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1 Chapter 5 Multiple Deposit Creation and the Money Supply Process.

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1 1 Chapter 5 Multiple Deposit Creation and the Money Supply Process

2 2 Players in the Money Supply Process Central Bank Banks (most important: depository banks; also other financial intermediaries) Depositors (households, firms) Borrowers from banks (households, firms, governments) Behavior of each actor influences the money supply.

3 3 Central Banks Balance Sheet Central Bank AssetsLiabilities Government bonds (Securities) Currency in circulation Discount loansReserves

4 Central Banks Balance Sheet CB Liabilities Currency in circulationpaper money & coins held by the nonfinancial sector (firms & households) Reservescommercial banks deposits at the CB and vault cash (cash held in ATM machines and branches of commercial banks). CB requires banks to hold a minimum level of reserves at the CB as a percentage of total deposits required reserve ratio. But banks may choose to hold excess reserves 4

5 5 Central Banks Balance Sheet CB Assets Government bonds (securities)CB holds Treasury bonds as a policy instrument to increase or decrease the money supply Discount loansCB extends discount loans to commercial banks at an interest rate called the discount rate in the US or marginal lending rate in Turkey and Europe. (Today, instead of direct lending, most CBs mostly conduct operations in the repo market as their primary policy tool. See Ch.6)

6 6 Monetary Base The CB controls the monetary base by open market operations. MB = C + R MB: Monetary Base C:Currency in circulation R: Reserves

7 7 Open Market Purchase CB buys bonds worth 100 TL from a commercial bank (banking system). In return, it writes a check to the com. bank. The com. bank could either deposit the check in its CB account or cash the check. In either case, reserves increase by 100 TL Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Securities-TL100Securities+TL100Reserves+TL100 Reserves+TL100

8 8 Open Market Purchase Currency in circulation does not change because the cash in banks vaults or ATM machines is not included in currency in circulation. Monetary base increases by 100 TL An open market purchase increases the monetary base by the amount of the purchase. When monetary base increases by 1 TL, money supply increases by much more than 1 TL (money supply increases by money multiplier x 1TL). Because the banking system creates additional money through credit creation. See below.

9 9 Open Market Sale Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Securities+TL100Securities-TL100Reserves-TL100 Reserves-TL100 Just the opposite of OM Purchase. CB sells bonds of value 100 TL to a commercial bank. The com. Bank pays from its account at the CB. Reserves decrease by the amount of the sale. Therefore monetary base decreases by the amount of the sale.

10 10 Open Market Sale When monetary base decreases by 1 TL, money supply decreases by much more than 1 TL. Money supply decreases bymoney multiplier x 1TL. Because the banking system is left with less reserves to create money.

11 Shifts from Deposits into Currency If some depositors (who are firms or households from the nonfinancial sector or nonbank public), choose to withdraw part or all of their deposits, then reserves decrease, currency in circulation increases, monetary base is unchanged. Money goes under the pillow maybe because depositors lose confidence. Banking system shrinks. 11

12 12 Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Checkable deposits -TL100Reserves-TL100Checkable deposits -TL100 Currency+TL100 Central Bank AssetsLiabilities Currency in circulation +TL100 Reserves-TL100

13 13 CB Making a Discount Loan to the Banking System When the CB extends discount loans to the banking system, Both Assets and Liabilities of the CB increases by 100 TL Monetary Base also increases by 100 TL. Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Reserves+TL100Discount loans +TL 100Discount loan +TL100Reserves+TL100 (borrowing from CB)

14 14 Banks Create Deposit in a Fractional Reserve System When the CB injects 1 TL reserve into the banking system through OMOs or disc. loans, money supply increases by more than 1 TL. This is because the required reserve ratio (RRR) is less than 100% of deposits. A smaller RRR leads to a greater expansion of the money supply for 1 TL injection. First let us assume banks do not hold excess reserves.

15 15 Deposit Creation: Single Bank When CB makes an open market purchase from First National Bank (FNB), FNBs reserves increase, securities decrease by 100 TL. Since FNBs deposits dont change, this 100 TL is excess reserve for FNB and it lends all of this money to a firm. Opens a checking account for the firm, loans and checkable deposits of FNB increase by 100 TL. When the borrower spends the credit, reserves and checkable deposits disappear on FNBs T- account.

16 16 Deposit Creation: Single Bank First National Bank AssetsLiabilitiesAssetsLiabilities Securities-TL100Securities-TL100Checkable deposits +TL100 Reserves+TL100Reserves+TL100 Loans+TL100 First National Bank AssetsLiabilities Securities-TL100 Loans+TL100

17 17 Deposit Creation: The Banking System When the firm X spends the credit, assuming that nobody wants to keep extra cash, 100 TL spent is deposited in a checking account at another bank, Bank A. Then Bank As reserves and checkable deposits increase by 100 TL. Bank A must hold 10% required reserves, but can lend the rest: 90 TL. When firm Y who borrowed this 90 TL spends this loan, reserves are deposited to another bank: Bank B.

18 18 Deposit Creation: The Banking System Bank A AssetsLiabilitiesAssetsLiabilities Reserves+TL100Checkable deposits +TL100Reserves+TL10Checkable deposits +TL100 Loans+TL90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+TL90Checkable deposits +TL90Reserves+TL9Checkable deposits +TL90 Loans+TL81

19 19 Deposit Creation: The Banking System Bank Bs checkable deposits and reserves increase by 90 TL. Bank B must hold 9 TL as required reserves but can lend 81 TL to another firm Z. This firm Z can spend the credit and proceeds are deposited to another bank: Bank C. Bank Cs checkable deposits increase by 81 TL. Bank C also keeps 10% reserves and lends the rest (72.9 TL).

20 20 Deposit Creation: The Banking System Everytime new credit is creat ed, money supply increases by: 100+90+81+72.9+…. = 100 (1+0.9+(0.9) 2 +(0.9) 3 +….) =100.(1/10) =1000 TL As required reserve ratio(r) increases (decreases), money multiplier 1/r decreases (incr.) and money creation slows down (accelerates).

21 21

22 22 The Formula for Multiple Deposit Creation

23 23 Critique of the Simple Model 1.In the simple model, we assumed banks do not hold any excess reserves. In reality, they may choose to hold some excess reserves for precautionary purposes. They may not use all of their excess reserves to make loans or buy securities. This slows down money creation process and gives us a smaller money multiplier than 1/r. But we do not know how much excess reserves they choose to hold at any time. When uncertainty increases in the market, they hold more excess reserves.

24 24 Critique of the Simple Model 2. If depositors or borrowers choose to hold their money in cash instead of depositing, this slows down the money creation process. What percentage of deposits and bank loans do depositors and borrowers want to hold as cash instead of holding them in their accounts? We assumed 0%. In reality, this is positive.

25 25 Critique of the Simple Model Results: Money multiplier in reality is smaller than 1/r. For example, while r is around 10% on average in Turkey, money multiplier is around 5, not 10. In some countries like the UK, CB stopped enforcing required reserves. But this does not make m. multiplier infinite. For the Central Bank, it is easier to control the monetary base but not easy to control the money supply.

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