THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 351
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CHAPTER 13
Banking and the Management of Financial Institutions
319
The key characteristic of banks is their ability to buy assets by issuing their own
deposit liabilities. Suppose that the First Bank has found some profitable loans that
it wants to add to its portfolio. It makes a loan in the amount of $100 to a business
and credits the business s chequable deposit in that amount. The business accepts
the First Bank s deposit liabilities because they have the characteristic of being the
medium of exchange and are accepted as money by others. The T-accounts for the
First Bank and the business look like these:
First Bank
Assets
Loans
*$100
Business
Liabilities
Chequable
deposits
Assets
*$100
Chequable
deposits
Liabilities
Bank loans
*$100
*$100
Note that the transaction is simply an exchange of assets and liabilities, with no
change in the net worth of both the First Bank and the business. The bank s act of
making a new loan to the business increases chequable deposits, and thus the
money supply, by the amount of the loan. Note, however, that the bank s objective is not to create deposits and increase the money supply; the bank is in the
business of making a profit for its shareholders and the creation of
deposits occurs as a byproduct of the bank s financing decisions.
Acquiring income-producing assets is not the only way in which the First Bank
can create new chequable deposits. Let s say that Jane Brown has heard that the First
Bank provides excellent service, so she opens a chequing account with a $100 bill.
She now has a $100 chequable deposit at the bank, which shows up as a $100 liability on the bank s balance sheet. The bank now puts her $100 bill into its vault so
that the bank s assets rise by the $100 increase in vault cash. The T-account for the
bank looks like this:
First Bank
Assets
Vault cash
Liabilities
*$100
Chequable deposits
*$100
Because vault cash is also part of the bank s reserves, we can rewrite the T-account
as follows:
Assets
Reserves
Liabilities
*$100
Chequable deposits
*$100
Note that Jane Brown s opening of a chequing account leads to an increase in
the bank s reserves equal to the increase in chequable deposits.
If Jane had opened her account with a $100 cheque written on an account at
another bank, say, the Second Bank, we would get the same result. The initial
effect on the T-account of the First Bank is as follows:
