Deposit Creation and the Money Supply Process – Part I

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

2. Deposit Creation • Who is involved? • Fed • Banks • Depositors • Borrowers

3. The Fed’s Balance Sheet • Assets Liabilities • Security holdings Notes • Loans Reserve Deposits • Gold and SDRs Treasury deposits • Cash Items For. & Agency Deposits • Coin Deferred Availability Cash Items • Other Assets Other Lia. & Capital • Physical and For. Cur.

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

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

6. 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

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

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

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

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

11. 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 Liabilities Securities -$100 Currency +$100 Fed Assets Liabilities Securities +$100 Currency +$100

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

13. 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 Liabilities Reserves -$100 Currency +$100 Banks Assets Liabilities Reserves -$100 Demand Deposits -$100

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

15. Discount Loans • Bank borrows reserves from Fed Bank Assets Liabilities Reserves +$100 Loans +$100 Fed Assets Liabilities Loans +$100 Reserves +$100

16. Discount Loans • Bank repays loan Bank Assets Liabilities Reserves -$100 Loans -$100 Fed Assets Liabilities Loans -$100 Reserves -$100

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

18. 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%

19. Multiple Deposit Creation • Bank 1 sells security, gains reserves Bank 1 Assets Liabilities Securities -$100 Reserves +$100

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

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

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

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

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

25. Deposit Creation

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

27. 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.

28. 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

29. 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 Liabilities Reserves -$100 Demand Deposits -$100

30. 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 Liabilities Reserves -$10 Demand Deposits -$100 Loans -$90

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