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By Mr. LAU san-fatCH4-Deposit Creation & MS1 HKCE Macroeconomics Chapter 4: Deposit Creation and Money Supply.

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Presentation on theme: "By Mr. LAU san-fatCH4-Deposit Creation & MS1 HKCE Macroeconomics Chapter 4: Deposit Creation and Money Supply."— Presentation transcript:

1 By Mr. LAU san-fatCH4-Deposit Creation & MS1 HKCE Macroeconomics Chapter 4: Deposit Creation and Money Supply

2 By Mr. LAU san-fatCH4-Deposit Creation & MS2 Assets and Liabilities of a bank Assets: Anything owned by a bank is an asset. Liquid assets are easily converted into cash, e.g. cash and short-term loans. Illiquid/Fixed assets cannot be converted into cash within a short period of time, e.g. estate and office premises. Liabilities: Anything borrowed from others is liability.

3 By Mr. LAU san-fatCH4-Deposit Creation & MS3 Assets & Liabilities: Examples AssetsLiabilities Amount due from authorized institutions Cash Negotiable CD held Bonds Investment in shareholdings Interest in land & buildings Amount due to authorized institutions Deposits from customers Negotiable CD outstanding Amount due to banks abroad

4 By Mr. LAU san-fatCH4-Deposit Creation & MS4 Deposits & Money Supply Bank deposits are the largest component of money supply. Banks increase money supply by engaging in deposit creation. Money supply will however be contracted if banks engage in deposit withdrawals.

5 By Mr. LAU san-fatCH4-Deposit Creation & MS5 The Fractional Reserve System A fractional reserve system means that banks are required by law to keep a given fraction of their total deposits (Dd) as required or legal reserves. (Minimum) Required reserves (RR) are the minimum amount of liquid assets (e.g. cash & CDs) that must be kept in banks for withdrawals or emergency purposes. Excess reserves (ER) are the amount in excess of the required reserves. Thus, Dd=RR+ER, RR=Dd-ER, & ER=Dd-RR

6 By Mr. LAU san-fatCH4-Deposit Creation & MS6 The Fractional Reserve System The minimum required reserve ratio (RRR) is the the minimum fraction of a bank's total deposits required by law to be kept in the form of cash or other liquid assets. Thus, RRR=RR/Dd. However, for the prudent/conservative purpose or insufficient loan demand, the actual reserves (AR) kept by a bank may eventually more than the required amount.

7 By Mr. LAU san-fatCH4-Deposit Creation & MS7 The Fractional Reserve System The actual reserves ratio (ARR) is found by dividing actual reserves by total deposits. Thus, ARR=AR/Dd. If the actual reserves is larger than the required reserves, excess reserves were actually kept in the banking system. Excess reserves actually kept=AR-RR

8 By Mr. LAU san-fatCH4-Deposit Creation & MS8 An Exercise Below is a bank's balance sheet with the RRR=20%. Find: RR=RRRXDd=0.2X100=20 AR=liquid assets kept in the bank=40 ARR=AR/Dd=40/100=0.4 AER(or excess reserves)=AR-RR=40-20=20 Assets($)Liabilities($) Cash Loans & Advances Deposits100

9 By Mr. LAU san-fatCH4-Deposit Creation & MS9 The Fractional Reserve System Cash reserve ratio specifies the minimum fraction of a bank's total deposits that is required by law to be kept in the form of cash. Liquidity ratio = (short-term liquid assets/short-term liabilities)X100% In HK, all authorized institutions are required to meet the minimum monthly average liquidity ratio of 25%.

10 By Mr. LAU san-fatCH4-Deposit Creation & MS10 Assumptions behind Deposits Creation 1. Fractional reserve banking system exists. 2. No banks keep excess reserves. 3. No cash leakage. 4. Sufficient loan demand exists. 5. There is only demand deposits.

11 By Mr. LAU san-fatCH4-Deposit Creation & MS11 Deposits Creation: An Illustration Assumptions: There are 3 banks: Bank A, B & C. An initial amount of $1 000 was deposited in Bank A. The min. reserve ratio is The Question: What will be the maximum amount of deposits created out of the initial deposits of $1 000?

12 By Mr. LAU san-fatCH4-Deposit Creation & MS12 Deposits Creation: An Illustration Step 1: $1 000 was deposited in Bank A. Bank A's balance sheet Assets($)Liabilities($) Cash+1000Deposits+1000

13 By Mr. LAU san-fatCH4-Deposit Creation & MS13 Deposits Creation: An Illustration Step 2: Bank A kept 25% of $1 000 as required reserves & loans out the rest. Bank A's balance sheet Assets($)Liabilities($) Cash Loans Deposits+1000

14 By Mr. LAU san-fatCH4-Deposit Creation & MS14 Deposits Creation: An Illustration Step 3: Suppose the loan of $750 was finally deposited in Bank B. Bank B's balance sheet Assets($)Liabilities($) Cash+750Deposits+750

15 By Mr. LAU san-fatCH4-Deposit Creation & MS15 Deposits Creation: An Illustration Step 4: Bank B has to keep 25% of the total deposits as its required reserves and used the rest for loans. Bank B's balance sheet Assets($)Liabilities($) Cash Loans Deposits750

16 By Mr. LAU san-fatCH4-Deposit Creation & MS16 Deposits Creation: An Illustration Step 5: Let Bank C receive $ After keeping 25% of the new deposits, $421.9 will be loaned out. Bank C's balance sheet Assets($)Liabilities($) Cash Loans Deposits+562.5

17 By Mr. LAU san-fatCH4-Deposit Creation & MS17 Deposits Creation: An Illustration Step 6: Total deposits being created by Banks A, B & C=$( )=$ Another bank follows the same suit: receiving a certain amount of new deposits, keeping the min. required reserves, & lending the rest. The process goes on until the decreasing deposits becomes zero. Deposits is said to be created in the sense of accounting.

18 By Mr. LAU san-fatCH4-Deposit Creation & MS18 Deposits Creation: Theoretical Process Step 1: Under the fractional reserves system, a bank will keep a fraction as the required reserves of a new deposits and lend the rest. Step 2: The amount of loans will finally be re- deposited into the same or another bank. That bank will also keep a fraction as the required reserves and loan the rest out. Step 3: The process of receiving new deposits, keeping the required reserves and lending the rest will go on and on, until the decreasing deposits becomes zero.

19 By Mr. LAU san-fatCH4-Deposit Creation & MS19 Banking Multipliers Maximum banking/money multiplier, k=1/RRR Actual banking multiplier=1/ARR

20 By Mr. LAU san-fatCH4-Deposit Creation & MS20 Remarks on Deposits Creation Maximum deposits being created =initial deposits X (1/RRR) However, if banks keep excess reserves, the maximum deposits being created is lesser as less money is lent out and re-deposited. Thus, the total deposits being actually created =initial deposits X (1/ARR) Total change in deposits in the banking system =deposits created + original total deposits

21 By Mr. LAU san-fatCH4-Deposit Creation & MS21 Remarks on Deposits Creation Maximum loans/credit being created =excess reserves X (1/RRR)

22 By Mr. LAU san-fatCH4-Deposit Creation & MS22 Limitations of Deposits Creation Cash leakage will reduce the amount of deposits being created. Banks keep excess reserves will also reduce the deposits being created. Insufficient demand for loans will decrease the amount of deposits being created. Full reserves baking system will, however, prohibit the process multiple creation of deposits from happening. Then the deposits being created is equal to the initial deposits.

23 By Mr. LAU san-fatCH4-Deposit Creation & MS23 Withdrawals/Contraction of Deposits Step 1: If there is a withdrawal of deposits from a bank, the bank reserves will fall short of the legal requirement. Step 2: The bank will then call back loans or sell assets to get enough reserves. Step 3: To repay the loans or to buy assets, customers will further withdraw deposits from the other banks. Step 4: Withdrawals make bank reserves less than the legal requirement. Banks continue to call back loans. The process goes on and on.

24 By Mr. LAU san-fatCH4-Deposit Creation & MS24 Remarks on Deposits Contraction Maximum deposits being withdrawn =initial withdrawal X (1/RRR) However, if banks keep excess reserves, the maximum deposits being contracted is less than expected. Thus, the total deposits being withdrawn =initial withdrawal X (1/ARR) Total change in deposits in the banking system = original total deposits - deposits withdrawn

25 By Mr. LAU san-fatCH4-Deposit Creation & MS25 Deposits Creation and Change in Money Supply If the initial deposits comes from currency in public circulation or cash, the change in deposits will be larger than the change in money supply. Thus, change in M1 =deposits created – fall in cash Example: if the initial deposits=$100, RRR=0.2; then Change in Deposits = $100X(1/0.2)=$500 Change in M1 = $500 - $100 = $400


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