What Do Banks Do?

  • Banks are financial intermediaries that use liquid assets in the form of bank deposits to finance illiquid investment of borrowers

  • Banks have restrictions on how much they allowed to lend out

  • Currency in bank vaults and deposits held at the Federal Reserve are called bank reserves (not part of currency in circulation)


  • If Park's Place Bank has loans of $1,000,000 and reserves of $100,000 with deposits of $1,000,000, then how would the t-chart look like?

Assets Loans Reserves Liabilities Deposits $100,000

  • Another example

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The Problem of Bank Runs

  • Banks have no problems on most days because only a fraction of its depositors want their funds disbursed in cash

  • But what if all depositors tried to withdraw their money all at once? What would happen?

  • If there's a rumor about financial trouble with a particular bank, depositors might leisurely withdraw their funds. At first.

  • More depositors will follow suit and then it creates a panic because the thought of other depositors panicking actually does lead to a panic

  • A self-fulfilling prophecy

Bank Regulation

  • Deposit Insurance

    • Currently, the Federal Deposit Insurance Corporation (FDIC) insures your deposits of up to $250,000
  • Capital Requirement

    • To avoid a "moral hazard," banks are required to have capital worth at least 7% of its assets
  • Reserve Requirement

    • The Required Reserve Ratio (RRR) stipulates that banks must keep a certain percentage of its check deposits as cash

    • Currently, it's at 10% or 0.10

  • In emergency situation like 9/11, the Fed will lend directly to banks through the discount window

Money Creation

  • Money Creation Process

table 25.1 How Banks Create Money First stage: Silas keeps his cash
under his bed. Second stage: Silas deposits cash in First Street Bank,
which lends out $900 to Mary, who then pays it to Anne Acme. Third
stage: Anne Acme deposits $900 in Second Street Bank, which lends out
$810 to another borrower. Currency in circulation $1 ,ooo 900 810
Checkable bank deposits $0 1 ,ooo 1 ,900 Money supply $1 ,ooo 1 ,900

  • Money Multiplier Formula

    • Excess reserves are a bank's reserves that's above and beyond the Required Reserve Ratio (RRR)

    • If the RRR is 10% with a $1 million in checking deposits, the excess reserves initially would be $900,000

    • Assume no "leaks" and that bank lend out all excess reserves, how much would a $1 million deposit increase the money supply by?

    • Initial Deposit * 1/RRR = Increase in Money Supply

    • $1 million * 1/0.10 = $10 million increase

  • Real World Money Multiplier

    • Not all people will deposit money in the banking system; some will hold onto cash

    • Difference between Monetary Base and Money Supply

    • Monetary Base = Currency in Circulation + Bank Reserves

    • The Federal Reserve controls the monetary base

    • Money Supply = Currency in Circulation + Checkable Bank Deposits

    Monetary base Bank reserves Currency in circulation Money supply
Checkable bank deposits

  • Money multiplier is the ratio of the money supply to the monetary base

  • In normal times, the money multiplier is ~1.9

  • In 2008, the money multiplier was smaller at ~0.8

  • Banks lent out even less money, thus more money "leaked" out of the system

Practice Questions

  • The amount of money that banks hold onto that's not part of the Required Reserve Ration, or RRR, is called which of the following?

    a. Surplus reserves

    b. Excess reserves

    c. Reserve requirement

    d. Monetary base

    e. Money supply

    Answer: b

  • How will each of the following affect the money supply through the money multiplier process?

    • People hold less cash

      • More money for banks

      • Increase in money supply

    • Banks hold more excess reserves

      • Less money let out

      • Decrease in money supply

    • The Federal reserves decreases the Required Reserve Ratio (RRR)

      • Initial Deposit / RRR = Increase in Money Supply

      • Increase in money supply

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