Deposit Creation and the Money Supply Process

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 • • • Assets Security holdings Loans Gold and SDRs Cash Items Coin • Other Assets – Physical and For. Cur. Liabilities Notes Reserve Deposits Treasury deposits For. & Agency Deposits Deferred Availability Cash Items Other Lia. & Capital

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 • Currency • Reserves – Vault Cash (Reserves) – Deposits • Surplus Vault Cash • Clearing Balances $ $ $ $ 808. 8 b 742. 7 b 45. 4 b 34. 7 b 10. 7 b 13. 5 b 7. 2 b

Bank Reserves • Total Reserves – Required – Excess • Borrowed Reserves – Primary – Seasonal $ 45. 4 b $ 43. 6 b $ 1. 8 b $ 175 m $ 24 m $ 151 m 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 Securities +$100 Liabilities Reserves +$100

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

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

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

Discount Loans • Bank repays loan Bank Assets Reserves -$100 Loans Liabilities -$100 Fed Assets Loans -$100 Reserves Liabilities -$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 Assets Securities Reserves Liabilities -$100 +$100

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

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

Multiple Deposit Creation • Bank 2 has required reserves of $10 (10% 0 f $100), and excess reserves of $90. Loans $90. Bank 2 Assets Reserves Loans +$100 + $90 Liabilities Demand Deposits +$100 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 Assets Reserves Loans Liabilities +$10 Demand Deposits +$100 + $90 Bank 3 Assets Liabilities Reserves +$90 Demand Deposits +$90

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

Deposit Creation

Multiple Deposit Creation • Result for banking system Banking System Assets Securities Reserves Loans -$100 +$1000 Liabilities Demand Deposits +$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 Securities Reserves Liabilities +$100 -$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 Assets Reserves Liabilities -$100 Demand 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 Assets Reserves Loans -$10 -$90 Liabilities Demand Deposits -$100

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