Multiple Deposit Creation and the Money Supply Process Chapter 15 Multiple Deposit Creation and the Money Supply Process

Money Supply Process It is important to understand how the money supply is determined because movements in the money supply affect interest rates and the overall health of the economy. How the money supply is determined? Who controls it? What causes it to change? How might control of it be improved? © 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 (or high-powered money), MB = C + R © 2004 Pearson Addison-Wesley. All rights reserved

Central Bank’s Balance Sheet LIABILITIES Currency in Circulation: The amount of currency in the hands of the public. Reserves : Consist of banks’ deposits at the central bank plus currency that is physically held by banks. ASSETS Government Securities : Central bank’s holdings of securities issued by the government Discount Loans : Reserves provided by the central bank to the banking system © 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

An OMO on the monetary base is much more certain than the effect on reserves 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 is always the same whether the seller of the bonds keeps the proceeds in deposits or in currency. © 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

Multiple Deposit Creation: A Simple Model Sum of an Infinite Series D = R ×[1+(1-r)+(1-r)**2+(1-r)**3+……] D = R ×1/[1-(1-r)] =1/r 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 © 2004 Pearson Addison-Wesley. All rights reserved

Critique of Simple Model Deposit creation stops if: 1. Proceeds from loan kept in cash (borrowers) Bank holds excess reserves (banks) Central bank is not the only player whose behavior influences the level of deposits and the money supply---borrowers, depositors, and banks also have the influence on money supply. © 2004 Pearson Addison-Wesley. All rights reserved