Creating Money Through the Banking System Multiple Deposit Creation

Money and Banking The largest component of the money supply is bank deposits. To understand how the Central Bank influences the supply of money in the economy, we need to examine the linkages between: The Central Bank The private banking system Depositors Borrowers The interactions between these four groups have direct effects on the money supply

The Fed’s Balance Sheet We first look at the Central Bank’s (Fed) assets and liabilities Assets The Fed purchases securities (mostly those issued by the U.S. Treasury) from private banks and the non-bank public The Fed makes discount loans to private banks that are repaid at the discount rate Liabilities Currency in circulation is currency held by the public Bank reserves refer to currency held by private banks in their own vaults or at the Fed. Assets Liabilities Government Securities Currency in Circulation Discount Loans Reserves

The Monetary Base We define the monetary base as the Federal Reserve’s liabilities: MB = Currency in Circulation + Reserves = C + R The Fed can increase or decrease MB by engaging in Open Market Operations, the buying and selling of bonds from/to the public. To increase MB, the Fed will buy bonds from the public, replacing a non-monetary asset (bonds) with a monetary one (currency) To decrease MB, the Fed will sell bonds from the public, exchanging a monetary public asset (currency) for a non-monetary asset (bonds)

Increasing MB through an Open Market Purchase Federal Reserve Assets Liabilities Securities +$100 Reserves +$100 Banking System Assets Liabilities Securities -$100 Reserves +$100 The Fed buys a $100 bond from a bank and pays with a $100 check. The bank cashes the check and places the $100 in its vault as reserves. The monetary base has increased by $100 with the conversion of the privately held security into currency (and then into bank reserves)

Open Market Purchase from the Public Suppose the Fed wanted to increase the monetary base and bought a $100 treasury bill from you. You now have two things you can do with your money: Hold it as currency Deposit it at the bank. Suppose you hold onto the $100 as currency. The Fed’s balance sheet now looks like: The monetary base has increased Federal Reserve Assets Liabilities Securities +$100 Currency in Circulation +$100

Open Market Purchase from the Public Now what would happen if you deposited your $100 in the bank? The bank takes your $100 and places it in reserve The monetary base still increases by $100, only now because reserves went up: Federal Reserve Assets Liabilities Securities +$100 Reserves +$100 Banking System Assets Liabilities Reserves +$100 Checkable Deposits +$100

Federal Reserve System Open Market Sale Nonbank Public Federal Reserve System Assets Liabilities Securities +$100 -$100 Currency in circulation Currency The Fed sells a bond to the public for $100 Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves

Making a Discount Loan to a Bank Banking System Federal Reserve System Assets Liabilities Reserves +$100 Discount loans Discount loan A bank borrows $100 from the Fed’s discount window Monetary liabilities of the Fed have increased by $100 Monetary base also increases by this amount

Paying off a Discount Loan from the Fed Banking System Federal Reserve System Assets Liabilities Reserves -$100 Discount loans The bank pays back $100 to the Fed (assume no interest) Net effect on monetary base is a reduction Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System

Fractional Reserve Banking So far we have been assuming that banks hold the entire amount of their deposits in reserve. Clearly this is a false assumption as banks rarely ever have enough currency in their vaults (or on reserve at the Fed) to cover all deposits made with them. The banking system operates as a fractional reserve system in which only a portion of the banks deposits are held in reserve. The Fed sets a lower limit for the fraction of deposits that must be held in reserve: the reserve requirement ratio Since banks earn profit by lending at higher interest rates than they give on deposits, the reserve requirement is generally a binding limit.

Reserve Requirement Ratio One way the Fed influences the money supply is by changing the reserve requirement ratio (r) As r increases, bank loans will fall, money in circulation falls Suppose you deposit $100 into your account at Bank of America The reserve requirement ratio is 20%. Bank of America has the following balance sheet: The money supply is equal to the $100 deposited in the bank plus the $80 in currency circulating as a loan  M = $180 BANK OF AMERICA Assets Liabilities Reserves $20.00 Deposits $100 Loans $80.00

Reserve Requirement Ratio Suppose the $100 is deposited in Bank of America, but now the bank maintains a 10% reserve ratio, lending the remaining 90% of deposits. Bank of America’s financial statement would then be: The money supply has increased There is $90 of currency in circulation and $100 worth of deposits. The money supply has increased to $190 Despite the increase in the money supply, there has been no increase in wealth. New money has been created, but so has debt. Now suppose that the borrower who got the $90 loan uses that currency to make a purchase.

Reserve Requirement Ratio Suppose the borrower uses that $90 to buy tickets to an Atlanta Braves playoff game. Ticketmaster will then deposit this $90 in their bank, SunTrust. Suppose SunTrust maintains a 10% reserve ratio as well: Of the $90 deposited at SunTrust, only 10% ($9) is held as reserves. The remaining 90% ($81) is loaned out. There has been a further increase in the money supply. The new value for M is Deposits at Bank of America + Deposits at SunTrust + Currency in Circulation = $100+$90+$81=$271

Reserve Requirement Ratio Now SunTrust bank loans out $81 to another borrower who uses that money to buy books from the UCSD bookstore. The bookstore deposits this $81 in Wachovia Bank, who also maintain a 10% reserve ratio. The money supply has increased again: M1 = Deposits at BoA + Deposits at SunTrust + Deposits at Wachovia + Currency = $100 + $90 + $81 + $72.90 = $343.90 Each time money is deposited and a bank loan is created, more money is created. The amount of money the banking system generates with each dollar of reserves is known as the money multiplier.

The Formula for Multiple Deposit Creation

Critique of the Simple Model Holding cash stops the process Banks may not use all of their excess reserves to buy securities or make loans