The story of checks

Its all about excess reserves

When you deposit currency in a bank checking account

• It is an on demand deposit

• The bank owes you the money– It is a liability to the bank– It is in debt to you for this amount

• The bank provides you with “letters of credit” or checks– Checks are a medium of exchange– The bank is circulating its debt

Reserves

• Your bank can hold the currency in its vault– It is an asset– It means the bank can pay the debt

• Your bank can deposit your deposit in its account at the Federal Reserve Bank– It can let the FED worry about security

• When your check is deposited in the bearer’s bank, that bank trusts your bank that the letter of credit is worth what it says

Unless you demand the currency

• The currency deposited never has to move

• One bank will accept another banks letter of credit as a deposit (liability) and reserve (asset) of its own– Its just a matter of bookkeeping

Lindsay Lohan has checked into rehab, said the 20-year-old actress in a statement.Photo: AP

Checks can more efficient than currency

So far the bank has only replaced

money with money(currency with checks)

It hasn’t yet created additional

money (expanded the money supply)

Money creation

And

Fractional

Reserves

Britney Spears has apparently checked herself out of a rehab facility just 24 hours after entering.

Reserve requirement

• In our example reserves (assets) equal checkable deposits (liabilities)– The ratio has been 1 to 1

• But our banking system allows a fractional reserve requirement

• Banks are required by law to maintain only a percent of the checkable deposits as reserves– Required reserves (currently 10%)

Fractional required reserves

create excess reserves

Money creation• Fractional reserves

– For every $100 deposited– The bank is only required to maintain $10– The bank can loan out the $90 of excess reserves

• Loans are assets for the bank• Every check you write, every debit card

transaction you make is only backed by 10% of your original currency deposit.– 90% of bank debt, circulating as checks, is

money created

Money expansion – $100 becomes $1,000

• The $90 loan is deposited in another bankThat bank must maintain $9 on reserve

and has $81 in excess reserves, which it can loan

• The reciprocal of the reserve requirement is the money multiplier– Assuming 10% (1/10) reserve requirement

• Customers want to borrow all loans available• All loans are fully re-deposited in banks• Banks loan all excess reserves

A $100 checkable deposit will expand the money supply to a total of $1,000

$100 + $900 all other banks = $1,000 ($100 * 10)