11PrinciplesOfBanking

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This publication is designed to provide accurate and authoritative information in regard to the subjectmatter covered. It is sold with the understanding that the publisher is not engaged in rendering legal,accounting, or other professional service. If legal advice or other expert assistance is required, theservices of a competent professional person should be sought.From a Declaration of Principles jointly adopted by a C ommittee of the American Ba r Asso ciationand a Committee of Publishers and Associations

The AMERICAN BANKERS ASSOCIATION is committed to providing innovative, high-qualityproducts and services that are responsive to its mem bers' critical needs.To comment about this product, or to learn more about the AMERICAN BANKERSASSOCIATION and the many products and services it offers, please call 1-800-338-0626.

@ 1998by the American Bankers AssociationCartoons on the following pages are reprinted with permission:

Pages 37, 53, 77, 93, 117, and 153 are Frank and Ernest 0 1988, 1994, 1995, 1996, and 1997by Thaves.

Page 209 62 1996Theodore Goff.Pages 169and 18962 1998and 1997Randy Glasbergen.Pages 1, 15, 137, and 229 0 1998American Bankers Association by Sharon C. Lamberton.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means-electronic, mech anical, photoco pying, reco rdin g,or otherwise-without prior written permission from the Am erican Bankers Association.

Printed in the United State s of America


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Role of Banks in Creating MoneyTh e Fed establishes ranges for the growth rate

of the money supply on the basis of a number ofeconom ic factors. The Fed then uses its tools formonetary control to keep the money supply withinthose ranges. Banks play an important role in thegrowth of the money supply because of their abil-ity to create demand deposits.

Banks create money for demand depositsthrough a combination of the deposit and the creditfunctions. When banks make loans, they also in-crease the volume of dem and deoosits. Here is anexample of how dem and deposits are increased:ABC Bank has $10 ,000 in cash assets-part ofthe stockholders ' origina l investment-and $0 indemand depos i t s . A consumer borrows the$10,000 in cash from ABC to buy a car and paysthe $10,000 cash to the car dealership. The deal-ership deposits the $10,000 to its checking ac-count, also at ABC. Now ABC Bank's demanddeposits are increased by $10,000, and its moneysupply is also increased. After the transaction, the

bank has $10,000 in loans, $10,000 in cash (thedealer's deposit) and $10,00 0 in de mand depos-i ts ; the s tockholders ' inves tment does notchange. Exhibit 3.5 uses a T-account to showhow this transaction would be shown in thebank's books (bank accounting is discussed inchapter 10).

If the bank has a reserve requirement of 10 per-cent, the bank must keep 10 percent of its demanddeposits in cash or balances at the Federal Re-serve. In this example the bank must keep $1,000as reserves (10 percent of $10,000), s o it has only$9,000 available to lend to other customers($10,000 minus $1,000). If the bank lends out itsavailable $9,000, that $9,000 w ill be deposited inthe same or another bank in a demand deposit ac-coun t. The result of this transac tion is that demanddeposits are increased by $9,000, as is the m oneysupply. The fact that the deposits may not be madeto the same bank is irrelevant. The point is thatmoney lent out by banks ends up in demand de-posits that can be loaned out again after reservesare kept, causing a recycling of funds.

Exhibit3.5 How Banks Create MoneyBANK BALANCESHEET BEFORE LOAN

Cash $10,000--Total

Deposits $ 0Stockholder equity $10,000Total liabilities&Assets $10,000 stockholder equity $10,000

BANK 6,'" '\NCE SHEET AFTER LOANCash $10,000 1 Deposits $1 0,000Loans $10,000

I Stockhotcter equity $10,000Total Total liabilities&Asse . '20,000 1 stnckholmr e m t L . $20,000


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11PrinciplesOfBanking

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