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*HOW BANKS
CREATE MONEY
   MODULE 25
*COMMERCIAL BANKS CREATE AND
            DESTROY MONEY

*How   can a commercial bank create
money? If it can create money, it can
destroy money, too.
*We’ll  begin with the organization of a
local commercial bank.
*COMMERCIAL BANKS CREATE AND
              DESTROY MONEY
*TRANSACTION 1: Creating a Bank
*Suppose the citizens of Nebaj,         Quiche
decide their town needs a new commercial
bank to provide banking services for that
growing community. Once they obtain the
permit for their bank, they turn to the task of
selling Q250,000 worth of capital stock
(equity shares) to buyers, both in and out of
the community. The Bank of Nebaj comes
into existence. What does its balance sheet
look like at this stage?
* FORMATION OF A COMMERCIAL BANK
The bank now has Q250,000 worth of capital stock
outstanding. This cash is an asset to the bank.
Cash held by a bank is called vault cash. These
shares of stock outstanding constitute an equal
amount of claims that owners have against the
bank’s assets. These shares of stock constitute
the net worth of the bank.
                      CREATING A BANK
                 Balance Sheet 1: Nebaj Bank
               ASSETS                 LIABILITIES
        Cash     Q250,000       Capital Stock Q250,000
* BUYING PROPERTY AND EQUIPMENT
TRANSACTION 2:              Acquiring Property and
Equipment
The directors of the bank purchase a building for
Q220,000 and pay Q20,000 for office equipment.
Now the balance sheet looks like this:
            ACQUIRING PROPERTY AND EQUIPMENT
               Balance Sheet 2: Nebaj Bank
             ASSETS                 LIABILITIES
          Cash   Q10,000      Capital Stock Q250,000
      Property   Q240,000
* DEPOSITS AT A COMMERCIAL BANK
TRANSACTION 3: Accepting Deposits
Now the bank is operating, suppose the citizens
and businesses of Nebaj decide to deposit
Q100,000 in the Nebaj bank. What happens to
the balance sheet?
            ACQUIRING PROPERTY AND EQUIPMENT
               Balance Sheet 2: Nebaj Bank
                 ASSETS              LIABILITIES
          Cash     Q110,000   Checkable
      Property    Q240,000        Deposits Q100.000
                               Capital Stock Q250,000
* CHANGE IN COMPOSITION OF THE MONEY
                       SUPPLY
Now the there has been no change in the
economy’s total supply of money as a result of
this transaction, but a change has occurred in the
composition of the money supply. Bank money, or
checkable deposits, has increased by Q100,000,
and currency held by the public has decreased by
Q100,000. Currency held by a bank, is not part of
the economy’s money supply.
A withdrawal of cash will reduce the bank’s
checkable deposit liabilities and its holdings of
cash by the amount of the withdrawal, which
would change the composition, but not the total
supply, of the money in the economy.
* REQUIRED RESERVES
All commercial banks that provide checkable
deposits must by law keep required reserves.
Required reserves are an amount of funds equal
to a specified percentage of the bank’s own
deposit liabilities.    A bank must keep these
reserve’s on deposit with the Federal Reserve
Bank in its district or as cash in the bank’s vault.
To simplify, we’ll the Bank of Nebaj keeps its
required reserves entirely as deposits in the Fed.
But remember: the vault cash is counted as
reserves, and real-world banks keep a significant
portion of their own reserves in their vaults.
* REQUIRED RESERVES
*
* DEPOSITING RESERVES AT THE FED
TRANSACTION 4:      Depositing Reserves in a
Federal Reserve Bank
Suppose the required reserve ratio for checkable
deposits in commercial banks is 1/5 or 20
percent. By depositing Q20,000 in the Federal
Reserve Bank, the Nebaj bank will just be
meeting the required reserve ratio between its
reserves and its own deposit liabilities.
But suppose that the Nebaj Bank anticipates that
its holdings of the checkable deposits will grow in
the future.
* DEPOSITING RESERVES AT THE FED
(2) Vault cash can be counted as reserves, we can
assume that all the bank’s cash is deposited in
the Fed and therefore constitutes the commercial
bank’s actual reserves. This way, we don’t need
to bother adding two assets – “cash” and
“deposits at the Fed” – to determine “reserves”.
After the Nebaj Bank deposits Q110,000 or
reserves, its balance sheet becomes:
                   Depositing Reserves at the Fed
                    Balance Sheet 4: Nebaj Bank
              ASSETS                      LIABILITIES
           Cash      Q0.00                 Checkable
        Reserves     Q110,000       Deposits      Q100,000
       Property      Q240,000       Capital Stock Q250,000
* EXCESS RESERVES
A bank’s excess reserves are found by subtracting
its required reserves from its actual reserves:
                  Excess Reserves =
       actual reserves – required reserves


                            In this case:
          Actual reserves                   Q110,000
          Required reserves                  - 20,000
          Excess reserves                   Q 90,000
* EXCESS RESERVES
The only reliable way to compute the excess
reserves is to multiply the banks checkable-
deposits by the reserve ratio to obtain the
required reserves (Q100,000 X .20 = Q20,000) and
then to subtract the required reserves from the
actual reserves listed on the asset side of the
bank’s balance sheet.
Test your understanding by computing the bank’s
excess reserves from balance sheet 4, assuming
that the required reserve ratio is: (1) 10 percent,
(2) 33⅓ percent, and (3) 50 percent.
* CHECK CLEARING PROCESS
The reserves created in transaction 4 are an asset
to the depositing commercial bank because they
are a claim this bank has against the assets of
another institution – the Federal Reserve Bank.
The checkable deposit you get by depositing
money in a commercial bank is an asset to you
and a liability to the bank.
In the same way, the reserves that a commercial
bank establishes by depositing money in a
banker’s bank are an asset to that bank and a
liability to the Federal Reserve Bank.
*   CLEARING A CHECK DRAWN AGAINST THE BANK

Assume that Juan Perez, a Nebaj farmer,
deposited a substantial portion of the Q100,000 in
checkable deposits that the Nebaj bank received
in Transaction 3. Now suppose that Juan buys
Q50,000 of farm machinery from the Caterpillar
Company of Guatemala City. Juan pays for his
machinery by writing a check for Q50,000, against
his account in the Nebaj Bank, to the Caterpillar
Co. How is this check collected or cleared, and
what effect does the collection of the check have
on the balance sheet of the banks involved in the
transaction?

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Module 25 banking and money creation practice

  • 2. *COMMERCIAL BANKS CREATE AND DESTROY MONEY *How can a commercial bank create money? If it can create money, it can destroy money, too. *We’ll begin with the organization of a local commercial bank.
  • 3. *COMMERCIAL BANKS CREATE AND DESTROY MONEY *TRANSACTION 1: Creating a Bank *Suppose the citizens of Nebaj, Quiche decide their town needs a new commercial bank to provide banking services for that growing community. Once they obtain the permit for their bank, they turn to the task of selling Q250,000 worth of capital stock (equity shares) to buyers, both in and out of the community. The Bank of Nebaj comes into existence. What does its balance sheet look like at this stage?
  • 4. * FORMATION OF A COMMERCIAL BANK The bank now has Q250,000 worth of capital stock outstanding. This cash is an asset to the bank. Cash held by a bank is called vault cash. These shares of stock outstanding constitute an equal amount of claims that owners have against the bank’s assets. These shares of stock constitute the net worth of the bank. CREATING A BANK Balance Sheet 1: Nebaj Bank ASSETS LIABILITIES Cash Q250,000 Capital Stock Q250,000
  • 5. * BUYING PROPERTY AND EQUIPMENT TRANSACTION 2: Acquiring Property and Equipment The directors of the bank purchase a building for Q220,000 and pay Q20,000 for office equipment. Now the balance sheet looks like this: ACQUIRING PROPERTY AND EQUIPMENT Balance Sheet 2: Nebaj Bank ASSETS LIABILITIES Cash Q10,000 Capital Stock Q250,000 Property Q240,000
  • 6. * DEPOSITS AT A COMMERCIAL BANK TRANSACTION 3: Accepting Deposits Now the bank is operating, suppose the citizens and businesses of Nebaj decide to deposit Q100,000 in the Nebaj bank. What happens to the balance sheet? ACQUIRING PROPERTY AND EQUIPMENT Balance Sheet 2: Nebaj Bank ASSETS LIABILITIES Cash Q110,000 Checkable Property Q240,000 Deposits Q100.000 Capital Stock Q250,000
  • 7. * CHANGE IN COMPOSITION OF THE MONEY SUPPLY Now the there has been no change in the economy’s total supply of money as a result of this transaction, but a change has occurred in the composition of the money supply. Bank money, or checkable deposits, has increased by Q100,000, and currency held by the public has decreased by Q100,000. Currency held by a bank, is not part of the economy’s money supply. A withdrawal of cash will reduce the bank’s checkable deposit liabilities and its holdings of cash by the amount of the withdrawal, which would change the composition, but not the total supply, of the money in the economy.
  • 8. * REQUIRED RESERVES All commercial banks that provide checkable deposits must by law keep required reserves. Required reserves are an amount of funds equal to a specified percentage of the bank’s own deposit liabilities. A bank must keep these reserve’s on deposit with the Federal Reserve Bank in its district or as cash in the bank’s vault. To simplify, we’ll the Bank of Nebaj keeps its required reserves entirely as deposits in the Fed. But remember: the vault cash is counted as reserves, and real-world banks keep a significant portion of their own reserves in their vaults.
  • 10. * DEPOSITING RESERVES AT THE FED TRANSACTION 4: Depositing Reserves in a Federal Reserve Bank Suppose the required reserve ratio for checkable deposits in commercial banks is 1/5 or 20 percent. By depositing Q20,000 in the Federal Reserve Bank, the Nebaj bank will just be meeting the required reserve ratio between its reserves and its own deposit liabilities. But suppose that the Nebaj Bank anticipates that its holdings of the checkable deposits will grow in the future.
  • 11. * DEPOSITING RESERVES AT THE FED (2) Vault cash can be counted as reserves, we can assume that all the bank’s cash is deposited in the Fed and therefore constitutes the commercial bank’s actual reserves. This way, we don’t need to bother adding two assets – “cash” and “deposits at the Fed” – to determine “reserves”. After the Nebaj Bank deposits Q110,000 or reserves, its balance sheet becomes: Depositing Reserves at the Fed Balance Sheet 4: Nebaj Bank ASSETS LIABILITIES Cash Q0.00 Checkable Reserves Q110,000 Deposits Q100,000 Property Q240,000 Capital Stock Q250,000
  • 12. * EXCESS RESERVES A bank’s excess reserves are found by subtracting its required reserves from its actual reserves: Excess Reserves = actual reserves – required reserves In this case: Actual reserves Q110,000 Required reserves - 20,000 Excess reserves Q 90,000
  • 13. * EXCESS RESERVES The only reliable way to compute the excess reserves is to multiply the banks checkable- deposits by the reserve ratio to obtain the required reserves (Q100,000 X .20 = Q20,000) and then to subtract the required reserves from the actual reserves listed on the asset side of the bank’s balance sheet. Test your understanding by computing the bank’s excess reserves from balance sheet 4, assuming that the required reserve ratio is: (1) 10 percent, (2) 33⅓ percent, and (3) 50 percent.
  • 14. * CHECK CLEARING PROCESS The reserves created in transaction 4 are an asset to the depositing commercial bank because they are a claim this bank has against the assets of another institution – the Federal Reserve Bank. The checkable deposit you get by depositing money in a commercial bank is an asset to you and a liability to the bank. In the same way, the reserves that a commercial bank establishes by depositing money in a banker’s bank are an asset to that bank and a liability to the Federal Reserve Bank.
  • 15. * CLEARING A CHECK DRAWN AGAINST THE BANK Assume that Juan Perez, a Nebaj farmer, deposited a substantial portion of the Q100,000 in checkable deposits that the Nebaj bank received in Transaction 3. Now suppose that Juan buys Q50,000 of farm machinery from the Caterpillar Company of Guatemala City. Juan pays for his machinery by writing a check for Q50,000, against his account in the Nebaj Bank, to the Caterpillar Co. How is this check collected or cleared, and what effect does the collection of the check have on the balance sheet of the banks involved in the transaction?