-take-closer-look-bitcoin.
Glossary
- money multiplier formula
- total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money
an accounting tool that lists assets and liabilities
something of value that you own with an expectation that it will produce income for you in the future
a debt or something you owe
asset value minus how much is owed (the liability); also called equity
a financial contract through which a borrower like a corporation, a city or state, or the federal government agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future
money that a bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments
total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money