Chapter 15 Multiple Deposit Creation and the Money Supply Process

2 Money Supply affect interest rate and the overall health of the economy It is important to understand how the money supply is determined Who controls it What causes it to change How might control of it be improved

3 This chapter provides an overview of how the banking system creates deposits, and describes the basic principles of the money suppl

4 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

5 Monetary policy Is the policy that is used to achieve certain macroeconomic objectives by regulating the money supply in the economy. Macroeconomic objectives are to achieve high growth rate, price stability, fiscal balance, trade balance, full employment, eliminating poverty and unequal distribution of income and wealth.

6 The Fed’s Balance Sheet Federal Reserve System Government securities Discount loans Currency in circulation Reserves AssetsLiabilities Monetary Base, MB = C + R= High Powered Money

7 Liabilities Currency in Circulation Reserves They are referred to as the monetary liabilities An increase in either or both will lead to an increase in the money supply, everything is equal

8 Monetary Base The sum of the Fed’s monetary liabilities and the US Treasury’s monetary liabilities (Treasury currency in circulation, primarily coins)

9 Currency in Circulation Green and Gray pieces of paper in your wallet that says “Federal Reserve Note” It is the amount of currency in the hands of the public Currency held by depository institution is a liability of the Fed, but it is counted in its reserve

10 Reserves All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks (Called vault cash because it is stored in bank vaults) Reserves are assets for banks but liabilities for the Fed

11 continued Reserves is divided into two catergories: Required and excess

12 Assets Government securities: They are securities issued by the U.S. Treasury. The Fed provides reserves to the banking system by purchasing securities, thereby increasing its holdings of these assets An increase in government securities held by the Fed leads to an increase in the money supply

13 Discount loans They are also referred to as borrowings from the Fed or as borrowed reserves

14 Control of The Monetary Base The monetary base is also called high- powered money MB=C+R

15 Open Market Operations A purchase of Bonds by the Fed is called an open Market Purchase and a sale of bonds by the Fed is called an open market sale

16 Open Market Purchase from a bank Suppose the Fed. Purchases $100 of bonds from a bank and pays them with $100 check The bank will either deposit the check in its account with the Fed or cash it in for currency which will be counted as vault cash

17 The Fed finds its liabilities have increased by the additional $100 of reserves, while its assets have increased by the $100 of additional securities

18 The net result of this open market purchase is that reserves have increased by $100. Because there has been no change of currency in circulation, the monetary base has also risen by $100

19 Open Market Purchase from the Nonbank Public Two cases 1. Assume that the person or the corporation that sells the $100 of bonds to the Fed deposits the Fed’s check in the local bank

20 When the bank receives the check, it credits the depositor’s account with the $100 and then deposits the check in its account with the Fed, thereby adding to its reserves.

21 What happen to the Fed’s T account; It has gained $100 of securities in its assets column, while it has an increase of $100 of reserves in its liabilities column

22 Control of the Monetary Base Open Market Purchase from Bank The Banking System The Fed AssetsLiabilitiesAssetsLiabilities Securities – $100 Securities + $100 Reserves + $100 Reserves + $100 Open Market Purchase from Public Public The Fed AssetsLiabilitiesAssetsLiabilities Securities – $100 Securities + $100 Reserves + $100 Check. Deposits + $100 Banking System AssetsLiabilities Reserves + $100 Checkable Deposits + $100 Result: R  $100, MB  $100

23 Second case If the person or corporation selling the bonds to the Fed cashes the Fed’s check either at a local bank or at a Federal Reserve bank for currency, the effect on reserves is different. The seller will receive currency of $100 while reducing holdings of securities by $100.

24 If Person Cashes Check Public The Fed Assets Liabilities Securities – $100Securities + $100 Currency + $100 Currency + $100 Result: R unchanged, MB  $100 Effect on MB certain, on R uncertain

25 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. If the proceeds are kept in currency, the open market purchase has no effect on reserves. If the proceeds are kept as deposits, reserves increase by the amount of the open market purchase

26 The effect of an open market purchase on the monetary base is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency. The impact of an open market purchase on reserves is much more uncertain than its impact on the monetary base.

27 Suppose that Jane Brown who opened a $100 checking account at the First National Bank decides that tellers are so abusive in all banks that she closes her account by withdrawing the $100 balance in cash and vows never to deposit it in a bank again.

28 If Person Cashes Check Shifts From Deposits into Currency Public The Fed Assets Liabilities AssetsLiabilities Deposits – $100 Currency + $100 Currency + $100 Reserves – $100 Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R  by $100, C  by $ 100, MB unchanged

29 Open Market Sale If the Fed sells $100 of bonds to a bank or the nonbank public, the monetary base decrease by $100 Example, if the Fed sells the bonds to an individual who pays for them with currency, the buyer exchanges $100 of currency for $100 of bonds

30 Open Market sale Public The Fed Assets Liabilities AssetsLiabilities Securities +$100Securities – $100 Currency – $100 Currency – $100 Result: R unchanged, MB  by $100 Effect on MB certain, on R uncertain

31 Discount Loans When the Fed makes a $100 discount loan to the First National Bank, the bank is credited with $100 of reserves from the proceeds of the loan.

32 Discount Loans Banking System The Fed AssetsLiabilities Assets Liabilities Res + $ 100 Disc. Loans +$100 Disc. Loans +$100 Res + $ 100 If the bank pays loan back to Fed, the reverse effects will take place in the T-accounts. Result: R  $100, MB  $100 Conclusion: Fed has better ability to control MB than R

33 Deposit Creation When the Fed supplies the banking system with $1 of additional reserve, deposits increase by a multiple of this amount- a process called multiple deposit creation

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

35 For simplicity, assume that the $100 of deposits created by the First National Bank’s loan is deposited at Bank A and that this bank and no other banks hold no excess reserves.

36 Deposit Creation: Banking System 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

37 Deposit Creation

38 Deposit Creation If Bank A buys securities with $90 check Bank A Assets Liabilities Reserves+ $10Deposits+ $100 Securities+ $90 Seller deposits $90 at Bank B and process is same Whether bank makes loans or buys securities, get same deposit expansion

39 Deposit Multiplier Simple Deposit Multiplier 1  D =   R r Deriving the formula R = RR = r  D 1 D =  R r 1  D =   R r

40 Deposit Creation: Banking System as a Whole Banking System Assets Liabilities Securities– $100Deposits+ $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

41 Four Players FED is not the only player that decides about the level of deposits and money supply Bank’s decision Depositor’s decisions Borrowers’ decisions Are also important