Money, Banking, and Finance Chapter 11

How Commercial Banks Create Money

• When a commercial bank decides to make a loan, it credits the amount to the checking account
• With the stroke of a key, deposit money is created!
• This increases M1
• Hence, commercial banks can create money!

The Central Bank and Commercial Banks‘ Money Creation

• In the euro area (and other jurisdictions), commercial banks are required to hold a certain share of their deposits as reserves
• Banks need to borrow these reserves
• From other banks
• From the ECB
• These reserves do not need to be available at the time when a deposit or a loan is made, but have to be put in the account within a certain time
• If commercial banks need cash, they have to borrow it from the ECB

Central Bank
Commercial Bank A
Commercial Bank B
Borrower
Bank makes loan
Increase Money Supply M1
Central Bank
Commercial Bank A
Commercial Bank B
Borrower
Commercial Bank hold certain share of deposits at Central Bank
Reserve Requirement
reserves do not need to be available at the time when a deposit or a loan is made!
Bank makes loan
Bank A/B borrows reserves from Bank B/A
or Bank A/B borrows from Central Bank against collateral and interest rate
Central Bank
Commercial Bank A
Commercial Bank B
Borrower
CB provides cash
Commercial Bank provides collateral and pays interest
ATM
Commercial Bank provides Cash
NO increase in M1

Money and Finance

Functions of Finance

• Provision of money to support investment in real capital
• Portfolio investment, i.e. investing funds in securities such as stocks or bonds

 another form of saving, a means of postponing consumption

Speculation as Investment

• Exploit changes in prices to achieve short-term profit
• Economic impact of risking their own funds is limited
• Speculators may borrow money in order to exploit what they see as market opportunities based on short-term price movements
• Leverage—investments based on borrowed funds