No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eleven: Money, Money, Money! 264 So what stops a bank from loaning me $22T? Well, I wasn’t completely thorough in my explanation that banks don’t have to worry about checking their vault prior to issuing me a loan. According to our current banking regulations, banks must keep a fraction of the deposits that they would like to loan out available as reserves—set at 10% for most banks. But on a normal sized loan, they really don’t have to check their vaults; if they don’t have enough cash on hand to meet the 10% requirement, they can borrow from other banks from the federal funds market . If for some reason that is not an option (e.g., heightened stress in the financial markets), they can also borrow the reserves from the Federal Reserve directly. Since the rate of interest they pay on the fed funds market is generally much lower than what my loan interest rate would be, it still makes sense. With this background, let’s see how the money creation process works by assuming the Federal Reserve initially buys securities from the Bank of the USA. When the Fed does this, they provide $1,000 of high powered money into the banking system. As we go through the banking process below, we’ll see why it’s called high powered money. Bank of the USA (BUSA) will initially see their T-account adjust as in Figure 11.5 , with securities going down while bank reserves go up. Given that reserves don’t pay much interest, does the bank want to hold these additional reserves? Usually a bank will sell an interest bearing security in order to invest in other more profitable investments such as loans to customers. If we assume the bank doesn’t want to hold any excess reserves, they will loan out the $1,000 in excess reserves, with their final T-account looking like Figure 11.6 . The first step in the money multiplication process is the creation of $1,000 of checkable deposits—newly created money courtesy of additional reserves from the Fed. Of course it doesn’t stop there; no one borrows money from the bank in order to just leave the money in his or her checking account—one would intend to spend it on something. Assume I received the loan of $1,000. When I get the loan, I go spend it at Best Buy on a new television for my basement. The initial Federal funds market: an interbank market where banks with excess reserves loan to those banks with insufficient reserves overnight. The interest rate that is charged is the federal funds rate, and the Federal Reserve targets this interest rate in conducting monetary policy. High powered money: currency and reserves provided to the banking system by the Federal Reserve (also known as the Monetary Base). This is often called high-powered since these reserves can be multiplied to create broader money that circulates in the economy. -$1000 +$1000 Securities Reserves Assets Liabilities Bank of the USA Figure 11.5, Bank of the USA T-Account. When the Fed purchases $1000 of securities from Bank of the USA, their asset composition changes by adding to reserves while subtracting from securities. +$1000 -$1000 +$1000 +$1000 Checking Account Securities Reserves Loans Assets Liabilities Bank of the USA Figure 11.6, Bank of the USA T-Account. To make the optimal return on their assets, Bank of the USA can lend out up to their excess reserves. This creates an asset of a loan and a liability of the checking account.