© 2008 Pearson Education Canada15.1 Chapter 15 Multiple Deposit Creation and the Money Supply Process

© 2008 Pearson Education Canada15.2 Players in the Money Supply Process Central bank (Bank of Canada) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions) Borrowers (individuals and institutions)

© 2008 Pearson Education Canada15.3 Bank of Canada’s Balance Sheet Monetary Liabilities –Currency in circulation—in the hands of the public –Reserves - bank deposits at Bank of Canada and vault cash Assets –Government securities - holdings by the Bank of Canada that affect money supply and earn interest –Advances to banks - provide reserves to banks and earn the discount rate Bank of Canada AssetsLiabilities Government securities Currency in circulation Advances to banksReserves

© 2008 Pearson Education Canada15.4 Bank of Canada’s Balance Sheet (Cont’d) All LVTS and ACSS participants have accounts at the Bank of Canada (B of C) in which they hold settlement balances Chartered banks hold desired reserves to manage their short term liquidity requirements and respond to clearing drains and currency drains Reserves above that desired are known as excess reserves

© 2008 Pearson Education Canada15.5Recall MB = C + R Monetary Base is also called ‘High Powered Money’ M2 = C + D This has proven to have impact on Price level and Income.

© 2008 Pearson Education Canada15.6 Thus, the idea of Monetary Policy is that government control MB so that M2 would change which in turn affect P or Y.

© 2008 Pearson Education Canada15.7 General Principle When Government buys(sells) ‘anything’ from the Private Sector, Money Supply is injected into (withdrawn from) the private sector. (The T Table Analysis on the next few pages are just for reference, not for test).

© 2008 Pearson Education Canada15.8 Open Market Purchase from a Bank Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Reserves+$100 Reserves+$100

© 2008 Pearson Education Canada15.9 Open Market Purchase from Nonbank Public I Person selling bonds to the Bank of Canada deposits the Bank’s cheque in the bank Identical results as the purchase from a bank Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Securities+$100Reserves+$100

© 2008 Pearson Education Canada15.10 Open Market Purchase from Nonbank Public (Cont’d) The person selling the bonds cashes the B of C’s cheque Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase Nonbank PublicBank of Canada AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Currency in circulation +$100 Currency+$100

© 2008 Pearson Education Canada15.11 Open Market Purchase: Summary 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 (MB) always increases the base by the amount of the purchase

© 2008 Pearson Education Canada15.12 Open Market Sale Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves Nonbank PublicBank of Canada AssetsLiabilitiesAssetsLiabilities Securities+$100Securities-$100Currency in circulation -$100 Currency-$100

© 2008 Pearson Education Canada15.13 Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Chequable deposits +$100Reserves+$100Cheqeable deposits -$100 Currency-$100 Bank of Canada AssetsLiabilities Currency in circulation +$100 Reserves-$100

© 2008 Pearson Education Canada15.14 Bank of Canada Advances Monetary liabilities of the Bank of Canada have increased by $100 Monetary base also increases by this amount Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100Advances+$100Advances+$100Reserves+$100

© 2008 Pearson Education Canada15.15 Paying Off a Loan from the Bank of Canada Net effect on monetary base is a reduction Monetary base changes one-for-one with a change in the borrowings from the Bank of Canada Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves-$100Advances-$100Advances-$100Reserves-$100

© 2008 Pearson Education Canada15.16 Other Factors Affecting the Monetary Base 1.Float 2.Government deposits at the Bank of Canada Although technical and external factors complicate control of the monetary base, they do not prevent the Bank of Canada from accurately controlling it

© 2008 Pearson Education Canada15.17 Deposit Creation: Single Bank First Bank AssetsLiabilitiesAssetsLiabilities Securities-$100Securities-$100Chequable deposits +$100 Reserves+$100Reserves+$100 Loans+$100 First Bank AssetsLiabilities Securities-$100 Loans+$100

© 2008 Pearson Education Canada15.18 Deposit Creation: The Banking System Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves+$10Chequable deposits +$100 Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Chequable deposits +$90Reserves+$9Chequable deposits +$90 Loans+$81

© 2008 Pearson Education Canada15.19 Creation of Deposits

© 2008 Pearson Education Canada15.20 The Formula for Multiple Deposit Creation

© 2008 Pearson Education Canada15.21 Simple Deposit Multiplier 1  D =   R r Deriving the formula: R = RR = r  D 1 D =  R r 1  D =   R r

© 2008 Pearson Education Canada15.22 Multiple Deposit Creation: The Banking System Banking System Assets Liabilities Securities - $100 Deposits+ $1000 Reserves + $100 Loans + $1000

© 2008 Pearson Education Canada15.23 Critique of the Simple Model Holding cash stops the process(C/D is a drain from money creation) Banks may not use all of their excess reserves to buy securities or make loans -> This means that Government may lose ‘fine tuning (control)’ of M2 in some cases.

© 2008 Pearson Education Canada15.24 Complex Money Multiplier Money Multiplier is “MB multipliers How many times into M2”: No one can relate the above to economic behaviors. Divide both numerator and denominator by D, we get (from definition of M2 and MB)

© 2008 Pearson Education Canada15.25 Public decides on C/D: At what ratio do they keep Cash and Deposit? R = RR + ER Banks decides on R/D: what percentage of Deposit do they keep as Excess Reserves(ER)? Government decides on R/D as well: what precentage of Deposit the government order the banks to hold as Required Reserves(RR) ?- In Canada, there is no RR

© 2008 Pearson Education Canada15.26 Application of Money Multiplier Analyze the process of ‘Credit Crunch’ during the Financial Crisis: Public: C/D up or down? Banks: ER/D up or down? Government/Central Bank: RR/D up or down? What will happen to Money Multiplier? What could Government do to offset this change?

© 2008 Pearson Education Canada15.27