When a customer makes a deposit into his account at a bank, this creates a liability for the bank. A liability describes the bank's obligations, or what it owes to others. In other words, the bank is liable for the amount of the deposit. On the other side of the coin, the deposit creates an asset for the bank. The bank now owns the value of the deposit and will put the money to work, looking for a rate of return that exceeds the interest it pays on the liability. This is the business of banking. By offering savers a return (and/or other services), banks take in deposits (liabilities), which creates assets that a bank can lend out. As long as the total return on assets exceeds the payment on liabilities (and other costs of doing business) the bank is profitable.
When a bank receives a deposit, it must keep a portion on reserve with the Federal Reserve (Fed) and pay a deposit insurance premium to the FDIC. At the present time, the Fed's reserve requirement is 10%. With this in mind, let us use a few balance sheets to demonstrate how banks create money from deposits. We will see that for every dollar deposited, the money supply increases by a multiple of the amount deposited.
Let us first examine the balance sheet of Glen Echo Bank. We see in Table 10-1 that the value of total liabilities to Glen Echo equals $100 million. In addition, the bank is required to have its own net worth as a buffer against bad loans and insolvency. Net worth is considered the value of the owners (share holders) stake in the bank. In this case, net worth is 3% of total liabilities and equals $3 million, which the bank raised by selling shares of stock to the public. The bank is obligated to hold reserves of 10% of total deposits with the Fed, in this case the amount of required reserves is $10.0 million ($100.0 million in deposits x 0.10).
Table 10-1: Glen Echo Bank Balance Sheet (1)
| Initial Balance | ||||
|---|---|---|---|---|
| Assets | Liabilites | |||
| | ||||
| Loans Outstanding | $ 80.0 million | Deposits | $100.0 million | |
| Government debt | 13.0 million | Net Worth | 3.0 million | |
| Required Reserves | 10.0 million | |||
| Total | 103.0 million | Total | 103.0 million | |
Consider a hard-working, thrifty (and rich) person like yourself. Let us assume that you deposit $1 million in your account at Glen Echo Bank. On the balance sheet that follows, Glen Echo now has an additional $1 million liability. Let us assume that the deposit insurance premium has no affect on our analysis, since it is so small. Your deposit also creates an additional $1 million in assets. Of your $1 million deposit, $100,000 (10%) is legally required to be kept as reserves with the Fed.
| After $1 million deposit | ||||
|---|---|---|---|---|
| Assets | Liabilites | |||
| | ||||
| Loans Outstanding | $ 80.9 million | Deposits | $101.0 million | |
| Government debt | 13.0 million | Net Worth | 3.0 million | |
| Required Reserves | 10.1 million | |||
| Total | 104.0 million | Total | 104.0 million | |
Notice in Table 10-2 what the bank did with your $1 million deposit. $100,000 went to the reserve requirement with the Fed, and the bank lent out the other $900,000 (loans outstanding increased from $80 million to $80.9 million). For simplicity, let us assume that the entire $900,000 made available by your deposit was borrowed by one business: Joe-Bob's Rooter.
Joe-Bob doesn't borrow the money for fun, he wants to invest in new capital equipment, which will increase the productivity of his workers. Joe-Bob wants to invest in a new laser rooter, for which he pays $900,000 to Sapphire Slick's Laser Emporium. Let us also assume that Sapphire has an account with Glen Echo Bank, where she deposits the $900,000 received from Joe-Bob's purchase. Table 10-3 shows the new balance sheet for Glen Echo Bank after Sapphire's deposit.
(Add $0.9 million deposit from Sapphire Slick)
| After $0.9 million deposit | ||||
|---|---|---|---|---|
| Assets | Liabilites | |||
| | ||||
| Loans Outstanding | $81.71 million | Deposits | $101.9 million | |
| Government debt | 13.00 million | Net Worth | 3.0 million | |
| Required Reserves | 10.19 million | |||
| Total | 104.90 million | Total | 104.9 million | |
Several things have occurred due to Sapphire's deposit of $900,000 in the Glen Echo Bank.
As we have shown, after meeting the reserve requirement, Glen Echo Bank loans out all the additional money available. You should be getting the basic idea: your initial deposit has triggered multiple rounds of lending and deposit activity. Things are happening well beyond your initial deposit. We can complete another round like the previous round, where someone borrows the money, spends it, and the recipient deposits the money in Glen Echo. However, rather than continue the tedious math, we can invoke the simple money multiplier to summarize our situation.
For the purposes of this course, we can define the money multiplier as equal to
= 1/r.r.which equals to one divided by the reserve requirement. While we will work with the simple multiplier, in reality there are a number of leakages from the above scenario that will reduce the value of the multiplier:
Note that in our example we assumed that all deposits end up in the same bank. As long as deposits end up in the domestic banking system the result is the same. The money multiplier will attain the same value as shown in this example, and the overall increase in the money supply will be the same.
