Presentation is loading. Please wait.

Presentation is loading. Please wait.

UCL ECON7003 Money and Banking Topic 6a The Money Multiplier Stylized history of banking. Deposit creation. Actors in the Money Supply process. Multiple.

Similar presentations


Presentation on theme: "UCL ECON7003 Money and Banking Topic 6a The Money Multiplier Stylized history of banking. Deposit creation. Actors in the Money Supply process. Multiple."— Presentation transcript:

1 UCL ECON7003 Money and Banking Topic 6a The Money Multiplier Stylized history of banking. Deposit creation. Actors in the Money Supply process. Multiple deposit creation. Simple deposit multiplier and assumptions underlying it. Deposit creation and money supply.

2 Stylized history of banking. Owner of safe house storing gold takes in £100 in gold coins: Safe house AssetsLiabilities. Gold coins+ £100 Deposit notes + £100 Deposit notes become accepted in transactions: Substitute for payment in gold. i.e. Gold (commodity money) customary money – a financial instrument (bank note)

3 Safe house owner now makes loans to the value of £900. Safe house AssetsLiabilities. Gold coins £ 100 Deposit notes £1000 Loans issued £ 900 £1000 Note: Trade-off in deciding gold:deposit-note ratio: Profitability of loans and liquidity. Liquidity insufficient to meet demands for withdrawal of gold coins may run, or panic.

4 Deposit creation. Bank of England makes open market purchase of £100 from Bank I. Bank I uses proceeds to make loan of £100, paid into borrowers current account. Bank I Assets Liabilities. Securities - £100Deposits+ £100 Reserves+ £100 Loans+ £100.+ £100 Bank I has expanded balance sheet through issuing credit / creating deposit.

5 Bank now has ER of £100. BUT: new deposit created for purpose of loan. assumed the sum will soon be withdrawn. bank cannot safely make further loans / the £100 ER short term only. Likely net outcome : ΔD=0, ΔR=0, ΔL=100.

6 Bank Is customer uses loan to make purchase by cheque. Firm receiving cheque pays it into its account at Bank A. Bank A takes full advantage of corresponding ER to make loan to another customer. Bank A Assets Liabilities. Reserves+ £ 10 Deposits+ £100 Loans+ £ 90.+ £100

7 Actors in money supply process: (a) The expansion of Bank Is deposit creation capacity Bank Is deposit creation capacity was outcome of decision by CB to expand MB. Controls MB with certainty through OMOs. Commercial banks, their borrowers, their depositors: No part in this decision.

8 Actors in money supply process: (b) Bank Is loan to its customer Bank Is own independent decision. Its borrowers may have affected decision through their level of demand for loans r L. CB: no direct part in decision, though influence or control over interest rates may have affected it indirectly.

9 Actors in money supply process: (c) Use the customer makes of loan. Customers action involved two decisions relevant to MS process: (α) use entire loan for purchase > hold as deposit (β) make purchase by cheque > cash

10 Multiple deposit creation. Increase in deposits in banking system as a whole so far: Deposits created Bk A receives £100 from customer of Bk I£100 Bk B receives £90 from customer of Bk A£ 90 Total deposits created£190

11 Bank As customer uses loan to make purchase by cheque from a further firm. Firm pays this into its account at Bank B. Bank B takes full advantage of ER to make loan to another customer. Bank B Assets Liabilities. Reserves+ £ 9 Deposits+ £ 90 Loans+ £ 81.+ £ 90

12 Increase in deposits in banking system as a whole so far: Deposits created Bk A receives £100 from customer of Bk I£100 Bk B receives £90 from customer of Bk A£ 90 Bk C receives £81 from customer of Bk B£ 81 Total deposits created£271

13 Series of further transactions involving loans by Banks C, D, E, F. Assumption: Banks make loans to full amount of ER. Bank ΔD ΔR ΔLoans I£ 0.00£ 0.00£ A£100.00£10.00£ B£ 90.00£ 9.00£ C£ 81.00£ 8.10£ D£ 72.90£ 7.29£ E£ 65.61£ 6.56£ F£ 59.05£ 5.91£ … … … … £0 £0 £0 £ £100.00£ Or: ΔD = 100 { (0.9) 2 + (0.9) 3 + (0.9) (0.9) n }

14 Simple deposit multiplier. R = RR + ER, and RR = r.D, where r RRR ER = 0 R = RR = r.D R = r.D D = (1/r).R ΔD = (1/r).ΔR Simple deposit multiplier

15 Equilibrium: Point at which process ends, i.e. deposit creation ceases: In terms of number of transactions in chain: Reached at limit as n i.e. as (0.9) n 0. In terms of level of ER in banking system: Reached at limit as all ER exhausted i.e. as ER 0. In terms of total R in banking system: R = RR + ER ER 0 R RR = r.D i.e. ER exhausted, R reaches min. level consistent with RRR.

16 OMP of £100 £900 expansion of deposits in banking system: Banking System Assets Liabilities. Securities - £100Deposits+ £900 Reserves+ £100 Loans+ £900.+ £900 ER not yet exhausted: ER = £10 > 0. Equivalently R not yet equilibrium level: R = 100 > r.D = 90. i.e. Simple deposit multiplication process has not yet reached equilibrium.

17 Once process has reached equilibrium, we have. Banking System Assets Liabilities. Securities - £ 100Deposits+ £1000 Reserves+ £ 100 Loans+ £ £1000 ΔD = (1/r).ΔR r = 0.10 and ΔR = 100 ΔD = (1/0.10).100 = 10.(100) = 1000

18 Now banks use 50% of ER to purchase secs. > make loans. No difference to deposit creation process / equilibrium! Banking System Assets Liabilities. Securities - £ 100Deposits+ £1000 Reserves+ £ 100 Securities+ £ 500 Loans+ £ £1000 Or, simplifying: Banking System Assets Liabilities. Reserves+ £ 100Deposits+ £1000 Securities+ £ 400 Loans+ £ £1000

19 The assumptions underlying the simple deposit multiplier. Note: Money here defined as M1 C + bank deposits (1) All banks exhaust ER in making loans. i.e. till ER = 0, or equivalently to maximum extent consistent with RRR (i.e. R = r.D). (2) All transactions are carried out by cheque. Amount of currency in circulation unaffected (ΔC = 0). Lifting these assumptions: Deposit creation process is interrupted: (1) Banks retain ER > lend to full amount possible consistent with RRR (2) Customers shift into cash; money leaks out of the banking system.

20 Deposit creation and money supply: M M1 = C + D deposit creation is supply of money. Extent to which the two processes proceed: MS process is interrupted before deposit creation equilibrium of SDM. Assumptions on which SDM equilibrium rests are unrealistic.

21 If the two assumptions underlying the SDM held, CB would have full control over MS process: Assumption (1) BB continue deposit creation until ER exhausted. i.e. the process continues till equilibrium implied by SDM. i.e. with certainty, given the level of R in the economy. Assumption (2) CB can control R with certainty, since MB = R + C, and ΔC = 0. The CB is thus sole actor with determining role in MS process.

22 Lifting the assumptions, we have: CB no longer has full control of MS process: Assumption (1) If BB decide not to issue loans to full extent of ER resulting from OMP, and instead to hold ER > 0: Some of the ΔR from the OMP leak out of the deposit creation process. Process is interrupted / does not reach equilibrium level implied by SDM.

23 Assumption (2) If banks borrowers decide to shift from cheque to cash transactions: ΔC > 0 and some of the ΔR from the OMP leaks out of the banking system, out of deposit creation process. i.e. Lifting the assumptions: CB no longer sole actor in MS process: Decisions of banks, depositors, borrowers now also affect extent to which process proceeds.

24 To allow for lifting of these assumptions, 2 additional ratios: Lifting of assumption (1), we need: e ER / Dexcess reserve ratio Lifting of assumption (2), we need: c C / Dcurrency ratio Model that will incorporate these ratios. The money multiplier m: m = (1 + c) / (r + e + c)

25 ΔD = (1/r).ΔR Simple deposit multiplier Underlying assumptions: (1) Banks exhaust all ER in making loans. (2) All transactions are carried out by cheque. Lifting these assumptions: Deposit creation process is interrupted. To allow for lifting of these assumptions, 2 additional ratios: e ER / Dexcess reserve ratio c C / Dcurrency ratio Model that will incorporate these ratios. The money multiplier m: m = (1 + c) / (r + e + c)

26 Deriving the money multiplier MB = R + C R = RR + ER and RR = r.D, so we can write R = r.D + ER MB = r.D + ER + C Note: Parameter of 1 on ER and C: increase in MB that public decides to hold in cash one-for-one increase in MB / not multiplied through creation of additional deposits. Similarly, increase that goes into ER.

27 MB = r.D + ER + C e = ER / D ER = e.D c = C /D C = c.D MB = r.D + e.D + c.D MB = (r + e + c).D D = {1 / (r + e + c)}. MB

28 M M1 D + C Substituting C = c.D: M = D + c.D = (1 + c ).D We have D = {1 / (r + e + c)}. MB M = { (1 + c) / (r + e + c) }.MB We thus have: m = (1 + c) / (r + e + c) the money multiplier

29 i.e. The change in M ( M1) resulting from given change in MB. In terms of calculus: m = dM / dMB. Note: Outside money: Created by CB (i.e. through expansion of MB). Inside money: created by the commercial banking system. i.e. through multiple deposit creation.

30 Money multiplier: numerical example. We have: r = 0.10 C = £400 bn D = £800 bn ER = £0.8 bn c = C / D = 400 / 800 = 0.5 e = ER / D = 0.8 / 800 = m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = 2.496

31 We have: m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = Note: If ER = 0 and no leakage into cash transactions (i.e. e = c = 0), m would reduce to: (1 + 0) / (r ) = 1/r i.e. the SDM model would hold / m would be: 1 / r = 1 / 0.1 = 10 i.e. about 4 times greater.

32 Determinants of money supply (a) required reserve ratio. Inverse relationship (ceteris paribus) between RRR and MS: r supportable D Bank must contract loans and consequently deposits. i.e. A contraction in MS. Relationship (ceteris paribus) between RRR and m: Also inverse -- r is in denominator of m !

33 Recall above example: m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = Now suppose r from 0.10 to 0.15: m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = i.e. m has fallen from to

34 Determinants of money supply (b) cash ratio. Relationship (ceteris paribus) between NBPs cash to deposits ratio and money supply money multiplier Deposits undergo multiple expansion; currency does not. shift from deposits into cash, i.e. rise in c, is switch from component of M that undergoes multiplication into one that does not. i.e. both m and M are negatively related to c.

35 Recall above example: m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = Now suppose c rises from 0.5 to 0.75 (cet. par.): m = m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.75 / = m falls from to

36 Determinants of money supply (c) excess reserve ratio. Recall above example: m = (1 + c) / (r + e + c) = ( ) / ( ) = 1.5 / = Now suppose fivefold increase in e: m = ( ) / ( ) = 1.5 / = i.e. The increase in r has reduced m VERY LITTLE -- from to

37 Note: RRR is equivalent to ER. Both: bank reduces amount of deposits supported by given level of R. Bank determines e by costs and benefits of holding ER. Two main factors: Market interest rates Expected deposit outflows.


Download ppt "UCL ECON7003 Money and Banking Topic 6a The Money Multiplier Stylized history of banking. Deposit creation. Actors in the Money Supply process. Multiple."

Similar presentations


Ads by Google