1 Chapter 14 The Deposit Expansion Process: The Simple Analytics ©Thomson/South-Western 2006

2 Banks & The creation of Bank Deposits Banking System Credit availability & The Money Supply Macroeconomic Variables 1.Output 2.Employment 3.Price Level

3 Banks And The Creation Of Bank Deposits  T-accounts  A T-account indicates the change in the balance sheet of the depository institution resulting from a given event.  Suppose your hometown bank lends $10,000 to a local shoe-store owner for the purpose of increasing her inventories.  Hometown bank has created $10,000 in new money:

4 1. Writing a Check  A $10,000 check drawn on her account at Hometown Bank is sent to a shoe manufacturer in St. Louis.  When the check is deposited in a St. Louis bank and clears,  Demand deposits in the St. Louis bank have increased by $10,000.  Demand deposits in the Hometown Bank have decreased by $10,000.

5 1. Writing a Check  The main point: Whenever banks increase their loans--whether in the form of currency or in the form of a demand deposit entry on the banks' books--the nation’s money supply increases by the amount of the loan. ☺

6 2. A Bank Buys Securities  Hometown Bank purchases $200,000 of U.S. government securities from a dealer located in New York City.  Hometown Bank sends a $200,000 check drawn on its account with the Federal Reserve.  After the security dealer deposits the check in a New York bank, the check is processed and cleared by the Federal Reserve System.  When the dealer deposits the check in its New York bank, the nation’s money supply rises by $200,000. ☺

7 Money Creation  Banks create demand deposits whenever banks  Make Loans  Purchase Securities  Loans and Securities are profitable (Earning Assets)  Are banks limited in the amount they can make loans / buy securities?  Yes, banks have to maintain “Reserves”

8 Recall  The reserve requirement is a percentage figure set by the Federal Reserve, applicable to demand deposits in banks.  Required reserves are the dollar amount of reserves a bank must maintain or exceed.  Excess reserves are the difference between reserves and required reserves. If reserves exceed required reserves, banks have positive excess reserves.  Once a bank has no excess reserves, it cannot afford to lose any reserves. ☻ ☼

9 Banks & The Creation of Bank Deposits Required Reserves Securities Loans Securities Loans Securities Loans

10 Multiple Expansion of Bank Deposits  Federal reserve banking system requires that banks maintain only a small portion of their demand deposit liabilities in the form of reserves (cash and deposits in the banking system).  New reserves can support deposits that are a multiple of the amount of these new reserves.

11 Illustration of the Deposit Multiplier  Suppose a bank initially has no excess reserves.  Suppose explorers discover a sunken ship off the coast of Florida that contains $5 million in coins. If the coins are placed in a Florida bank (Bank A):

12 Illustration Continued  Assume:  Each bank in the nation desires to rid itself of all its excess reserves.  The reserve requirement for all banks is 10 percent.  Then:  Bank A has excess reserves of $4.5 million.  Bank A loans it all to real estate developers who buy land from customers of Bank B.

13 Illustration Continued  Bank B received demand deposits and reserves of 4.5 million  Bank B has required reserves = 10% of 4.5 million deposits = 0.45 million  Excess reserves = reserve – required reserve = 4.5 – 0.45 = 4.05 million  Bank B can use this reserves to make loans, buy securities.

14 Illustration Continued  Suppose Bank B buys U.S. government securities from a New York securities dealer.  Bank C can now grant loans and/or purchase securities in the amount of its excess reserves, $3.645 million.  ….and so on

15 Table 14-1

16 Maximum Expansion of Deposits  Induced Expansion of Deposits in the Banking System

17 Your turn (p.332) Q: Suppose the reserve requirement is 20%, you find $1million of currency in your grandmother’s attic and deposit into her bank checking account. Calculate: 1.The change in reserves in her bank 2.The change in required reserves in her bank 3.The change in excess reserves in her bank 4.The maximum amount by which her bank can expand its loans 5.The maximum amount the entire banking system can expand its loans 6.The potential expansion in the nation’s deposits 7.The potential exansion in M1

18 Banking system and Money Supply  Money Supply increases when  Bank makes loans  Bank purchases securities  Money Supply decreases when  Bank calls back loans  Bank sells securities

19 Multiple Contraction of Deposits  A withdrawal of reserves from the banking system precipitates a multiple contraction of deposits.  Suppose customers of Bank Q obtain $7 million in currency by drawing down their bank demand deposits.  Bank Q's required reserves decline by $0.7 million,  Actual reserves fall by the full $7 million.  Bank Q’s reserves are deficient by $6.3 million.  Bank Q initially exhibit excess reserves of negative $6.3 million.

20 Bank Q Reacts and Starts a Stampede  Bank Q can alleviate its reserve deficiency by selling $6.3 million in securities, by demanding repayment of $6.3 million worth of loans, or by some combination of those two actions.  Bank Q simply shifts its reserve deficiency to another bank, Bank R.  Bank R becomes deficient in reserves and must liquidate loans or securities, thereby shifting the hot potato to another bank, Bank S.  And so on.

21 The Result and Conclusion  The banking system cannot control its own reserves.  The public influences reserves by depositing or withdrawing currency from banks.  The Federal Reserve System influences reserves by buying and selling securities in the open market and by lending to banks.

22 How The Federal Reserve Gets A Grip On The Money Supply  With its unlimited authority to purchase or sell government securities in the open market, the Fed can easily swamp any influence of outside forces and thereby control the supply of reserves in the banking system.  When the Fed purchases securities (say $900m) in the open market:  When the Fed sells securities to individuals, firms, or banks, aggregate reserves are withdrawn from the banking system.

23 Study Question Suppose the reserve requirement is 10%. The Fed buys $1,000 million worth of securities from the dealer. 1.What is the initial (direct) change in the reserves (money supply)? 2.What is the ultimate effect on the money supply?