Chapter 13

Multiple Deposit Creation and the Money Supply Process

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Money Supply (MS) Process Definition: The mechanism that determines the money

supply, or the implementation of monetary policy.  It is important to understand the MS Process to

understand exactly how do the tools of monetary policy

change the money supply, and thereby affect economic indicators (e.g. interest rates, inflation, output, employment). 

Note: control over the money supply through monetary tools (including interest rates) is called Monetary Policy.

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THE FOUR PLAYERS IN THE MS PROCESS

1 .The central bank The most important player since it ultimately controls the

supply of money in the economy.

-Functions of the Central Bank:(A)Issuing Currency (B) Holding Ministries’ Accounts(C)Determining Exchange Rate (D) Banking Supervision(E)Monetary Policy (F) Checks Clearing

-Tools of Monetary Policy (Chapter 15):(A) Determining the Discount Rate(B) Open Market Operations(C)Setting the Required Reserve Ratio

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2. Commercial banks Depository institutions that accept deposits

and make loans. 3. Depositors Bank customers (individuals, companies and

institutions) holding bank deposits. 4. Borrowers from banks Bank customers (individuals, companies, etc)

who borrow money from banks.

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CENTRAL BANK'S BALANCE SHEET AND THE MONETARY BASE

Monetary policy works by affecting the Central bank's balance sheet.

Assets

1 .Securities:

Most of the assets are government securities.

2 .Discount Loans:

Loans that the central bank makes to banks.

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Liabilities1.  Currency in Circulation:

Cash in the hands of the public, outside the banking

system.

2 .Reserves:

Which are in the form of either:

a) bank deposits at the central bank (RR), or

b) cash at commercial banks (ER).

 

Note: Reserves are a liability of the Central Bank and an asset for commercial banks

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Monetary Base Known also as high-powered money because an

increase in it leads to multiple increases in the money supply.

Consists of central bank notes outstanding, coins and reserves.

Central bank notes outstanding and coins can be defined as currency in circulation (C), thus the monetary base is defined as:

MB = C (currency) + R (reserves)

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CONTROL OF THE MONETARY BASE (MB)

Monetary Base is controlled by the Central Bank, through:

(1) Open Market Operations

(2) Discount Loans (discount rate)

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Open Market Operations

(1)Open Market Purchase

(A)Open Market Purchase from a Bank The C.B. buys government securities from a bank. The bank gives the C.B. $100 government securities. The C.B. pays for the securities by increasing the bank’s

reserves by $100.  The bank: reserves increase by $100 while its holdings of

securities decline by $100.

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The T-account for the bank is:  Commercial Bank

Central Bank: liabilities _____ by $____ because of the _____ in __________, while its assets ______ by $______ because of the _________ in its ___________.

AssetsLiabilities

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The T-account for the central bank is:

The Central Bank

Result:

Reserves and MB ______ by $____ (amount of OMO).

AssetsLiabilities

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(B)Open Market Purchase from Non-bank Public

Non-bank public: Any natural or judicial person other than commercial banks.

There are two possible cases:

CASE 1:The central bank buys a ($100) government security from the non-bank public, and the seller makes a bank deposit.

The T-account for the non-bank public is:

Non-Bank Public

AssetsLiabilities

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When the commercial bank receives the check, it credits the depositor's account with $100 and then deposits the check at its account at the central bank who increases its _______ by $_____.

The T-account for the commercial bank is:

Commercial Bank

AssetsLiabilities

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The central bank's holdings of _______ increase by $____, while the _______ increase by $____.

The Central Bank

Similar to the case of purchasing securities from a bank

(increase in ____, _____ and ____)

AssetsLiabilities

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CASE 2:The central bank buys a ($100) T-Bond from the non-bank public, and the person cashes the check.

The T-account for the non-bank public is:

Non-Bank Public

AssetsLiabilities

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The central bank's holdings of _______increase by $____, while _________ increase by $____.

The Central Bank

Result:

Reserves _________, while (C) and (MB) _________ by the amount of the OMO.

AssetsLiabilities

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General Result for purchases:

The effect of open market purchase is to increase the MB by the amount of the OMO whether the seller keeps the proceeds in deposits or in currency.

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(2)Open Market Sale

“If the central bank sells $100 of bonds to a bank or non-bank public, the monetary base declines by $100.”

(A)Open Market Sale for a non Bank

For Example: If the buyer pays for the bonds with currency, his T-account is:

Non-Bank Public

AssetsLiabilities

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The central bank lowers its holdings of securities and currency by $100. Its T-account is:

The Central Bank

AssetsLiabilities

ResultsOpen market sale _____ MB by the same amount, although reserves are ______ (Why?)

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(B)Open Market Sale for a Bank The C.B sells government securities to a

bank($100). Commercial Bank

Central Bank

Results:

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AssetsLiabilities

AssetsLiabilities

General Result for sales:

The effect of open market sales is to decrease the MB by the amount of the OMO whether the buyer pays the proceeds from deposits or in currency.

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General result for sale and purchases

The effect of OMOs on MB is more certain than its effect on reserves.

Thus, the central bank can control MB more effectively than reserves by using OMOs.

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Shifts from Deposits into CurrencyCommercial Bank

The Central Bank

AssetsLiabilities

AssetsLiabilities

ResultHas _____ effect on the central bank liabilities because the increase in (C) is _______ by a decline in (R).

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Discount Loans

Commercial Bank

The Central Bank

AssetsLiabilities

AssetsLiabilities

ResultIf the Central Bank makes a discount loan, (R) and (MB) _______ by the same amount.

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MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

Assumptions:

The commercial bank holds no excess reserves. The public don’t hold cash. The required reserve ratio is 10%.

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MULTIPLE DEPOSIT CREATION:A SIMPLE MODEL

Deposit Creation: The Single Bank

Assume that the central bank conducts Open Market Purchase of $100 from a bank. The T-account is:

1) Open Market Purchase Commercial Bank

AssetsLiabilities

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2) Making a loan

AssetsLiabilities

3 (The bank deposits the loan in the borrower’s account

AssetsLiabilities

Commercial Bank

Commercial Bank

AssetsLiabilities

4) The borrower withdraws the amount of the loan

5) The final effect on the bank’s balance sheet

AssetsLiabilities

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Commercial Bank

Commercial Bank

Result:

The initial increase in reserves from the open market purchase has been converted by the bank into $100 of additional loans and $100 of deposits.

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SUMMARY

SIMPLE MODEL

Assumptions: The commercial bank holds no excess reserves. The public don’t hold cash. The required reserve ratio is 10%.

Deposit Creation Steps (single bank):

1) Open Market Purchase

2) Making a loan

3) The bank deposits the loan in the borrower’s account

4) The borrower withdraws the amount of the loan

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Deposit Creation: The Banking System

1) Assume the $100 deposit (created by the loan) is deposited at bank (A), the T-account is:

Bank A

AssetsLiabilities

• Bank (A)’s required reserves equal $______, and excess reserves equal $______• The maximum amount of loans the bank can make is $______.

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2) Bank (A) makes a loan

Bank AAssetsLiabilities

The borrower from Bank (A) uses the money to make purchases

3) The seller deposits the amount of the purchase in his bank (B)

Bank BAssetsLiabilities

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Bank (B) now has $___ of reserves. It only needs $____ as required reserves, it can lend $_____.

Bank (B) creates a new loan of $____ and a new deposit of $___ for the borrower. When check clears, R= $___, L= $ ___ and D= $ ___.  T-account of Bank B is:

Bank (B)AssetsLiabilities

The $ ____ spent by the borrower (from Bank B) will be deposited in another bank (Bank C).

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Result: The initial increase in reserves in the banking system of

$____, so far has increased checkable deposits in the system by $ 271 (= ____+ ____ +____).

As a result, if all banks make loans for the full amount of their excess reserves, the total increase in deposits will be $ 1000.

In general, deposits increase as follows:

∆ D = (1/RRR) x  ∆ R

= (1/____) x (_____) = $______ Where ∆ D = change in checkable bank deposits (D)

          RRR = required reserve ratio            ∆ R = change in Reserves (R)

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Deposit Creation

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Simple Deposit Multiplier The multiple increase in deposits generated from an

increase in the banking system's reserves. Our simple multiple deposit creation process depends on

two factors to get the full potential deposit expansion of the Simple Deposit Multiplier on D, e.g. 10X:

1. Banks hold NO excess reserves (ER) 2. No cash (C) is held by the public

Note: The central bank directly controls the MB, but can't directly

control MS, it is influenced by public's behavior (cash demand) and bank's behavior (holding excess reserves).

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