Creation of money from banks

Making Loans to Create Deposits

How do banks essentially create money? Assume that there are two banks: bank A and bank B.

Let’s say that bank A has an excess of reserves, and bank B is short on reserves. Bank A decides to use some of its reserves to pay bank B. What has exactly happened?

For bank A:

1. The reserves have decreased.
2. The loans have increased.

For bank B:

1. The reserves have increased.
2. The deposits have increased

If we were to look at the whole banking system, we see that the amount of reserves has not changed, but the amount of loans has increased the amount of deposits. In other words, we have just created money.

There are 3 factors which limit the quantity of loans and deposits.

1. The Monetary Base: is the sum of Federal Reserve notes, coins, and deposits at the Fed. The size of this limits how much money the banks can make. This is due to banks having a desired reserve, and households having a desired amount of currency to hold.


2. Desired Reserves: is the amount of reserves that a bank plans to hold. The desired reserves are determined by the desired reserve ratio, which is the ratio of reserves to deposits that a bank plans to hold. In other words,
   
   Desired Reserve Ratio = $\frac{Desired\;Reserves} {Deposits} = \frac{R} {D}$
   Note: This is different from the required reserves, which is the minimum amount of reserves that a bank must hold.


3. Desired Currency Holding: is the amount of currency a household or firm plan to hold.
   
   How much currency a household or a firm plan to hold or put in the bank deposits depends on how they choose to make payments. For example, would they rather use cash, a debit card or a credit card to make payments? Payment changes happen slowly and will also slowly change the ratio of desired currency to deposits.
   
   
   Desired Currency Holding Ratio = $\frac{Desired\;Currency} {Deposits} = \frac{C} {D}$

At any given time, this ratio is fixed. So,

1. If bank deposits $\, \uparrow \,$, then desired currency $\, \uparrow \,$.
2. If bank deposits $\, \downarrow \,$, then desired currency $\, \downarrow \,$.

Note: Since an increase in bank deposits increases desired currency holdings, then some of the currency leaves the bank, which decreases reserves. We call this leakage of bank reserves the currency drain.


The Process of Creating Money

The process of creating money occurs when there is an increase in monetary base, which happens when the Fed buys securities from banks and other institutions. The process of creating money has a total of 8 steps:

1. Banks have excess reserves


2. Banks lend excess reserves


3. Loans and deposits increase, so the quantity of money increases.


4. New money is used to make payments


5. Some of the new money remains in deposit


6. Some of the new money is a currency drain.


7. Desired reserves increase because of the increase in deposit.


8. Excess reserves decrease.

Note: the opposite of the 8 steps happens when the Fed sells securities.


Money Multiplier

The money multiplier is the following formula:

Money Multiplier = $\frac{Change\;in\;quantity\;of\;Money} {Change\;in\;Monetary\;Base} = \frac{\Delta M} {\Delta MB}$

Example: If a $1 million increase in the monetary base increases the quantity of money by $3 million, then

Money Multiplier = $\frac{3\; million} {1\;million} =$ 3

Note: The smaller the desired reserve ratio and the smaller the currency drain ratio, the larger the money multiplier is.