1. Multiple Deposit Creation and the Money Supply Process
Chapter 15
Multiple Deposit Creation and the Money Supply Process

2. Money Supply Process
It is important to understand how the money supply is determined because movements in the money supply affect interest rates and the overall health of the economy.
How the money supply is determined?
Who controls it?
What causes it to change?
How might control of it be improved?
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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 (or high-powered money), MB = C + R
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5. Central Bank’s Balance Sheet
LIABILITIES
Currency in Circulation:
The amount of currency in the hands of the public.
Reserves :
Consist of banks’ deposits at the central bank plus currency that is physically held by banks.
ASSETS
Government Securities :
Central bank’s holdings of securities issued by the government
Discount Loans :
Reserves provided by the central bank to the banking system
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6. 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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7. 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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8. An OMO on the monetary base is much more certain than the effect on reserves
The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits
The effect of an open market purchase on the monetary base is always the same whether the seller of the bonds keeps the proceeds in deposits or in currency.
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9. 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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10. Multiple Deposit Creation: A Simple Model
Sum of an Infinite Series
D = R ×[1+(1-r)+(1-r)**2+(1-r)**3+……]
D = R ×1/[1-(1-r)] =1/r R
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11. Deposit Creation: Single Bank
First National Bank
Assets Liabilities
Securities – $100
Reserves + $100
Securities – $100 Deposits + $100
Loans + $100

12. 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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13. Deposit Creation
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14. 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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15. Deposit Multiplier Simple Deposit Multiplier 1 D =  R r
Deriving the formula
R = RR = r  D
D =  R
D =  R
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16. Deposit Creation: Banking System as a Whole
Assets Liabilities
Securities – $100 Deposits + $1000
Reserves + $100
Loans + $1000
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17. Critique of Simple Model
Deposit creation stops if:
1. Proceeds from loan kept in cash (borrowers)
Bank holds excess reserves (banks)
Central bank is not the only player whose behavior influences the level of deposits and the money supply---borrowers, depositors, and banks also have the influence on money supply.
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