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

Chapter Eleven: Money, Money, Money! 265 result can be seen in Figure 11.7 . When Best Buy deposits my check at their bank, the Bank of Narnia (BON), the BON will send the check to the Fed, who will credit their account with $1,000 of reserves (an asset), while subtracting $1,000 of reserves from the BUSA’s account with the Fed. The BON now also has a liability because they credit Best Buy’s checking account with $1,000. Banks exist to make money for their shareholders, and excess reserves have historically not paid interest (although this changed in 2008 due to the financial crisis—nevertheless, we will assume no interest is paid on reserves for this analysis). So non-interest earning money as part of a bank’s assets does little for their bottom line. Since the banking regulations only require them to keep 10% reserves, BON only needs to keep $100 as reserves to back the $1,000 liability of Best Buy’s checking account. So they will optimally want to loan out $900 since they can make interest on the $900 loan. After they do that, their T-Account will look like Figure 11.8 . The Federal Reserve will take $900 in reserves from the Bank of Narnia (as we saw in Figure 11.8 ) , and they will add them to the reserves of the Bank of Texas, as in Figure 11.9 . As before, sitting on idle excess reserves will usually not be a profit maximizing strategy, so they will loan much of it out, legally up to $810, keeping $90 (10% of $900) as the required reserves. The final Bank of Texas (BOT) T-Account is seen in Figure 11.10 (we’ve left out the initial increase in assets and liabilities that we saw on the top half of Figure 11.8 ; for the rest of the T-accounts we’ll go straight to the final outcome). Figure 11.7, First Wave of Money Creation. When Best Buy cashes my check with their bank, the Bank of Narnia (BON), the BON’s reserves and liabilities both increase the same amount, in this case $1000. Meanwhile, Bank of USA sees their initial portfolio of securities ultimately transformed into loans. -$1000 +$1000 Securities Loans +$1000 +$1000 Reserves Checking Account Assets Liabilities Bank of the USA Liabilities Assets Bank of Narnia