 |  Macroeconomics, 9/e Campbell R. McConnell,
University of Nebraska, Lincoln
Stanley L. Brue,
Pacific Lutheran University
Thomas P. Barbiero,
Ryerson University
How Banks Create Money
Chapter HighlightsCHAPTER 13- The operation of a chartered bank can be understood through its balance sheet, where assets equal liabilities
plus net worth.
- Modern banking systems are fractional reserve systems: only a fraction of deposits are backed by currency.
- Chartered banks keep reserves as vault cash and a small amount in the Bank of Canada for cheque-clearing
purposes. This reserve is equal to a desired percentage of the chartered bank's deposit liabilities. Excess reserves
are equal to actual reserves minus desired reserves.
- Banks lose both reserves and deposits when cheques are drawn against them.
- Chartered banks create money—create demand deposits, or deposit money—when they make loans. The
creation of demand deposits by bank lending is the most important source of money in the Canadian economy.
Money is destroyed when bank loans are repaid.
- The ability of a single chartered bank to create money by lending depends on the size of its excess reserves.
Generally speaking, a chartered bank lends only an amount equal to the amount of its excess reserves.
- Rather than making loans, chartered banks may decide to use excess reserves to buy bonds from the public.
In doing so, banks merely credit the demand-deposit accounts of the bond sellers, thus creating demanddeposit
money. Money vanishes when banks sell bonds to the public because bond buyers must draw down
their demand-deposit balances to pay for the bonds.
- Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding cash and
excess reserves. Banks having temporary excess reserves often lend them overnight to banks that are short
of desired cash reserves. The interest rate paid on loans in this market is called the overnight loans rate.
- The chartered banking system as a whole can lend by a multiple of its excess reserves because the banking
system cannot lose reserves, although individual banks can lose reserves to other banks in the system.
- The multiple by which the banking system could lend on the basis of each dollar of excess reserves is the
reciprocal of the desired reserve ratio. This multiple credit expansion process is reversible.
- The fact that profit-seeking banks would tend to alter the money supply in a pro-cyclical direction underlies
the need for the Bank of Canada to control the money supply.
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2002 McGraw-Hill Higher Education