HEDGING: Buying or selling futures contracts to protect against price changes. This is a common form of "insurance" used by those who produce various commodities, such as wheat, cattle, coffee, and natural gas, as well as those who buy these commodities as inputs.
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MONEY CREATION, THE PROCESS:
The process in which the banking system creates checkable deposits by lending excess reserves. The total amount of checkable deposits (and money) created by the banking system depends on the amount of excess reserves available and the reserve requirement ratio specifying the reserves needed to back up deposits. The money creation process is the movement of reserves from bank to bank, with each bank using excess reserves to make loans (and checkable deposits), then keeping a fraction of the reserves to back up newly created deposits. The deposit expansion multiplier captures the money creation process, indicating the amount of checkable deposits created if the banking reserve acquires a given amount of excess reserves. The money creation process is a natural feature of fractional-reserve banking that occurs as banks act as both safekeepers of deposits and financial intermediaries making loans. Banks keep a portion of available reserves to back up deposits, then lend out excess reserves, creating checkable deposits in the process.
Injecting ReservesThe money creation process begins with the injection of reserves into the banking system, which is usually accomplished by the Federal Reserve System. However, for this particular analysis, here is something a little simpler. Consider what might happen if Duncan Thurly happens upon a $100 bill wedged in a knothole of an elm tree while walking his pet lobster in the park. Of course, he retrieves this money. But what should he do with it? He could use it to buy T-shirts, shoes, and mittens for his lobster. But this analysis works better if he chooses to deposit the money in his bank--Amos National Bank. The graph at the right records the result of Duncan's deposit in what is called a T-account. A T-account is a handy method of noting the changes in a bank's assets and liabilities resulting from a transaction. It is essentially a streamlined balance sheet, with assets listed in the left column and liabilities in the right.
Two entries are recorded with Duncan's $100 deposit into Amos National Bank.
Amos National has acquired an extra $100 of deposits and an extra $100 of reserves. Some of these reserves are required, and some are excess.
- First, Amos National adds $100 to its liabilities, specifically to Duncan's checking account. Deposits are assets to customers, but liabilities to the bank.
- Second, Amos National adds $100 to its assets, specifically vault cash reserves.
Now suppose that Amos National is required by the Federal Reserve System to keep 10 percent of deposits in reserve. This means that required reserves are $10 and excess reserves are $90. What might Amos National do with this $90 of excess reserves? How about generating a little interest revenue with a loan?
As luck would have it, a credit-worthy, loan-seeking customer named Lucy enters Amos National shortly after Duncan's deposit is made. Lucy needs a $90 loan for a new set of tires. What timing. After the paperwork is done and the loan is approved, Amos National makes the loan.
But how? How does Amos National actually get the loan TO Lucy? It has two options:
Presuming that Amos National uses the second option, click the [Make Loan] button to reveal the changes from this loan recorded in the T-account.
- One, it could simply pull out $90 of cash from the vault--four twenties and a ten.
- Two, it could use a checkable deposit. Amos National could issue Lucy a $90 check or, the preferred method, it could add $90 to Lucy's checking account.
Before moving on, note that the Amos National just created $90 of money, money that did NOT exist previously, money that was created by the stroke of a pen (or computer entry). But more money creation is yet to come.
- On the asset side, Amos National has a $90 loan.
- On the liability side, this is balanced with a $90 checkable deposit.
Another BankAmos National Bank is not alone in the money creation process. More money creation magic occurs because the loan to Lucy is borrowed for a reason, to spend, to buy tires. And those tires are purchased from Lucy's favorite tire boutique, Tires By Tony, using a check written on Lucy's checking account at Amos National Bank.
With the tire purchase completed, Tires By Tony deposits Lucy's check in its bank, Bob's State Bank. Now the fun really begins. This check must be cleared. That is, reserves are transferred from Lucy's account at Amos National Bank to Tires By Tony's account at Bob's State Bank.
This check clearing process can be demonstrated using the two T-accounts displayed at the right--one for Amos National Bank and the other for Bob's State Bank. Click the [Clear Check] button to illustrate.
What has happened at Amos National Bank?
- Bob's Bank adds $90 worth of liabilities to the Tires By Tony account.
- This liability is ultimately balanced by transferring $90 reserves from Amos National.
- In principle, Bob's Bank sends Amos National the check written by the Lucy and Amos National sends Bob's Bank vault cash in return.
- In practice, this is largely handled with Federal Reserve deposits.
- Banks send checks to the Federal Reserve System, and the Federal Reserve System does the necessary transfer. One reason banks have Federal Reserve deposits, by the way, is to facilitate the check-clearing process.
- Amos National loses $90 of reserves and Bob's Bank gains $90 of reserves.
- Amos National then reduces Lucy's account by $90 and Bob's State Bank adds $90 to Tires By Tony's account.
Now consider changes at Bob's State Bank.
- On the asset side, Amos National ends up with $10 of reserves and a $90 loan.
- On the liability side, Amos National still has the original $100 deposit.
- In effect, Amos National has converted $90 of non-revenue-generating excess reserves into a $90 revenue-generating loan.
Hmmm, what can it do? How about a loan? Click the [Make Loan] button to illustrate.
- Bob's Bank has $90 in reserves balancing $90 of deposits. This is much like what Amos National had after the original $100 deposit.
- Like Amos National Bank, part of those reserves are required and part are excess. It is legally required to keep only 10 percent of this $90, $9. That gives Bob's Bank $81 of excess reserves.
Once again, this process creates $81 worth of money that did not previously exist. But there is even more money creation to come.
- As luck would have it, Ned, another loan-seeking customer, enters Bob's Bank in search of an $81 loan to buy a CD player.
- Bob's Bank completes this loan, and like Amos National Bank earlier, it adds $81 of liability to Ned's checking account and $81 of asset as a loan.
Yet Another BankAdditional money creation magic occurs because the loan to Ned is used to buy a CD player from Ned's favorite electronic store, CD Playarama, using a check written on Ned's checking account at Bob's State Bank.
After the CD player is purchased, CD Playarama deposits Ned's check in its bank, Charley's Credit Union. This check is cleared by transferring reserves and debiting and crediting accounts.This can be demonstrated using the T-accounts for Bob's State Bank and Charley's Credit Union displayed here. Click the [Clear Check] button to illustrate.
How has Bob's State Bank assets and liabilities changed?
- Charley's Credit Union adds $81 worth of liabilities to CD Playarama's account.
- This liability is ultimately balanced by transferring $81 reserves from Bob's Bank using the Federal Reserve System's check-clearing process.
- Bob's Bank loses $81 of reserves and Charley's Credit Union gains $81 of reserves.
- Bob's Bank then reduces Ned's account by $81 and Charley's Credit Union adds $81 to CD Playarama's account.
Now consider Charley's Credit Union.
- On the asset side, Bob's Bank ends up with $9 of reserves and a $81 loan.
- On the liability side, Bob's Bank still has the original $90 deposit.
- In effect, Bob's Bank has converted $81 of non-revenue-generating excess reserves into a $81 revenue-generating loan.
What can Charley's Credit Union do with these excess reserves? How about another loan? Click the [Make Loan] button to illustrate.
- Charley's Credit Union has $81 in reserves balancing $81 of deposits. This is much like what Bob's Bank had after the original $90 deposit.
- Like Bob's State Bank, part of those reserves are required and part are excess. It legally needs to keep only 10 percent of this $81, $8.10 in reserves. That gives Charley's Credit Union $72.90 of excess reserves.
Once again, this process creates $72.90 worth of money that did not previously exist. Up to this point, these three banks have created a total of $243.90 worth of money.
- To continue this analysis, suppose that Stacy, another loan-seeking customer enters Charley's Credit Union, in search of a $72.90 loan to buy a pair of boots.
- Charley's Credit Union completes this loan, and like the other banks, it adds $72.90 of liability to the Stacy's checking account and $72.90 of asset as a loan.
How much more money creation is to come? Actually quite a bit. Dozens of other banks receive deposits and reserves, and are able to make loans. Each round, however, becomes smaller and smaller, until virtually nothing is left. The next step in this analysis is to sum up this money creation process.
Total CreationConsider what has happened up to this point:
This means that $243.90 worth of money, new money, money that did NOT previously exist, has been created. Other banks also get involved.
- Amos National Bank created a $90 deposit, which was transferred to our Bob's State Bank.
- Bob's State Bank created an $81 deposit, which was transferred to Charley's Credit Union.
- Charley's Credit Union created a $72.90 deposit, which is on the verge of begin transferred to another bank.
How long will this continue? When will this stop? How many deposits will the alphabetized banks create? First consider a total number, then an explanation.
- A bank starting with the letter D receives reserves from Charley's Credit Union that it uses to create a $65.61 deposit.
- Then another bank with a catchy name starting with the letter E creates a deposit of $59.05.
- Then a bank using the letter F creates a deposit of $53.14.
- The remaining letters of the alphabet are also used, with each bank creating additional deposits.
- The first three banks create $243.90 worth of deposits.
- The first six banks create $421.70 worth of deposits.
- A Total Number: When all is said and done, the banking system creates $900 of checkable deposits. When added to Duncan's original $100 deposit, the banking system has $1,000 of deposits that did not previously exist, $1,000 of checkable deposits brought about because Duncan gave Amos National Bank $100 of vault cash.
- An Explanation: Fractional-reserve banking is what makes the money creation process possible. In this example, banks keep reserves equal to 10 percent of their deposits. Each $10 of deposits is backed by $1 of reserves. Or stated in a reverse way, each $1 of reserves is used to back $10 of deposits. The key is the 10 to 1 ratio between deposits and reserves. The extra $100 of vault cash reserves Duncan provided to Amos National Bank is used to back up ten times as many deposits, or $1,000.
MONEY CREATION, THE PROCESS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2022. [Accessed: May 26, 2022].
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