Money Creation

Dr. Aidil Rizal Shahrin

October 22, 2021

NIVERSITI
A L AYA
Faculty of Business and
Accountancy

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CONTENTS

1. The Fractional Reserve System

1.1 The Goldsmiths

2. A Single Commercial Bank

2.1 Transaction of a Single Commercial Bank
2.2 Money-Creating Transactions of a Commercial Bank
2.3 Profits and Liquidity
2.4 Overnight Policy Rate (OPR)

3. The Banking System: Multiple-Deposit Expansion

3.1 The Banking System’s Lending Potential
3.2 The Monetary Multiplier

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THE GOLDSMITHS

i. Banks in most countries are only required to keep a

percentage (fraction) of demand/checkable deposits in cash
or with the central bank.
ii. In the 16th century goldsmiths had safes for gold and
precious metals, which they often kept for consumers and
merchants.
iii. They issued receipts for these deposits.
iv. Receipts came to be used as money in place of gold
because of their convenience, and goldsmiths became
aware that much of the stored gold was never redeemed.
v. Goldsmiths realized they could loan gold by issuing receipts
to borrowers, who agreed to pay back gold plus interest.

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 THE GOLDSMITHS

vi. Such loans began fractional reserve banking, because the

actual gold in the vaults became only a fraction of the
receipts held by borrowers and owners of gold.
vii. Significance of Fractional Reserve Banking
I Banks can create money by lending more than the original
reserves on hand. (Note: Today gold is not used as reserves.)
I Lending policies must be prudent to prevent bank panics or
runs by depositors worried about their funds.
I Also, Malaysia has Perbadanan Insurans Deposit Malaysia
(PIDM) to protect band depositors in the event of a member
institution failure, to prevents panics.

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A SINGLE COMMERCIAL BANK

i. The balance sheet of a commercial bank is a statement of

the bank assets and claims on assets that summarizes the
financial position of the bank at a certain time.
ii. All balance sheets must balance, that is, the value of assets
must equal value of claims.
iii. Claims on a balance sheet are divided into:
a. Liabilities
Which the bank owes to depositors or others
b. Net worth
Claims of the bank’s owners (shareholders) against the bank’s
assets
And balance sheet is balanced because:
claims
z }| {
Assets = liablities + net worth
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TRANSACTION OF A SINGLE COMMERCIAL BANK

i. Transaction 1: Creating a Bank

I In Malaysia, the Rimau bank is formed with $250,000 worth
of owners’ stock shares (see Balance Sheet 1 Tab.1).

Table 1: Balance Sheet 1

Creating a Bank
Balance Sheet 1: Rimau Bank

Assets Liabilities and net worth

Cash $250,000 Stock shares $250,000

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TRANSACTION OF A SINGLE COMMERCIAL BANK

ii. Transaction 2: Acquiring Property and Equipment

Table 2: Balance Sheet 2

Acquiring Property and Equipment

Balance Sheet 2: Rimau Bank

Assets Liabilities and net worth

Cash $10,000 Stock shares $250,000

Property $240,000

I This bank than obtains property and equipment worth of

$240,000 leaving only $10,000 cash (see Balance Sheet 2 of
Tab.2).
I Blue fonts denote accounts affected by each transaction
onward.

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TRANSACTION OF A SINGLE COMMERCIAL BANK

iii. Transaction 3: Accepting Deposits

I The bank than begins its operations by accepting deposits
$100,00 from public (see Balance Sheet 3, Tab.3).

Table 3: Balance Sheet 3

Accepting Deposits
Balance Sheet 3: Rimau Bank

Assets Liabilities and net worth

Cash $110,000 Demand deposits $100,000

Property $240,000 Stock shares $250,000

iv. Transaction 4: Depositing Reserve in BNM

I The Statutory Reserve Requirement (SRR) is a monetary
policy instrument available to BNM to manage liquidity and
hence credit creation in the banking system
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TRANSACTION OF A SINGLE COMMERCIAL BANK

I The SRR requires every banking institutions in Malaysia to

maintain balances in their Statutory Reserve Accounts (SRA)
equivalent to a certain proportion of their eligible liabilities
(EL), this proportion being the SRR rate
I Penalties on the non-compliance of the SRR will be imposed
on banking institutions.
I Effective 20 March 2020, the SRR rate for banking institutions
is 2.0% of EL (see Statutory Reserve Requirement for detail
explanation of SRR)

Table 4: Balance Sheet 4

Depositing Reserved at the BNM
Balance Sheet 4: Rimau Bank

Assets Liabilities and net worth

Cash $0
Reserves $110,000 Demand deposits $100,000
Property $240,000 Stock shares $250,000

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TRANSACTION OF A SINGLE COMMERCIAL BANK

I For simplification, let say the SRR is 20% (call it reserve) and
the EL is the demand deposit that Rimau bank received.
I Thus, the reserve is $20,000 (0.2×$100,000).
I But instead, Rimau bank sends an extra $90,000, for a total of
$110,000 to BNM (see Tab.4).
I In so doing, Rimau bank will avoid the inconvenience of
sending additional reserves to the BNM each time its own
demand-deposit liabilities increase.
I And, as you will see, it is these extra reserves that enable
banks to lend money and earn interest income.
I Bank Rimau excess reserve is
Actual reserves $110,000

Required reserves ($20,000)

Excess reserves $90,000

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TRANSACTION OF A SINGLE COMMERCIAL BANK

I Required reserves give BNM control over the amount of

lending or deposits that banks can create.
I In other words, required reserves help the BNM control credit
and money creation.
I Banks cannot loan beyond their excess reserves.

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TRANSACTION OF A SINGLE COMMERCIAL BANK

Figure 1: Required Reserve Ratio (Percent of Deposit Liabilities), 2018

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TRANSACTION OF A SINGLE COMMERCIAL BANK

v. Transaction 5: Clearing a Check Drawn Against the Bank

Table 5: Balance Sheet 5

Clearing a Check
Balance Sheet 5: Rimau Bank

Assets Liabilities and net worth

Reserves $60,000 Demand deposits $50,000

Cash $240,000 Stock shares $250,000

I A $50,000 check is drawn against the Rimau bank by Mr.

Dolah, who buys farm equipment in Temerloh, Pahang.
I The firm in Termerloh deposits the check in the Sotong Bank,
which gains reserves at the BNM, and the Rimau bank loses
$50,000 reserves at the BNM; Mr. Dolah’s account goes
down, and the firm in Temerloh account increases in the
Sotong bank.
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TRANSACTION OF A SINGLE COMMERCIAL BANK

I The results of this transaction are shown in Balance Sheet 5

(Tab.5).

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MONEY-CREATING TRANSACTIONS OF A COMMER-
CIAL BANK

i. Transaction 6: Granting a Loan

I Rimau bank grants a loan of $50,000 to Buaya (see Balance
Sheet 6a (Tab.6)).
I Money ($50,000) has been created in the form of new
demand deposit (M1) worth $50,000.
I The Rimau bank has reached its lending limit. It has no more
excess reserves as soon as Buaya writes a check for $50,000
to AliBaba Construction (see Balance Sheet 6b (Tab.7)).

Table 6: Balance Sheet 6a

When a Loan Is Negotiated
Balance Sheet 6a: Rimau Bank

Assets Liabilities and net worth

Reserve $60,000 Demand deposits $100,000

Loans $50,000 Stock shares $250,000
Property $240,000

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MONEY-CREATING TRANSACTIONS OF A COMMER-
CIAL BANK

Table 7: Balance Sheet 6b

After a Check Is Drawn on the Loan
Balance Sheet 6b: Rimau Bank

Assets Liabilities and net worth

Reserve $10,000
Loans $50,000 Demand deposits $50,000
Property $240,000 Stock shares $250,000

I Legally, a bank can lend only to the extent of its excess

reserves.

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MONEY-CREATING TRANSACTIONS OF A COMMER-
CIAL BANK
ii. Transaction 7: Buying Government Securities

Table 8: Balance Sheet 7

Buying Government Securities
Balance Sheet 7: Rimau Bank

Assets Liabilities and net worth

Reserves $60,000
Securities $50,000 Demand deposits $100,000
Property $240,000 Stock shares $250,000

I When banks or the BNM buy government securities from the

public, they create money in much the same way as a loan
does (see Balance Sheet 7 (Tab.8)).
I Rimau bank buys $50,000 of bonds from a securities dealer.
I The dealer’s checkable deposits rise by $50,000.
I This increases the money supply in same way as the bank
making the loan to Buaya.
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MONEY-CREATING TRANSACTIONS OF A COMMER-
CIAL BANK

I Likewise, when banks or the BNM sell government securities

to the public, they decrease supply of money like a loan
repayment does.

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PROFITS AND LIQUIDITY

i. The asset items on a commercial bank’s balance sheet

reflect the banker’s pursuit of two conflicting goals:
a. Profit
I Banks are in business to make a profit like other firms.
I They earn profits primarily from interest on loans and securities
they hold.
b. Liquidity
I Banks must seek safety by having liquidity to meet cash needs
of depositors and to meet check-clearing transactions.

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OVERNIGHT POLICY RATE (OPR)

i. An interesting way in which banks can partly reconcile the

goals of profit and liquidity is to lend temporary excess
reserves held at the BNM to other commercial banks.
ii. Normal day-to-day flows of funds to banks rarely leave all
banks with their exact levels of required reserves.
iii. Also, funds held at the BNM are highly liquid, but they do not
draw interest
iv. Banks therefore lend these excess reserves to other banks
on an overnight basis as a way of earning additional interest
without sacrificing long-term liquidity.
v. With the implementation of monetary policy targets the
overnight interbank rate to fluctuate within a corridor around
the overnight policy rate (OPR) (for US is called Federal
funds rate).
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 OVERNIGHT POLICY RATE (OPR)

vi. Interbank Institutions would transact among themselves at

rates within this corridor to meet their overnight liquidity
needs before utilising the BNM’s standing facilities.
vii. BNM’s Monetary Policy Committee (MPC) announces OPR
every 2 months and as of September 2020, it is 1.75%. Click
this link for the announcement https:
//www.bnm.gov.my/index.php?ch=mone&pg=mone_opr_stmt
viii. Increase in OPR will increase the cost of borrowing for the
bank and vice versa.

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THE BANKING SYSTEM: MULTIPLE-DEPOSIT EXPANSION

i. The entire banking system can create an amount of money,

which is a multiple of the system’s excess reserves, even
though each bank in the system can only lend dollar for
dollar with its excess reserves.
ii. Three simplifying assumptions
I Required reserve ratio is assumed to be 20 percent.
I Initially banks have no excess reserves; they are "loaned up."
I When banks have excess reserves, they loan it all to one
borrower, who writes a check for the entire amount to give to
someone else, who deposits it at another bank. The check
clears against the original lender.

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THE BANKING SYSTEM’S LENDING POTENTIAL

i. Suppose a junkyard owner finds a $100 bill and deposits it in

Bank A.
Table 9: Balance Sheet: Commercial Bank A
Balance Sheet: Commercial Bank A

Assets Laiblities and net worth

Reserve $+100 (a1) Demand deposits $+100 (a1)
-80 (a3) +80 (a2)
Loans +80 (a2) -80 (a3)

ii. The system’s lending begins with Bank A having $80 in

excess reserves, lending this amount, and having the
borrower write an $80 check which is deposited in Bank B.

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THE BANKING SYSTEM’S LENDING POTENTIAL

Table 10: Balance Sheet: Commercial Bank B

Balance Sheet: Commercial Bank B

Assets Laiblities and net worth

Reserve $+80 (b1) Demand deposits $+80 (b1)
-64 (b3) +64 (b2)
Loans +64 (b2) -64 (b3)

iii. See further lending effects on Bank C.

Table 11: Balance Sheet: Commercial Bank C

Balance Sheet: Commercial Bank C

Assets Laiblities and net worth

Reserve $+64 (c1) Demand deposits $+64.00 (c1)
-51.20 (c3) +51.20 (c2)
Loans +51.20 (c2) -51.20 (c3)

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THE BANKING SYSTEM’S LENDING POTENTIAL

Figure 2: Expansion of the Money Supply by the Commercial Banking

System

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THE MONETARY MULTIPLIER

i. The formula for the monetary or checkable deposit multiplier

is:
1
Money multiplier =
required reserved ratio
or, in symbols
1
m=
R
in our example, m = 1/0.20, which is 5.
ii. Maximum deposit expansion possible is equal to:

Max. demand deposit creation=excess reserves×money multiplier

or, more simply

D=E×m
iii. Fig.3 illustrates this process
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THE MONETARY MULTIPLIER

Figure 3: The outcome of the money expansion process.

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THE MONETARY MULTIPLIER

iv. Higher reserve ratios generate lower money multipliers

I Changing the money multiplier changes the money creation
potential.
I Changing the reserve ratio changes the money multiplier, but
be careful! It also changes the amount of excess reserves
that are acted on by the multiplier.
I Cutting the reserve ratio in half will more than double the
deposit creation potential of the system.
v. The process is reversible. Loan repayment destroys money,
and the money multiplier increases that destruction

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