3.3 Banks and the creation of money

increased) by the fact that the borrower wrote cheques which other people paid into

their accounts at other banks. If we were to look at the balance sheets of these other

banks, we should nd that their customers’ deposits had increased () and that this

increase was matched on the asset side by an increase in their operational balances

at the Bank of England ().

Other things being equal, an increase in lending raises prots and the supply of

money. Provided there is a demand for bank lending at a protable rate of interest,

from customers that banks think creditworthy, we can see why it will always be

difcult for the authorities to control monetary expansion.

3.3.2How banks create money

We have just seen that if an individual bank increases its lending, other things being

equal, the money supply will expand. When we talk of an increase in bank lending

leading to monetary expansion, however, we are not normally talking about the

behaviour of an individual bank but about banks as a whole. However, the process

remains essentially the same. Imagine bank A grants an overdraft as before, but that

banks B, C...nare doing the same. If the borrower of bank A uses the overdraft to

pay people who bank with banks B, C, etc., then the increase in the money supply

appears in their deposits just as it did in the single bank case. The difference, of course,

is that borrowers from banks B, C...nare paying clients of bank A and so part of

the increase in money supply will appear in bank A’s deposits.

Notice, however, that all the time this expansion is taking place, the composition

of the aggregate balance sheet must be changing. Each individual bank does as

our single bank did. It lends to a customer whose spending leads to an increase in

‘advances’ at the expense of ‘operational balances’. If banks in general are doing this,

however, each individual bank will be receiving additional customer deposits and

corresponding operational balances. Remember though that each bank was able to

lend only by running down operational balances in order to make advances. Therefore,

each time it receives new deposits and operational balances, the additional balances

serve only to replace the balances used to increase its own advances. If we were to

inspect the balance sheet at intervals as this process continued over time we should

nd that operational balances were constant (though their ownership would be

oscillating between banks) while the increases appeared in deposits (on the liabilities

side) matched by advances (on the asset side). The balance sheet is expanding, but

the ratio of operational balances to total assets/liabilities is falling. The process is

illustrated in Exercise 3.1.

Clearly, then, the answer to our question of how banks create money is that they

do so by increasing their lending, provided that they are prepared to accept a change

in their portfolio composition. Specically, this means provided they are prepared

to work with a smaller reserve ratio.

Sight deposits:Deposits which can be used without notice to make payments or to

exchange for notes and coin.

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Chapter 3 • Deposit-taking institutions

Exercise 3.1Loans create deposits

Imagine a system in which there are just three banks, A, B and C, whose balance sheets

are shown below.

Bank A	Bank B	Bank C
LA	LA	LA

D		1,000	C10	D		1,000	C10	D		1,000	C10
p			b	p			b	p			b
			D40				D40				D40
			b				b				b
			L950				L950				L950
			p				p				p

where Dare customer deposits, Cis cash (notes and coin) held by banks, Dare banks’

pbb

deposits at the central bank, and Lare advances (loans) to customers. Bank reserves,

p

R, consist of CD, and a bank’s reserve ratio is thus R/D. Assume that banks’

bbp

customers are holding notes and coin (C) of 500.

p

(a)	What is the size of the money stock, CD? pp

(b)	Calculate the reserve ratio, R/D, for each bank and for the system as a whole. p

Suppose now that bank A increases its advances (L) by 10 and its customers use this

p

lending to pay 5 to clients of bank C and 5 to clients of bank B.

(c)	Show the new balance sheet position for each bank.
(d)	By how much has the money supply increased?

(e)	Calculate the new reserve ratio for each individual bank and the aggregate reserve ratio.

Suppose now that bank B also increases its lending by 10 and that its customers pay 5

each to clients of A and C, and that bank C increases its lending by 10 and payments are

made equally to clients of A and B.

(f)	What is the size of the money stock now?
(g)	What is the reserve ratio for each bank?
(h)	What is the aggregate reserve ratio?
		Answers at end of chapter

However, the dangers of doing this are obvious. Remember that the need for reserves

arises fundamentally from the need to be able to meet unforeseen demand for deposit

convertibility. Any suggestion that a bank could notmeet these demands would

immediately result in depositors at that bank rushing to withdraw cash. No bank

could meet a generalwithdrawal of cash of this kind, and the inability to pay would

not only cause the rst bank to fail but would almost certainly cause the rapid spread

of similar demand to other banks which would also fail. (This is another example of

the ‘negative externalities’ of bank failure that we discussed in section 3.1.4.)

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