Chapter 15 Multiple Deposit Creation and the Money Supply Process
Players in the Money Supply Process Central bank - the government agency that oversees the banking system and is responsible for the conduct of monetary policy Banks (depository institutions) - financial intermediaries that accept deposits from individuals and institutions and make loans: commercial banks, savings and loan associations, mutual savings banks, and credit unions Depositors (individuals and institutions) Borrowers (individuals and institutions) Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-2
Fed s Balance Sheet Monetary Liabilities Currency in circulation in the hands of the public Reserves bank deposits at the Fed and vault cash Assets Government securities Discount loans Federal Reserve System Liabilities Currency in circulation Reserves increases in either or both will lead to an increase in the money supply (everything else being constant). Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-3
Assets Government securities holdings by the CB (Fed) of securities issued by Treasury, that affect money supply and earn interest Fed provides reserves to the banking system by purchasing securities, thereby increasing its holdings of these assets. An increase in government securities held by the Fed leads to an increase in the money supply. Discount loans provide reserves to banks by making discount loans to banks and earn the discount rate An increase in discount loans can also be the source of an increase in the money supply Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-4
Monetary Base R C High-powered money MB = C + R = currency in circulation = total reserves in the banking system The CB exercises control over the monetary base through its purchases or sale of government securities in the open market, called open market operations, and through its extension of discount loans to banks. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-5
Open Market Purchase from a Bank Suppose that the Fed (CB) purchases $100 of bonds from a bank and pays for them with a $100 check Banking System Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 Federal Reserve System Assets Liabilities Assets Liabilities Securities -$100 Securities +$100 Reserves +$100 Reserves +$100 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-6
Open Market Purchase from Nonbank Public I Banking System Federal Reserve System Assets Liabilities Assets Liabilities Reserves +$100 Checkable deposits +$100 Securities +$100 Reserves +$100 Person selling bonds to the Fed, deposits the Fed s check in the bank Identical result as the purchase from a bank Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-7
Open Market Purchase from Nonbank Public II Nonbank Public Federal Reserve System Assets Liabilities Assets Liabilities Securities -$100 Securities +$100 Currency in circulation +$100 Currency +$100 The person selling the bonds cashes the Fed s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-8
Open Market Purchase: Summary The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits The effect of an open market purchase on the monetary base always increases the base by the amount of the purchase Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-9
Open Market Sale Nonbank Public Federal Reserve System Assets Liabilities Assets Liabilities Securities +$100 Securities -$100 Currency in circulation Currency -$100 -$100 if the Fed sells the bonds to an individual who pays for them with currency, the buyer exchanges $100 of currency for $100 of bonds Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-10
Shifts from Deposits into Currency Nonbank Public Banking System Assets Liabilities Assets Liabilities Checkable deposits Currency -$100 +$100 Reserves -$100 Checkable deposits -$100 Federal Reserve System Assets Liabilities Currency in circulation +$100 Reserves -$100 Net effect on monetary liabilities is zero Reserves are changed by random fluctuations Monetary base is a more stable variable Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-11
Making a Discount Loan to a Bank Banking System Federal Reserve System Assets Liabilities Assets Liabilities Reserves +$100 Discount loans (borrowing from Fed) +$100 Discount loan (borrowing from Fed) +$100 Reserves +$100 When the Fed makes a $100 discount loan to the First National Bank, the bank is credited with $100 of reserves from the proceeds of the loan. Monetary liabilities of the Fed have increased by $100 Monetary base also increases by this amount Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-12
Paying Off a Discount Loan from the Fed Banking System Federal Reserve System Assets Liabilities Assets Liabilities Reserves -$100 Discount loans (borrowing from Fed) -$100 Discount loans (borrowing from Fed) -$100 Reserves -$100 Net effect on monetary base is a reduction Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-13
Other Factors Affecting the Monetary Base Float - When the Fed clears checks for banks, it often credits the amount of the check to a bank that has deposited it (increases the bank s reserves) but only later debits (decreases the reserves of) the bank on which the check is drawn. The resulting temporary net increase in the total amount of reserves in the banking system (and hence in the monetary base) occurring from the Fed s check-clearing process Treasury deposits at the Federal Reserve - Treasury moves deposits from commercial banks to its account at the Fed, leading to a rise in Treasury deposits at the Fed, it causes a deposit outflow at these banks and thus causes reserves in the banking system and the monetary base to fall Interventions in the foreign exchange market - Decisions by the U.S. Treasury to have the Fed intervene in the foreign exchange market also affect the monetary base Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-14
Deposit Creation: Single Bank Suppose that the $100 open market purchase described earlier was conducted with the First National Bank. After the Fed has bought the $100 bond from the First National Bank, the bank finds that it has an increase in reserves of $100 assume that the bank does not want to hold excess reserves because it earns no interest on them. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-15
Deposit Creation: Single Bank First National Bank Assets Liabilities Securities -$100 Reserves +$100 First National Bank Assets Liabilities Securities -$100 Loans +$100 Excess reserves increase Bank loans out the excess reserves Creates a checking account Borrower makes purchases The money supply has increased Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-16
Deposit Creation: Single Bank Assets First National Bank Liabilities Securities -$100 Checkable deposits +$100 Reserves +$100 Loan +$100 Let s say that the bank decides to make a loan equal in amount to the $100 increase in excess reserves. When the bank makes the loan, it sets up a checking account for the borrower and puts the proceeds of the loan into this account. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-17
Deposit Creation: Single Bank The borrower took out a loan not to leave $100 idle at the First National Bank but to purchase goods and services from other individuals and corporations. When the borrower makes these purchases by writing checks, they will be deposited at other banks, and the $100 of reserves will leave the First National Bank. After the borrower taken the loan the balance sheet occur like this A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan. Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-18
Deposit Creation: The Banking System Bank A Bank A Reserves Assets Liabilities Assets Liabilities +$100 Checkable deposits +$100 Reserves +$10 Checkable deposits Loans +$90 +$100 Bank B Bank B Reserves Assets Liabilities Assets Liabilities +$90 Checkable deposits +$90 Reserves +$9 Checkable deposits Loans +$81 +$90 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-19
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The Formula for Multiple Deposit Creation RR Assuming banks do not hold excess reserves Required Reserves ( RR) = Total Reserves ( R) = Required Reserve Ratio ( r) times the total amount of checkable deposits ( D) Substituting r D = R Dividing both sides by r 1 D = R r Taking the change in both sides yields 1 D = R r Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-21
Critique of the Simple Model Holding cash stops the process Banks may not use all of their excess reserves to buy securities or make loans Copyright 2007 Pearson Addison-Wesley. All rights reserved. 13-22