1. *HOW BANKS
CREATE MONEY
MODULE 25

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.

9. * REQUIRED RESERVES
*

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?