1. Multiple Deposit Creation and the Money Supply Process
Chapter 14
Multiple Deposit Creation and the Money Supply Process

2. Meaning and Function of Money
Economist’s Meaning of Money
1. Anything that is generally accepted in payment for goods and services
2. Not the same as wealth or income
Functions of Money
1. Medium of exchange
2. Unit of account
3. Store of value
Evolution of Payments System
1. Precious metals like gold and silver
2. Paper currency (fiat money)
3. Checks
4. Electronic means of payment
5. Electronic money: Debit cards, Stored-value cards, Smart cards, E-cash
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3. Four Players in the Money Supply Process
1. Central bank: the Fed
2. Banks
3. Depositors
4. Borrowers from banks
Federal Reserve System
1. Conducts monetary policy
2. Clears checks
3. Regulates banks
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4. The Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Discount loans
Currency in circulation
Reserves
Monetary Base, MB = C + R
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5. Control of the Monetary Base
Open Market Purchase from Bank
The Banking System The Fed
Assets Liabilities Assets Liabilities
Securities – $100 Securities + $100 Reserves + $100
Reserves + $100
Open Market Purchase from Public
Public The Fed
Securities – $100 Securities + $100 Reserves + $100
Deposits + $100
Banking System
Assets Liabilities
Reserves Checkable Deposits
+ $100 + $100
Result: R  $100, MB  $100
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6. If Person Cashes Check Public The Fed
Assets Liabilities Assets Liabilities
Securities – $100 Securities + $ Currency + $100
Currency + $100
Result: R unchanged, MB  $100
Effect on MB certain, on R uncertain
Shifts From Deposits into Currency
Deposits – $100 Currency + $100
Currency + $100 Reserves – $100
Banking System
Assets Liabilities
Reserves – $100 Deposits – $100
Result: R  $100, MB unchanged
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7. Discount Loans Banking System The Fed
Assets Liabilities Assets Liabilities
Reserves Discount Discount Reserves
+ $100 loan + $100 loan + $ $100
Result: R  $100, MB  $100
Conclusion: Fed has better ability to control MB than R
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8. Deposit Creation: Single Bank
First National Bank
Assets Liabilities
Securities – $100
Reserves + $100
Securities – $100 Deposits + $100
Loans + $100

9. Deposit Creation: Banking System
Bank A
Assets Liabilities
Reserves + $100 Deposits + $100
Reserves + $10 Deposits + $100
Loans + $90
Bank B
Reserves + $90 Deposits + $90
Reserves + $ 9 Deposits + $90
Loans + $81
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10. Deposit Creation
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11. Deposit Creation If Bank A buys securities with $90 check Bank A
Assets Liabilities
Reserves + $10 Deposits + $100
Securities + $90
Seller deposits $90 at Bank B and process is same
Whether bank makes loans or buys securities, get same deposit expansion
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12. Deposit Multiplier Simple Deposit Multiplier 1 D =  R r
Deriving the formula
R = RR = r  D
D =  R
D =  R
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13. Deposit Creation: Banking System as a Whole
Assets Liabilities
Securities – $100 Deposits + $1000
Reserves + $100
Loans + $1000
Critique of Simple Model
Deposit creation stops if:
1. Proceeds from loan kept in cash
2. Bank holds excess reserves
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14. Deriving Money Multiplier R = RR + ER RR = r  D R = (r  D) + ER
M = m  MB
Deriving Money Multiplier
R = RR + ER
RR = r  D
R = (r  D) + ER
Adding C to both sides
R + C = MB = (r  D) + ER + C
1. Tells us amount of MB needed support D, ER and C
2. $1 of MB in ER, not support D or C
MB = (r  D) + (e  D) + (c D)
= (r + e + c)  D
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15. 1 D =  MB r + e + c M = D + (c D ) = (1 + c) D 1 + c M =  MB m =
m < 1/r because no multiple expansion for currency and because as D  ER 
Full Model
M = m  (MBn + DL)
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16. Excess Reserves Ratio Determinants of e
1. i , relative Re on ER  (opportunity cost ), e 
2. Expected deposit outflows, ER insurance worth more, e 

17. Factors Determining Money Supply
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18. Deposits at Failed Banks: 1929–33
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19. e, c: 1929–33
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20. Money Supply and Monetary Base: 1929–33
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