Chapter 13 Multiple Deposit Creation and the Money Supply Process 1

Money Supply (MS) Process Definition: The mechanism that determines the money supply, or the implementation of monetary policy. It is important to understand the MS Process to understand exactly how do the tools of monetary policy change the money supply, and thereby affect economic indicators (e.g. interest rates, inflation, output, employment). Note: control over the money supply through monetary tools (including interest rates) is called Monetary Policy. 2

THE FOUR PLAYERS IN THE MS PROCESS 1. The central bank The most important player since it ultimately controls the supply of money in the economy. -Functions of the Central Bank: (A)Issuing Currency (B) Holding Ministries’ Accounts (C)Determining Exchange Rate (D) Banking Supervision (E)Monetary Policy (F) Checks Clearing -Tools of Monetary Policy (Chapter 15): (A) Determining the Discount Rate (B) Open Market Operations (C)Setting the Required Reserve Ratio 3

2. Commercial banks Depository institutions that accept deposits and make loans. 3. Depositors Bank customers (individuals, companies and institutions) holding bank deposits. 4. Borrowers from banks Bank customers (individuals, companies, etc) who borrow money from banks. 4

CENTRAL BANK'S BALANCE SHEET AND THE MONETARY BASE Monetary policy works by affecting the Central bank's balance sheet. Assets 1. Securities: Most of the assets are government securities. 2. Discount Loans: Loans that the central bank makes to banks. 5

Liabilities 1. Currency in Circulation: Cash in the hands of the public, outside the banking system. 2. Reserves: Which are in the form of either: a) bank deposits at the central bank (RR), or b) cash at commercial banks (ER). Note: Reserves are a liability of the Central Bank and an asset for commercial banks 6

Monetary Base Known also as high-powered money because an increase in it leads to multiple increases in the money supply. Consists of central bank notes outstanding, coins and reserves. Central bank notes outstanding and coins can be defined as currency in circulation (C), thus the monetary base is defined as: MB = C (currency) + R (reserves) 7

CONTROL OF THE MONETARY BASE (MB) Monetary Base is controlled by the Central Bank, through: (1) Open Market Operations (2) Discount Loans (discount rate) 8

Open Market Operations (1) Open Market Purchase (A) Open Market Purchase from a Bank The C.B. buys government securities from a bank. The bank gives the C.B. $100 government securities. The C.B. pays for the securities by increasing the bank’s reserves by $100. The bank: reserves increase by $100 while its holdings of securities decline by $100. 9

The T-account for the bank is: Commercial Bank Central Bank: liabilities _____ by $____ because of the _____ in __________, while its assets ______ by $______ because of the _________ in its ___________. AssetsLiabilities 10

The T-account for the central bank is: The Central Bank Result: Reserves and MB ______ by $____ (amount of OMO). AssetsLiabilities 11

(B)Open Market Purchase from Non-bank Public Non-bank public: Any natural or judicial person other than commercial banks. There are two possible cases: CASE 1:The central bank buys a ($100) government security from the non-bank public, and the seller makes a bank deposit. The T-account for the non-bank public is: Non-Bank Public AssetsLiabilities 12

When the commercial bank receives the check, it credits the depositor's account with $100 and then deposits the check at its account at the central bank who increases its _______ by $_____. The T-account for the commercial bank is: Commercial Bank AssetsLiabilities 13

The central bank's holdings of _______ increase by $____, while the _______ increase by $____. The Central Bank Similar to the case of purchasing securities from a bank (increase in ____, _____ and ____) AssetsLiabilities 14

CASE 2:The central bank buys a ($100) T-Bond from the non-bank public, and the person cashes the check. The T-account for the non-bank public is: Non-Bank Public AssetsLiabilities 15

The central bank's holdings of _______increase by $____, while _________ increase by $____. The Central Bank Result: Reserves _________, while (C) and (MB) _________ by the amount of the OMO. AssetsLiabilities 16

General Result for purchases: The effect of open market purchase is to increase the MB by the amount of the OMO whether the seller keeps the proceeds in deposits or in currency. 17

(2)Open Market Sale “If the central bank sells $100 of bonds to a bank or non-bank public, the monetary base declines by $100.” (A) Open Market Sale for a non Bank For Example: If the buyer pays for the bonds with currency, his T-account is: Non-Bank Public AssetsLiabilities 18

The central bank lowers its holdings of securities and currency by $100. Its T-account is: The Central Bank AssetsLiabilities Results Open market sale _____ MB by the same amount, although reserves are ______ (Why?) 19

(B) Open Market Sale for a Bank The C.B sells government securities to a bank($100). Commercial Bank Central Bank   Results: 20 AssetsLiabilities AssetsLiabilities

General Result for sales: The effect of open market sales is to decrease the MB by the amount of the OMO whether the buyer pays the proceeds from deposits or in currency. 21

General result for sale and purchases The effect of OMOs on MB is more certain than its effect on reserves. Thus, the central bank can control MB more effectively than reserves by using OMOs. 22

Shifts from Deposits into Currency Commercial Bank The Central Bank AssetsLiabilities AssetsLiabilities Result Has _____ effect on the central bank liabilities because the increase in (C) is _______ by a decline in (R). 23

Discount Loans Commercial Bank The Central Bank AssetsLiabilities AssetsLiabilities Result If the Central Bank makes a discount loan, (R) and (MB) _______ by the same amount. 24

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL Assumptions: The commercial bank holds no excess reserves. The public don’t hold cash. The required reserve ratio is 10%. 25

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL Deposit Creation: The Single Bank Assume that the central bank conducts Open Market Purchase of $100 from a bank. The T-account is: 1) Open Market Purchase Commercial Bank AssetsLiabilities 26

27 2) Making a loan AssetsLiabilities 3) The bank deposits the loan in the borrower’s account AssetsLiabilities Commercial Bank

AssetsLiabilities 4) The borrower withdraws the amount of the loan 5) The final effect on the bank’s balance sheet AssetsLiabilities 28 Commercial Bank

Result: The initial increase in reserves from the open market purchase has been converted by the bank into $100 of additional loans and $100 of deposits. 29

SUMMARY SIMPLE MODEL Assumptions: The commercial bank holds no excess reserves. The public don’t hold cash. The required reserve ratio is 10%. Deposit Creation Steps (single bank): 1) Open Market Purchase 2) Making a loan 3) The bank deposits the loan in the borrower’s account 4) The borrower withdraws the amount of the loan 30

Deposit Creation: The Banking System 1) Assume the $100 deposit (created by the loan) is deposited at bank (A), the T-account is: Bank A AssetsLiabilities Bank (A)’s required reserves equal $______, and excess reserves equal $______ The maximum amount of loans the bank can make is $______. 31

2) Bank (A) makes a loan Bank A AssetsLiabilities The borrower from Bank (A) uses the money to make purchases 3) The seller deposits the amount of the purchase in his bank (B) Bank B AssetsLiabilities 32

Bank (B) now has $___ of reserves. It only needs $____ as required reserves, it can lend $_____. Bank (B) creates a new loan of $____ and a new deposit of $___ for the borrower. When check clears, R= $___, L= $ ___ and D= $ ___. T-account of Bank B is: Bank (B) AssetsLiabilities The $ ____ spent by the borrower (from Bank B) will be deposited in another bank (Bank C). 33

Result: The initial increase in reserves in the banking system of $____, so far has increased checkable deposits in the system by $ 271 (= ____+ ____ +____). As a result, if all banks make loans for the full amount of their excess reserves, the total increase in deposits will be $ In general, deposits increase as follows: ∆ D = (1/RRR) x ∆ R = (1/____) x (_____) = $______ Where ∆ D = change in checkable bank deposits (D) RRR = required reserve ratio ∆ R = change in Reserves (R) 34

Deposit Creation 35

Simple Deposit Multiplier The multiple increase in deposits generated from an increase in the banking system's reserves. Our simple multiple deposit creation process depends on two factors to get the full potential deposit expansion of the Simple Deposit Multiplier on D, e.g. 10X: 1. Banks hold NO excess reserves (ER) 2. No cash (C) is held by the public Note: The central bank directly controls the MB, but can't directly control MS, it is influenced by public's behavior (cash demand) and bank's behavior (holding excess reserves). 36