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

2. Players in the Money Supply Process
Central Bank (Federal Reserve System)
Banks (depository institutions; financial intermediaries)
Depositors (individuals and institutions)
Borrowers from banks (individuals and institutions)

3. Central Bank’s Balance Sheet
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Monetary Liabilities
Currency in circulation—notes in the hands of the public
Reserves—commercial bank deposits at the CB and vault cash (cash in ATM machines and branches of commercial banks). CB requires banks to hold a minimum level of reserves at the CB as a fraction of total deposits. But banks may hold excess reserves

4. Central Bank’s Balance Sheet
Assets
Government securities—CB holds Treasury bonds as a policy instrument to increase or decrease the money supply
Discount loans—lend reserves to commercial banks and earn the discount rate

5. Monetary Base (High-powered money)
The CB controls the monetary base by “open market operations”.

6. Open Market Purchase
Banking System
Central Bank
Assets
Liabilities
Securities
-TL100
+TL100
Reserves
CB buys 100 TL bond from a commercial bank. In return writes a check. The commercial bank could either deposit the check in CB or cash the check.
Net result is that reserves have increased by 100 TL
No change in currency. (Cash in banks’ vaults or ATM machines is not included in C)
Monetary base increases by 100 TL

7. Open Market Purchase: Summary
The effect of an open market purchase always increases the monetary base by the amount of the purchase.
When monetary base increases by 1 TL, money supply increases by more than 1 TL (increases by the money multiplier).

8. Open Market Sale
Banking System
Central Bank
Assets
Liabilities
Securities
+TL100
-TL100
Reserves
CB sells 100 TL bond to a commercial bank. Deducted from bank’s account at CB in return.
Reserves decrease by the amount of the sale.
Monetary base decreases by the amount of the sale. In any open market sale, Monetary Base decreases.

9. Open Market Sale Summary
In any open market sale, Monetary Base decreases by the amount of the sale.
When monetary base decreases by 1 TL, money supply decreases by more than 1 TL. This amount is called the money multiplier.

10. Shifts from Deposits into Currency
Nonbank Public
Banking System
Assets
Liabilities
Checkable deposits
-TL100
Reserves
Currency
+TL100
Central Bank
Assets
Liabilities
Currency in circulation
+TL100
Reserves
-TL100

11. CB Making a Discount Loan to a Bank
Banking System
Central Bank
Assets
Liabilities
Reserves
+TL100
Discount loans
+TL 100
Discount loan
(borrowing from CB)
Monetary liabilities of the CB have increased by 100 TL
Monetary Base also increases by 100 TL.

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

13. Deposit Creation: Single Bank
First National Bank
Assets
Liabilities
Securities
-TL100
Checkable deposits
+TL100
Reserves
Loans
First National Bank
Assets
Liabilities
Securities
-TL100
Loans
+TL100

14. Deposit Creation: Single Bank
When CB makes an open market purchase from First National Bank (FNB), FNB’s reserves increase, securities decrease by 100 TL.
100 TL is excess reserve for FNB and it lends this money to a firm. Opens a checking account for the borrower, loans and checkable deposits increase by 100 TL.
When the borrower spends the credit, reserves and checkable deposits disappear on FNB’s T-account.

15. Deposit Creation: The Banking System
Bank A
Assets
Liabilities
Reserves
+TL100
Checkable deposits
+TL10
Loans
+TL90
Bank B
+TL9
+TL81

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

17. Deposit Creation: The Banking System
Bank B’s 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. This firm can spend the credit and proceeds are deposited to another bank: Bank C.
Bank C’s checkable deposits increase by 81 TL. Bank C also keeps 10% reserves and lends the rest (72.9 TL).

18. Deposit Creation: The Banking System
If there are many banks, checkable deposits and of course money supply increases by: ….
= 100 (1+0.9+(0.9)2+(0.9)3+….)
=100.(1/10)
=1000 TL
As required reserve ratio (r) increases, 1/r decreases and money creation is slower.

20. The Formula for Multiple Deposit Creation

21. Critique of the Simple Model
If borrowers & depositors hold their money in cash instead of depositing, this stops the money creation process. What fraction of bank loans is held in cash? We assumed zero.
Banks may not use all of their excess reserves to make loans or buy securities. They may choose to hold excess reserves for precaution purposes. This also slows down money creation.
Result is that it is not easy to control money supply (MB). It is easier to control the monetary base.