Ec. 132 Harold Petersen
Principles of Economics-Macro Feb. 18, 2014
Lecture 9: Banking and the Supply of Money
We looked last time at money and demand for money. Then we began to
talk about the banking system. We noted we have two types of banks--
commercial banks and central banks. A commercial bank is a business firm that
provides services in the hope of earning a profit. A central bank is a public
institution with social responsibilities. Let's begin now to look at commercial
banks in some detail. Commercial banks as we know them grew out of the
activities of the goldsmiths in the Middle Ages. Goldsmiths worked with gold, as
did blacksmiths with iron or coppersmiths with copper. Gold was also the
dominant form of money and was valuable. Goldsmiths of necessity developed
secure vaults, to forestall robbery. Households and business firms who had gold
as money began to bring it to the goldsmiths for safekeeping. They did so, for a
fee, much as in checking parcels or parking your car in a garageWhen people
needed to make a transaction they came to the goldsmith to get their gold or a
part of it.
Gradually the goldsmiths discovered that people didn't care if they got
back their own gold, so long as what they got was equivalent in weight and purity
(and thus purchasing power as money). Thus they could mingle the accounts, or
put all the gold in one pile. The goldsmiths would give the depositors a
warehouse receipt, which could be redeemed for gold at any time. But this was
inconvenient. So depositors began to use the warehouse receipts as a means of
payment. The warehouse receipts became a form of paper money, which was
accepted because it could be exchanged for gold.
Then the goldsmiths began to honor checks, or instructions from one
customer to pay money from their account to another. They found that through
the use of warehouse receipts as paper money and payment through checks, that
the total amount in the vault didn’t change very much. Most people just left
their gold with the goldsmiths for safekeeping.And the total stayed pretty
much the same. Then they began to lend or invest a portion of the gold,
keeping some fraction of deposits on reserve. Thus came fractional reserve
banking . The bank is best understood by looking at its balance sheet. Shown
below are a goldsmith with 100% reserves and then with fractional reserves:
Assets Liabilities Assets Liabilities
Gold 1000 Dep 1000 Gold 100 Dep 1000
But what happens to the gold that is loaned to customers? Typically the
customer borrows to pay a bill or to buy something. But the recipient of the
money brings it back to the bank or to another bank. Thus even the act of 2
lending does not significantly reduce the amount of gold in the vaults, Rather it
increases the amount of deposits. Let's look now at expansion of loans and
deposits through the banking system. Gold has been replaced by paper money,
and reserves can be held either as currency in the vaults or as deposits with the
Federal Reserve System. (More about this later.)
Let's assume that banks are required by law to hold 10% of their deposits
on reserve and that they lend out the rest of it. Assume that all banks hold the
legally required reserves.
A typical bank Bank A, might initially look like this in terms of its balance
Assets Liabilities and Net Worth
Reserves 10,000 Demand Deposits 100,000
Other Assets 7,000 Net Worth 8,000
Total Assets 108,000 Liab. & Net Worth 108,000
We call this a balance sheet because the assets, or things of value, are balanced
by the claims against them. Think of the reserves as cash. Loans are money
due from people who have borrowed. In that sense they are things of value.
Other assets might include buildings and equipment. Deposits are the money put
in the bank by customers, payable on demand. It is a liability of the bank because
it is owed to the customers and must be paid out to them on demand (or paid to
others through writing checks). Net Worth is Assets minus liabilities, or it is the
owners’ claim against the assets after all debts have been paid. Let’s suppose
that the bank is required by law to hold reserves equal to 10% of its demand
deposits, and that initially it just meets the requirement.
Now some customer of Bank A, Stan Smith, makes a new deposit of $1000
in Bank A. Smith takes the money from his mattress and puts it in the bank. The
bank holds 10%, or 100, in reserve and lends the 900 to a customer, Mary Jones.
When Jones borrows the money, she signs an IOU (loan contract) and receives a
deposit slip noting that $900 has been deposited in her account.
Bank A Chk Bank B
Res 1000 Dep 1000 (Smith) Chk 900 Dep 900 (O'Leary)
Loans 900 Dep 900 (Jones)
But Jones does not borrow the money to leave it in a checking account,
but rather to pay a bill or to buy something. Jones writes a check for 900 to
Gladys O'Leary, who deposits the 900 in her bank, Bank B. Bank B now has the 3
check from M. Jones as an asset and the dep. of G. O'Leary as a liability. Bank B
sends the check back to Bank A and gets 900 of Reserves in return. Bank A
notes the reduction in its Res of 900 and reduction in dep. (M. Jones) of 900.
___________Bank A____________ ___________Bank B__________
Res 100 Dep 1000 (Smith) Res 900 Dep 900 (O'Leary)
The net impact of Bank A's lending has been to create a new deposit, first in its
own bank (Jones), and then in Bank B as Jones pays the 900 to O'Leary. But
Bank B now has excess reserves and can make new loans. Bank B lends 810 to a
customer, Brown, who deposits the 810 in her account, and then pays it out.
And the 810 turns up in another bank, Bank C, which now has excess reserves.
We can summarize the process in a single table, as in the text on page 180 (p.
526 in the hardcover version).
Bank New New New
Deposits Loans Reserves
Bank A 1000 900 100
Bank B 900 810 90
Bank C 810 729 81
Bank D 729 656 73
banks 10,000 9000 1000
Note that the original deposit in Bank A has been multiplied throughout the
system by a factor of 10. New loans have been expanded by 9000. We call this
process the multiple expansion of loans and deposits throughout the banking
We have a bank multiplier, or money supply multiplier, which is equal to one
over the reserve requirement.
MSM = 1/RR. In this case the multiplier is equal to 1/.10 = 10
Let's look now at commercial bank behavior, and then at central banking.
Recall that the commercial bank is a business firm--it provides services for which
it hopes to earn a profit. For the most part it earns its profit by lending out
depositor's money and charging interest on the loans. Depositors accept this in
return for either free or low-cost checking, and they may even receive interest on
their checking accounts.
Note that the bank is a thin -equity organization. (It's equity or net
worth is a small part of its total assets--perhaps 7% on average.) 4
_Typical Commercial Bank_
Res 10 Deposits 93
L & I 90 Equity 7
As such it is vulnerable to rather minor fluctuations in the value of its assets. It is
well advised to stay away from investments in common stocks and even real
estate ventures unless they are protected by substantial investments by the
developers as well.
It is useful to look at the banker's job as that of managing portfolio ,
or a collection of assets, in light of three objectives:
1) profitability--the bank