chapter 15 Multiple Deposit Creation and the Money Supply Process

Copyright © 2002 Pearson Education Canada Inc Four Players in the Money Supply Process 1.Central bank: the Bank of Canada 2.Banks 3.Depositors 4.Borrowers from banks Bank of Canada 1.Conducts monetary policy 2.Clears cheques 3.Regulates banks

Copyright © 2002 Pearson Education Canada Inc Bank of Canada Balance Sheet

Copyright © 2002 Pearson Education Canada Inc The Monetary Base MB = Bank of Canada notes outstanding + Settlement balances + Coins outstanding = C + R Bank of Canada notes outstanding + Settlement balances = Securities and investments + Advances + Foreign assets + SPRAs – Government deposits – SRAs + Other assets (net) MB = Securities and investments + Advances + Foreign assets + SPRAs + Other assets (net) + Coins outstanding – Government deposits – SRAs

Copyright © 2002 Pearson Education Canada Inc Summary: Factors That Affect the Monetary Base

Copyright © 2002 Pearson Education Canada Inc Control of the Monetary Base MB = C + R Open Market Purchase from Bank The Banking SystemThe Bank of Canada AssetsLiabilitiesAssetsLiabilities Securities – $100Securities + $100Reserves + $100 Reserves + $100 Open Market Purchase from Public Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities Securities – $100Securities + $100Reserves + $100 Deposits + $100 Banking System AssetsLiabilities ReservesChequable Deposits+ $100 Result: R  $100, MB  $100

Copyright © 2002 Pearson Education Canada Inc If Person Cashes Cheque Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities Securities – $100Securities + $100 Currency + $100 Currency + $100 Result: R unchanged, MB  $100 Effect on MB certain, on R uncertain The effect of an open market purchase on R depends on whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency. The effect of an open market purchase on MB, however, is always the same whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency.

Copyright © 2002 Pearson Education Canada Inc Open Market Sale of Bonds MB = C + R Open Market Sale to a Bank The Banking SystemThe Bank of Canada AssetsLiabilitiesAssetsLiabilities Securities + $100Securities - $100Reserves - $100 Reserves - $100 Open Market Sale to the Public Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities Securities + $100Securities - $100Reserves - $100 Deposits - $100 Banking System AssetsLiabilities ReservesChequable Deposits- $100 Result: R  $100, MB  $100

Copyright © 2002 Pearson Education Canada Inc Open Market Purchase in the Foreign Exchange (FX) Market MB = C + R Open Market Purchase of foreign exchange from a bank The Banking SystemThe Bank of Canada AssetsLiabilitiesAssetsLiabilities FX – $100FX + $100Reserves + $100 Reserves + $100 Open Market Purchase of foreign exchange from the Public Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities FX – $100FX + $100Reserves + $100 Deposits + $100 Banking System AssetsLiabilities ReservesChequable Deposits+ $100 Result: R  $100, MB  $100

Copyright © 2002 Pearson Education Canada Inc If Person Cashes Cheque Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities FX – $100FX + $100 Currency + $100 Currency + $100 Result: R unchanged, MB  $100 Effect on MB certain, on R uncertain Again, the effect of an open market purchase on R depends on whether the seller of FX keeps the proceeds from the sale in deposits or in currency. The effect of an open market purchase of FX on MB, however, is always the same whether the seller of the FX keeps the proceeds from the sale in deposits or in currency.

Copyright © 2002 Pearson Education Canada Inc Open Market Sale in the FX Market MB = C + R Open Market Sale of FX to a bank The Banking SystemThe Bank of Canada AssetsLiabilitiesAssetsLiabilities FX + $100FX - $100Reserves - $100 Reserves -$100 Open Market Sale of FX to the Public Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities FX + $100FX - $100Reserves - $100 Deposits - $100 Banking System AssetsLiabilities ReservesChequable Deposits- $100 Result: R  $100, MB  $100

Copyright © 2002 Pearson Education Canada Inc Shifts from Deposits into Currency Even if the Bank of Canada does not conduct open market operations, a shift from deposits into currency will affect R. However, such a shift will have no effect on MB. Shifts From Deposits into Currency: Public The Bank of Canada AssetsLiabilitiesAssetsLiabilities Deposits – $100Currency + $100 Currency + $100Reserves – $100 Banking System AssetsLiabilities Reserves – $100Deposits – $100 Result: R  $100, MB unchanged

Copyright © 2002 Pearson Education Canada Inc Advances Banking System The Bank of Canada AssetsLiabilitiesAssetsLiabilities Reserves AdvancesAdvancesReserves + $100 + $100 + $100 + $100 Result: R  $100, MB  $100 Conclusion: Bank of Canada has better ability to control MB than R

Copyright © 2002 Pearson Education Canada Inc Deposit Creation: Single Bank Consider a $100 open market purchase from First Bank First Bank Assets Liabilities Securities– $100 Reserves+ $100 First Bank Assets Liabilities Securities– $100Deposits+ $100 Reserves+ $100 Loans+ $100

Copyright © 2002 Pearson Education Canada Inc Deposit Creation: Single Bank (continued) A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan. The final T-account of the First Bank is: First Bank Assets Liabilities Securities– $100 Loans+ $100

Copyright © 2002 Pearson Education Canada Inc Deposit Creation: Banking System (r D = 10%) Bank A Assets Liabilities Reserves+ $100Deposits+ $100 Bank A Assets Liabilities Reserves+ $10Deposits+ $100 Loans + $90 Bank B Assets Liabilities Reserves+ $90Deposits+ $90 Bank B Assets Liabilities Reserves+ $ 9Deposits+ $90 Loans + $81

Copyright © 2002 Pearson Education Canada Inc Deposit Creation

Copyright © 2002 Pearson Education Canada Inc Banking System As a Whole Banking System Assets Liabilities Securities– $100Deposits+ $1000 Reserves+ $100 Loans+ $1000

Copyright © 2002 Pearson Education Canada Inc Same Result When Banks Invest Their ER in Securities If the banks choose to invest their ER in securities, the result is the same. If Bank A buys securities with $90 cheque, Bank A Assets Liabilities Reserves+ $10Deposits+ $100 Securities+ $90 Seller deposits $90 at Bank B and process is same. Hence, whether a bank chooses to use its ER to make loans or to buy securities, the effect on deposit expansion is the same.

Copyright © 2002 Pearson Education Canada Inc Simple Deposit Multiplier 1  D =   R r D Deriving the formula R = DR = r D  D 1 D =  R r D 1  D =   R r D

Copyright © 2002 Pearson Education Canada Inc Multiple Deposit Contraction The multiple deposit creation process should also work in reverse. When the Bank of Canada withdraws reserves from the banking system, there should be a multiple contraction of deposits. In fact, the contraction in deposits will be  D = (1/ r D )   R For example, if  R = -100 and (1/ r D ) = 10%, then  D =

Copyright © 2002 Pearson Education Canada Inc $100 Open Market Sale to First Bank Consider a $100 open market sale to First Bank First Bank Assets Liabilities Securities+ $100 Reserves- $100 The First Bank has lost $100 of R, and because it has not been holding any ER, it has a reserve deficiency. It can obtain the needed reserves by selling $100 of securities or by demanding repayment of $100 of loans. At the end the banking system’s D and L will decline by $1000, as shown in the next slide.

Copyright © 2002 Pearson Education Canada Inc Multiple Deposit Contraction: The Banking System Banking System Assets Liabilities Securities+ $100Deposits- $1000 Reserves- $100 Loans- $1000

Copyright © 2002 Pearson Education Canada Inc Critique of the Simple Model Our simple model seems to indicate that the Bank of Canada has complete control over D. It ignores, however, the fact that deposit creation stops if: 1. Proceeds from loan are kept in cash (in this case nothing is deposited in Bank B, and the deposit creation process stops). In this case  D = 100, not 1000 we calculated earlier. 2. Banks hold more reserves. If Bank A decides to hold on to all $90 of ER, no deposits would be made to Bank B, and this would also stop the deposit creation process. Again, in this case  D = 100, not 1000 we calculated earlier.

Copyright © 2002 Pearson Education Canada Inc Conclusion The Bank of Canada is not the only player whose behaviour influences D and M. D and M depend on: the public’s decisions regarding how much C to hold the banks’ decisions regarding the amount of R they wish to hold, and borrowers’ decisions on how much to borrow from banks.