Deposit Creation and the Money Supply Process – Part I Chapter 13

Deposit Creation Who is involved? –Fed –Banks –Depositors –Borrowers

The Fed’s Balance Sheet AssetsLiabilities Security holdingsNotes Loans Reserve Deposits Gold and SDRsTreasury deposits Cash ItemsFor. & Agency Deposits CoinDeferred Availability Cash Items Other AssetsOther Lia. & Capital –Physical and For. Cur.

Monetary base or high-powered money MB = Fed notes + Treasury currency – coin + bank reserves MB = C + R Uses of base are C + R

Sources of base Federal Reserve Credit Securities Discount Lending Float Gold and SDR’s Other Fed assets Treasury currency

Monetary Base Monetary Base$ 808.8b Currency$ 742.7b Reserves$ 45.4b –Vault Cash (Reserves)$ 34.7b –Deposits$ 10.7b Surplus Vault Cash$ 13.5b Clearing Balances$ 7.2b

Bank Reserves Total Reserves$ 45.4b –Required$ 43.6b –Excess$ 1.8b Borrowed Reserves$ 175m –Primary$ 24m –Seasonal$ 151m Data as of May 2006

Controlling the Monetary Base Open Market Operations Lending to Financial Institutions Fed has better control of base than of reserves

Open Market Operations Open market purchase Buy securities from bank or public Example: Purchase from bank Bank Assets Liabilities Securities -$100 Reserves +$100 Fed Assets Liabilities Securities +$100Reserves+$100

Open Market Operations Next, assume security purchased from nonbank public Pat Public AssetsLiabilities Securities -$100 Dem.Dep+$100 Pat’s Bank Assets Liabilities Reserves +$100 Dem.Dep. +$100 Fed AssetsLiabilities Securities +$100 Reserves+$100

Open Market Operations Result differs if Pat holds currency In both cases, monetary base increases, but reserves increase only when funds deposited in bank Pat Public AssetsLiabilities Securities -$100 Currency +$100 Fed AssetsLiabilities Securities +$100 Currency +$100

Open Market Operations Open Market Sale Pat Public AssetsLiabilities Securities+$100 Currency-$100 Fed Assets Liabilities Securities -$100 Currency-$100

Increase in Currency Shifts from deposits to currency reduce bank reserves but leaves base unchanged Pat Public AssetsLiabilities Demand Deposits -$100 Currency +$100 Banks AssetsLiabilities Reserves -$100 Demand Deposits -$100 Fed AssetsLiabilities Reserves -$100 Currency +$100

Foreign Exchange Intervention Purchases and sale of foreign currency has same effect as security purchases and sales

Discount Loans Bank borrows reserves from Fed Bank Assets Liabilities Reserves+$100 Loans +$100 Fed AssetsLiabilities Loans+$100Reserves+$100

Discount Loans Bank repays loan Bank Assets Liabilities Reserves-$100 Loans -$100 Fed AssetsLiabilities Loans-$100 Reserves-$100

Float and Treasury deposits Float and Treasury deposits affect monetary base. Fed can still control base by engaging in offsetting open market operations.

Multiple Deposit Creation Fractional reserve banking – hold a fraction of deposits as reserves Assume bank sells security to Fed, reserves increase. Also assume no excess reserves or currency. Required reserves are 10%

Multiple Deposit Creation Bank 1 sells security, gains reserves Bank 1 AssetsLiabilities Securities-$100 Reserves+$100

Multiple Deposit Creation Bank 1 has $100 of excess reserves, makes loan of $100 Bank 1 AssetsLiabilities Securities -$100Demand Deposits +$100 Reserves+$100 Loan+$100

Multiple Deposit Creation Borrower writes check, spends loan Bank 1 AssetsLiabilities Securities-$100 Loan+$100 Funds deposited in Bank 2 Bank 2 AssetsLiabilities Reserves+$100 Demand Deposits +$100

Multiple Deposit Creation Bank 2 has required reserves of $10 (10% 0f $100), and excess reserves of $90. Loans $90. Bank 2 AssetsLiabilities Reserves+$100 Demand Deposits +$100 Loans+ $90 Demand Deposits + $90 Note that deposits of $90 created. Total deposits $190.

Multiple Deposit Creation Borrower spends proceeds of loan, which are deposited in Bank 3 Bank 2 AssetsLiabilities Reserves+$10Demand Deposits +$100 Loans+ $90 Bank 3 AssetsLiabilities Reserves+$90Demand Deposits +$90

Multiple Deposit Creation Bank 3 has excess reserves of $81 (10% of $90), which it uses to make loan Bank 3 AssetsLiabilities Reserves+$90Demand Deposits +$90 Loan+$81Demand Deposits +$81 Process continues

Deposit Creation

Multiple Deposit Creation Result for banking system Banking System AssetsLiabilities Securities -$100 Demand Deposits +$1000 Reserves+$100 Loans +$1000 If banks purchase securities instead of making loans, deposit expansion is the same.

Simple deposit multiplier Multiplier reflects increase in deposits for a given increase in reserves  D = 1/r x  R Change in demand deposits equals one divided by required reserve ratio times change in reserves In levels D = 1/r x R Total demand deposits equals one divided by reserve ratio times total reserves.

Multiple Contraction Loss of reserves results in multiple contraction of deposits Assume bank buys security and reduces reserves Bank A Assets Liabilities Securities +$100 Reserves-$100

Multiple Contraction Bank is short of reserves of $100, assuming no excess reserves When loan is repaid, bank gains reserves, and has no shortage Loan paid from a check on Bank B, which is now short of reserves Bank B AssetsLiabilities Reserves-$100Demand Deposits -$100

Multiple Contraction Bank B is short $90 of reserves (since DD down $100) Bank B can replenish reserves by reducing loans by $90 Bank B AssetsLiabilities Reserves-$10Demand Deposits -$100 Loans-$90

Multiple Contraction For system as a whole, deposits fall by multiple of drop in reserves Banking System AssetsLiabilities Securities +$100 Demand Deposits -$1000 Reserve -$100 Loans -$1000 Limitations of analysis: Assumes no currency or excess reserves Changing these assumptions changes multiplier