Presentation on theme: "Creating Money Through the Banking System"— Presentation transcript:
1 Creating Money Through the Banking System Multiple Deposit Creation
2 Money and BankingThe largest component of the money supply is bank deposits.To understand how the Central Bank influences the supply of money in the economy, we need to examine the linkages between:The Central BankThe private banking systemDepositorsBorrowersThe interactions between these four groups have direct effects on the money supply
3 The Fed’s Balance Sheet We first look at the Central Bank’s (Fed) assets and liabilitiesAssetsThe Fed purchases securities (mostly those issued by the U.S. Treasury) from private banks and the non-bank publicThe Fed makes discount loans to private banks that are repaid at the discount rateLiabilitiesCurrency in circulation is currency held by the publicBank reserves refer to currency held by private banks in their own vaults or at the Fed.AssetsLiabilitiesGovernment SecuritiesCurrency in CirculationDiscount LoansReserves
4 The Monetary BaseWe define the monetary base as the Federal Reserve’s liabilities:MB = Currency in Circulation + Reserves = C + RThe Fed can increase or decrease MB by engaging in Open Market Operations, the buying and selling of bonds from/to the public.To increase MB, the Fed will buy bonds from the public, replacing a non-monetary asset (bonds) with a monetary one (currency)To decrease MB, the Fed will sell bonds from the public, exchanging a monetary public asset (currency) for a non-monetary asset (bonds)
5 Increasing MB through an Open Market Purchase Federal ReserveAssetsLiabilitiesSecurities $100Reserves $100Banking SystemAssetsLiabilitiesSecurities $100Reserves $100The Fed buys a $100 bond from a bank and pays with a $100 check.The bank cashes the check and places the $100 in its vault as reserves.The monetary base has increased by $100 with the conversion of the privately held security into currency (and then into bank reserves)
6 Open Market Purchase from the Public Suppose the Fed wanted to increase the monetary base and bought a $100 treasury bill from you.You now have two things you can do with your money:Hold it as currencyDeposit it at the bank.Suppose you hold onto the $100 as currency.The Fed’s balance sheet now looks like:The monetary base has increasedFederal ReserveAssetsLiabilitiesSecurities $100Currency in Circulation +$100
7 Open Market Purchase from the Public Now what would happen if you deposited your $100 in the bank?The bank takes your $100 and places it in reserveThe monetary base still increases by $100, only now because reserves went up:Federal ReserveAssetsLiabilitiesSecurities $100Reserves +$100Banking SystemAssetsLiabilitiesReserves $100Checkable Deposits +$100
8 Federal Reserve System Open Market SaleNonbank PublicFederal Reserve SystemAssetsLiabilitiesSecurities+$100-$100Currency in circulationCurrencyThe Fed sells a bond to the public for $100Reduces the monetary base by the amount of the saleReserves remain unchangedThe effect of open market operations on the monetary base is much more certain than the effect on reserves
9 Making a Discount Loan to a Bank Banking SystemFederal Reserve SystemAssetsLiabilitiesReserves+$100Discount loansDiscount loanA bank borrows $100 from the Fed’s discount windowMonetary liabilities of the Fed have increased by $100Monetary base also increases by this amount
10 Paying off a Discount Loan from the Fed Banking SystemFederal Reserve SystemAssetsLiabilitiesReserves-$100Discount loansThe bank pays back $100 to the Fed (assume no interest)Net effect on monetary base is a reductionMonetary base changes one-for-one with a change in the borrowings from the Federal Reserve System
11 Fractional Reserve Banking So far we have been assuming that banks hold the entire amount of their deposits in reserve.Clearly this is a false assumption as banks rarely ever have enough currency in their vaults (or on reserve at the Fed) to cover all deposits made with them.The banking system operates as a fractional reserve system in which only a portion of the banks deposits are held in reserve.The Fed sets a lower limit for the fraction of deposits that must be held in reserve: the reserve requirement ratioSince banks earn profit by lending at higher interest rates than they give on deposits, the reserve requirement is generally a binding limit.
12 Reserve Requirement Ratio One way the Fed influences the money supply is by changing the reserve requirement ratio (r)As r increases, bank loans will fall, money in circulation fallsSuppose you deposit $100 into your account at Bank of AmericaThe reserve requirement ratio is 20%.Bank of America has the following balance sheet:The money supply is equal to the $100 deposited in the bank plus the $80 in currency circulating as a loan M = $180BANK OF AMERICAAssetsLiabilitiesReserves$20.00Deposits$100Loans$80.00
13 Reserve Requirement Ratio Suppose the $100 is deposited in Bank of America, but now the bank maintains a 10% reserve ratio, lending the remaining 90% of deposits.Bank of America’s financial statement would then be:The money supply has increasedThere is $90 of currency in circulation and $100 worth of deposits.The money supply has increased to $190Despite the increase in the money supply, there has been no increase in wealth. New money has been created, but so has debt.Now suppose that the borrower who got the $90 loan uses that currency to make a purchase.
14 Reserve Requirement Ratio Suppose the borrower uses that $90 to buy tickets to an Atlanta Braves playoff game.Ticketmaster will then deposit this $90 in their bank, SunTrust.Suppose SunTrust maintains a 10% reserve ratio as well:Of the $90 deposited at SunTrust, only 10% ($9) is held as reserves. The remaining 90% ($81) is loaned out.There has been a further increase in the money supply.The new value for M is Deposits at Bank of America + Deposits at SunTrust + Currency in Circulation = $100+$90+$81=$271
15 Reserve Requirement Ratio Now SunTrust bank loans out $81 to another borrower who uses that money to buy books from the UCSD bookstore.The bookstore deposits this $81 in Wachovia Bank, who also maintain a 10% reserve ratio.The money supply has increased again:M1 = Deposits at BoA + Deposits at SunTrust + Deposits at Wachovia + Currency = $100 + $90 + $81 + $72.90 = $343.90Each time money is deposited and a bank loan is created, more money is created.The amount of money the banking system generates with each dollar of reserves is known as the money multiplier.