Credit Creation Introduction : banks can influence the money supply directly though the deposit and lending mechanism.

$ Economy Two Sectors Public Bank The mechanism has two main sectors : public and bank sectors

Public The role of the public in the model is to borrow money from the bank sector and put deposit to the bank sector.

$ Bank The role of the bank sector in the model is to receive deposit from the public and to lend out loans to the public sector.

Assumptions Fractional reserve banking system Demand deposit only No excess reserves No cash leakage For simplification, there is 4 assumptions.

? Illustration Required reserve ratio (RRR) =25% Jack put $200 into the bank as an initial demand deposit Illustrated by example.

First Round

$200 First Round Bank Public $ Jack as a member of the public, deposit $200 to the bank sector.

$150 $200 First Round Bank Public $ The bank sector have excess reserve $150 ($200 x 75%) As the bank sector will not maintain excess reserve, the bank sector lend out $150. $150

Second Round

$150 Second Round Bank Public $ $200 $150 People who borrow the $150 may use the $150 for any purpose, but the $150 will eventually deposit back to the bank sector. (no cash leakage) $150

$112.5 Second Round Bank Public $ $200 $150 $150 The bank sector again have excess reserve $112.5 ($150 x 75%) The bank sector will lend out $112.5 (the excess reserve) $112.5 $150

Third Round

$112.5 Third Round Bank Public $ $200 $150 $112.5 $150 $112.5 deposit back to the bank sector (no cash leakage) $112.5 $150

$84.4 Third Round Bank Public $ $200 $150 $112.5 $112.5 $150 The bank sector lend out $84.4 (no excess reserve) $84.4 $112.5 $150

Nth Round

Nth Round Bank Public $ $200 $150 $112.5 $84.4 $63.3 . $84.4 $112.5 The process carries on. $84.4 $112.5 $150

Nth Round Bank Public $ $200 $150 $112.5 $84.4 $63.3 . $84.4 $112.5 Emphasis the circulation. $84.4 $112.5 $150

Credit Creation 1st round : $200 2nd round : $150 3rd round : $112.5 4th round : $84.4 5th round : $63.3 6th round : . 7th round : . Question : How much deposits the bank sector gets in n round? Hint: we can we get the sum of all deposits?

Credit Creation Total ? Remember M1= currency hold by the public + demand deposit in LB Question : Any easier method to calculate the increment of deposit?

Calculation of Credit Creation Bank multiplier = 1 Required reserve ratio Total deposit increment = initial deposit x banking multiplier Introduce the bank multiplier. (ref. the infinitive GP in S5 General Maths) $ Bank

$ Bank Re-emphasis the idea of creating money without physically printing more banknotes.

? Remember Required reserve ratio (RRR) =25% Jack put $200 into the bank as an initial demand deposit Refer back to the illustration before.

Required reserve ratio Bank multiplier = 1 Required reserve ratio = 1 25% Calculation Teacher can ask students to calculate the multiplier and the deposit created before showing the result from the slides. = 4

Total deposit increment = initial deposit x banking multiplier Total deposit increment = $200 x 4 = $800 The maximum amount of deposit created is $800

$800 Bank $200 RRR=25% Multiplier = 4 Emphasis the relation between initial deposit, RRR and deposit created.

P. C. Ed (Part time) Major : Economics Designed by Eric Leung 97