# Checking Clearing and Money Creation

Bank reserves play a role in the most common banking transaction, the clearing of checks. A check clears in the system when a person writes a check that is deposited in another bank. Suppose Jones, a depositor at Bank A, writes a check for \$100 to Smith that Smith deposits in Bank B. When Bank B receives this check, it pays Smith \$100 by increasing his checking account. Bank B has now paid for this piece of paper, and in turn wants to be paid. It could send the check on to Bank A and demand payment. Bank A legally must pay, and one way it could pay would be to ship paper money to Bank B.1 Bank A would now have paid for this piece of paper, and it in turn wants to be paid. It is paid when it subtracts \$100 from Jones' checking account. The table below shows the end result of the story. Bank A has lost deposits and reserves and Bank B has gained them.

 The Logic of Check Clearing Bank A . Bank B Assets . Liabilities + Net Worth Assets . Liabilities + Net Worth - \$100 paper money - \$100 Jones' checking account + \$100 paper money + \$100 Smith's checking account

Paying by check sets into motion a chain of transactions. Although the table above shows the logic of how a check clears, the chain is usually more complex than in this story. Bank B could have sent the check to Central Bank for payment. Central Bank would have paid Bank B by increasing the deposits Bank B has at Central Bank, and then sent the check on to Bank A with a note saying that its deposits at Central Bank had been reduced by \$100. In this case, Bank A would have lost not paper money but deposits at Central Bank and Bank B would have gained them.2

Once you understand how a check clears, you are ready to understand how modern banks create and destroy money. Suppose Bank A decides that it has \$100 more of reserves than it wants. This means that it would prefer to hold an interest-bearing asset rather than non-interest bearing reserves. To obtain such an asset, it can write a check on itself and buy government securities (debt of the government that earns interest) from the public. The public now has a reduction in its security holdings and a check for \$100 from Bank A. Suppose this check is deposited in Bank B. The check will clear as any check, and the end result will be the changes in this table:

 Creating Money Central Bank . Bank A Assets . Liabilities + Net Worth Assets . Liabilities + Net Worth -- deposits of Bank A -\$100 deposits of Bank B +100 deposits at central bank -\$100 government securities +\$100 -- ******************************************** Bank B . Public Assets Liabilities + Net Worth Assets Liabilities + Net Worth deposits at central bank +\$100 deposits of public +\$100 government securities -\$100 deposits at Bank B +\$100 --

Notice that the public now has \$100 more in checking accounts than it previously had: money has been created. This creation of money is not readily apparent to anyone in the banking system. Bank A did not intend to create more money—it merely wanted to exchange non-interest bearing assets for assets that earn interest. Bank B receives the new money, but this new money looks to it just the same as the "old" money that it received when Jones wrote a check to Smith. The creation of money, an aspect of the banking system that economists consider central, is to the banking system merely a side effect or by-product of its quest for profit.

Banks also create money when they lend money to borrowers and they destroy money when loans are repaid. But banks cannot create money in unlimited amounts. Their ability to create money is limited by the amount of legal reserves they have and by regulations that tell them how much reserves they must hold. Banks cannot create or destroy these reserves, but the central bank can. Hence it is the central bank that ultimately determines how much money circulates in an economy.

1 In practice, banks rarely if ever ship paper money in such transactions, but we assume it happens here to see the logic of the process.

2After years of hype about a paperless payment system, we are starting to get there. Many transactions that used to be done with checks are now done electronically by debit card or automatic payment. Even the clearing of paper checks is becoming paperless. See www.federalreserve.gov/paymentsystems/truncation/faqs2.htm. The effect on balance sheets is the same whether payment is with paper checks or done electronically.