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Process of Multiple Deposit Creation in a Fractional Reserve Banking System

Process of Multiple Deposit Creation in a Fractional Reserve Banking System. Assumptions. 1. Fractional reserve system Minimum reserve ratio / legal reserve ratio e.g. 20% of the total deposits. Banks do not hold excess reserves. Assumptions.

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Process of Multiple Deposit Creation in a Fractional Reserve Banking System

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  1. Process of Multiple Deposit Creation in a Fractional Reserve Banking System Deposit creation by Jody Wong, YLMASS

  2. Assumptions 1. Fractional reserve system Minimum reserve ratio / legal reserve ratio e.g. 20% of the total deposits. Banks do not hold excess reserves Deposit creation by Jody Wong, YLMASS

  3. Assumptions No cash leakages ( loans made by a bank will return to the banking system. ) • Adequate qualified borrowers ( enough investment opportunities ) • One type of deposits Deposit creation by Jody Wong, YLMASS

  4. Why do banks need to keep minimum reserves? Banks keep minimum reserves because • They are required by the law to do so. • Banks keep minimum reserves to meet the normal withdrawal of the depositors. Deposit creation by Jody Wong, YLMASS

  5. What are minimum reserves? Minimum reserves refer to the minimum amount of reserves/reserves required by the law that a bank must keep to meet the withdrawal of the depositors. The amount depends on the legal reserve ratio and the amount of deposits. Deposit creation by Jody Wong, YLMASS

  6. How to calculate the amount of minimum reserves? Suppose a bank receives a new deposit of $5000 and the minimum reserve ratio is 25%. The minimum amount of deposits kept by the bank = $5000 ( 25% ) = $1250 Deposit creation by Jody Wong, YLMASS

  7. What are excess reserves? New deposit = $5000 and minimum reserve ratio = 25% Minimum reserves = $5000( 25% ) = $1250 Excess reserves = $5000 - $1250 = $3750 Excess reserves = Actual reserves – minimum reserves Deposit creation by Jody Wong, YLMASS

  8. Assets include Reserves ( in the form of cash or very liquid assets ) kept in banks Loans Investment Liabilities Deposits A Bank’s Balance Sheet Deposit creation by Jody Wong, YLMASS

  9. Process of Deposit creation • Minimum reserve ratio, e.g. 20% of deposits • No cash leakage Assumptions : Revisited • Adequate investment opportunities/enough qualified borrowers • One type of deposits Deposit creation by Jody Wong, YLMASS

  10. Process of Deposit Creation New deposits = $1000 Mr. deposits $1000 cash in Bank A. Minimum reserve ratio = 20% Deposit creation by Jody Wong, YLMASS

  11. Bank A’s Balance Sheet: Immediate effect ( New deposits ) Liabilities: Assets: Balance Sheet Reserves Deposits 1000 1000 Deposit creation by Jody Wong, YLMASS

  12. Bank A • Minimum reserves = $1000 ( 20% ) = $200 • Excess reserves = $1000 - $200 = $800 • Excess reserves are loaned out. $800 loan made to a borrower will be deposited to his bank, say Bank B. Deposit creation by Jody Wong, YLMASS

  13. Bank A’s Balance Sheet after loaning out excess reserves Bank A’s Balance Sheet Assets: Liabilities: Minimum reserves Deposits 200 1000 800 Loans Deposit creation by Jody Wong, YLMASS

  14. Bank B gains a new deposit of $800 Deposit creation by Jody Wong, YLMASS

  15. Bank B’s Balance Sheet: Immediate effect ( New deposits ) Balance Sheet Assets: Liabilities: Reserves 800 Deposits 800 Deposit creation by Jody Wong, YLMASS

  16. Bank B • Minimum reserves = $800 ( 20% ) = $160 • Excess reserves = $800 - $160 = $640 • Excess reserves are loaned out. $640 loan made to a borrower will be deposited to his bank, say Bank C. Deposit creation by Jody Wong, YLMASS

  17. Bank B’s Balance Sheet after loaning out excess reserves Bank B’s Balance Sheet Assets: Liabilities: Minimum reserves 160 Deposits 800 640 Loans Deposit creation by Jody Wong, YLMASS

  18. Bank C gains a new deposit of $640 Deposit creation by Jody Wong, YLMASS

  19. Bank C’s Balance Sheet: Immediate effect ( New Deposits ) Balance Sheet Assets: Liabilities: Reserves 640 640 Deposits Deposit creation by Jody Wong, YLMASS

  20. Bank C • Minimum reserves = $640 ( 20% ) = $128 • Excess reserves = $640 - $128 = $512 • Excess reserves are loaned out. $512 loan made to a borrower will be deposited to his bank, say Bank D. Deposit creation by Jody Wong, YLMASS

  21. Bank C’s Balance Sheet after loaning out excess reserves Bank C’s Balance Sheet Assets: Liabilities: Minimum reserves 128 Deposits 640 Loans 512 Deposit creation by Jody Wong, YLMASS

  22. The process goes on and on …….. Deposit creation by Jody Wong, YLMASS

  23. Summary of the above balance sheets Minimum reserves Deposits Loans Bank A 1000 200 800 Bank B 640 800 160 Bank C 640 128 512 Deposit creation by Jody Wong, YLMASS ……… on and on …………………

  24. Maximum Amount of Deposits Created Maximum amount of deposits created = $1000 + $800 + $ 640 + $512 …… = $1000 ( 1 + 0.8 + 0.82 + 0.83 + 0.84 …. ) = $1000 ( 1/1-0.8 ) = $1000 ( 1/0.2 ) Deposit creation by Jody Wong, YLMASS

  25. Maximum Amount of Deposits Created Maximum amount of deposits created = Initial deposits ( 1/minimum reserve ratio ) Maximum Banking Multiplier = 1/minimum reserve ratio Deposit creation by Jody Wong, YLMASS

  26. Does the supply of money change? Yes! But Why? Bank deposits are components of money supply. When more deposits are created, the money supply also increases. But by how much ? Deposit creation by Jody Wong, YLMASS

  27. Is the increase in money supply the same as the amount of deposits created? It depends on the source of the initial deposits! Deposit creation by Jody Wong, YLMASS

  28. If the initial deposit comes from money in circulation, then the maximum increase in money supply is smaller than the maximum increase in total deposits. Deposit creation by Jody Wong, YLMASS

  29. Initial deposit = $1000 ( cash in circulation, before being deposited in Bank A) The maximum increase in deposits is $5000. The maximum increase in money supply is $5000 - $1000 = $4000 Deposit creation by Jody Wong, YLMASS

  30. If the initial deposit does not come from money in circulation, then the maximum increase in money supply is the same as the maximum increase in total deposits. Deposit creation by Jody Wong, YLMASS

  31. Initial deposit = $1000 ( e.g. $1000 brought into the economy by a 金山阿伯 阿威 from the US ) The maximum increase in deposits is $5000. The maximum increase in money supply is also $5000 Deposit creation by Jody Wong, YLMASS

  32. What if ………………? Deposit creation by Jody Wong, YLMASS

  33. Limitations to the process of multiple deposit creation What if banks keep excess reserves ? Deposit creation by Jody Wong, YLMASS

  34. Limitations to the process of multiple deposit creation What if there are cash leakages? Deposit creation by Jody Wong, YLMASS

  35. Limitations to the process of multiple deposit creation What if there are not enough qualified borrowers? Deposit creation by Jody Wong, YLMASS

  36. Process of Multiple Deposit Contraction in a Fractional Reserve Banking System What happens to the total deposits of the banking system if a depositor withdraws money from the bank, assuming the banking system is fully loaned up? How will the change in bank deposits affect the money supply? Deposit creation by Jody Wong, YLMASS

  37. END Deposit creation by Jody Wong, YLMASS

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