Multiple Deposit Creation and the Money Supply Process Chapter 14 Multiple Deposit Creation and the Money Supply Process

Meaning and Function of Money Economist’s Meaning of Money 1. Anything that is generally accepted in payment for goods and services 2. Not the same as wealth or income Functions of Money 1. Medium of exchange 2. Unit of account 3. Store of value Evolution of Payments System 1. Precious metals like gold and silver 2. Paper currency (fiat money) 3. Checks 4. Electronic means of payment 5. Electronic money: Debit cards, Stored-value cards, Smart cards, E-cash © 2004 Pearson Addison-Wesley. All rights reserved

Four Players in the Money Supply Process 1. Central bank: the Fed 2. Banks 3. Depositors 4. Borrowers from banks Federal Reserve System 1. Conducts monetary policy 2. Clears checks 3. Regulates banks © 2004 Pearson Addison-Wesley. All rights reserved

The Fed’s Balance Sheet Federal Reserve System Assets Liabilities Government securities Discount loans Currency in circulation Reserves Monetary Base, MB = C + R © 2004 Pearson Addison-Wesley. All rights reserved

Control of the Monetary Base Open Market Purchase from Bank The Banking System The Fed Assets Liabilities Assets Liabilities Securities – $100 Securities + $100 Reserves + $100 Reserves + $100 Open Market Purchase from Public Public The Fed Securities – $100 Securities + $100 Reserves + $100 Deposits + $100 Banking System Assets Liabilities Reserves Checkable Deposits + $100 + $100 Result: R  $100, MB  $100 © 2004 Pearson Addison-Wesley. All rights reserved

If Person Cashes Check Public The Fed Assets Liabilities Assets Liabilities Securities – $100 Securities + $100 Currency + $100 Currency + $100 Result: R unchanged, MB  $100 Effect on MB certain, on R uncertain Shifts From Deposits into Currency Deposits – $100 Currency + $100 Currency + $100 Reserves – $100 Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R  $100, MB unchanged © 2004 Pearson Addison-Wesley. All rights reserved

Discount Loans Banking System The Fed Assets Liabilities Assets Liabilities Reserves Discount Discount Reserves + $100 loan + $100 loan + $100 + $100 Result: R  $100, MB  $100 Conclusion: Fed has better ability to control MB than R © 2004 Pearson Addison-Wesley. All rights reserved

Deposit Creation: Single Bank First National Bank Assets Liabilities Securities – $100 Reserves + $100 Securities – $100 Deposits + $100 Loans + $100

Deposit Creation: Banking System Bank A Assets Liabilities Reserves + $100 Deposits + $100 Reserves + $10 Deposits + $100 Loans + $90 Bank B Reserves + $90 Deposits + $90 Reserves + $ 9 Deposits + $90 Loans + $81 © 2004 Pearson Addison-Wesley. All rights reserved

Deposit Creation © 2004 Pearson Addison-Wesley. All rights reserved

Deposit Creation If Bank A buys securities with $90 check Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same Whether bank makes loans or buys securities, get same deposit expansion © 2004 Pearson Addison-Wesley. All rights reserved

Deposit Multiplier Simple Deposit Multiplier 1 D =  R r Deriving the formula R = RR = r  D D =  R D =  R © 2004 Pearson Addison-Wesley. All rights reserved

Deposit Creation: Banking System as a Whole Assets Liabilities Securities – $100 Deposits + $1000 Reserves + $100 Loans + $1000 Critique of Simple Model Deposit creation stops if: 1. Proceeds from loan kept in cash 2. Bank holds excess reserves © 2004 Pearson Addison-Wesley. All rights reserved

Deriving Money Multiplier R = RR + ER RR = r  D R = (r  D) + ER M = m  MB Deriving Money Multiplier R = RR + ER RR = r  D R = (r  D) + ER Adding C to both sides R + C = MB = (r  D) + ER + C 1. Tells us amount of MB needed support D, ER and C 2. $1 of MB in ER, not support D or C MB = (r  D) + (e  D) + (c D) = (r + e + c)  D © 2004 Pearson Addison-Wesley. All rights reserved

1 D =  MB r + e + c M = D + (c D ) = (1 + c) D 1 + c M =  MB m = m < 1/r because no multiple expansion for currency and because as D  ER  Full Model M = m  (MBn + DL) © 2004 Pearson Addison-Wesley. All rights reserved

Excess Reserves Ratio Determinants of e 1. i , relative Re on ER  (opportunity cost ), e  2. Expected deposit outflows, ER insurance worth more, e 

Factors Determining Money Supply © 2004 Pearson Addison-Wesley. All rights reserved

Deposits at Failed Banks: 1929–33 © 2004 Pearson Addison-Wesley. All rights reserved

e, c: 1929–33 © 2004 Pearson Addison-Wesley. All rights reserved

Money Supply and Monetary Base: 1929–33 © 2004 Pearson Addison-Wesley. All rights reserved