Multiple Deposit Creation and the Money Supply Process Chapter 16

Overview The Fed’s T-account Controlling the Monetary Base Multiple Deposit Expansion Simple Deposit Multiplier Critique of the Simple Model

∆ Money Supply (MS) = ∆ Interest Rate (i) How does Fed change MS?? 4 players involved Federal Reserve Banks Depositers Borrowers

The Fed’s Balance Sheet Assets Securities Discount Loans Gold and SDR’s Special Drawing Rights Coin (Treasury) Cash in Process of Collection Foreign Assets Liabilities Federal Reserve Notes Outstanding Member Bank Reserves Treasury Deposits Foreign/Other Deposits Foreign Central Banks Other Gov’t agencies Deferred availability cash items Capital Account (Stock)

The Fed’s Balance Sheet Assets Government Securities Discount Loans Liabilities Currency in Circulation Reserves Monetary Liabilities: Currency and Reserves Increase in either results in increase in MS Changes in assets = changes in liabilities

Monetary Base (High-powered money) Monetary Base (MB) = Currency in Circulation (c) + Reserves (r) + Treasury “Currency” Increase the MB: Assets Securities purchased Discount loans given Gold/SDR’s purchased “Float”: temporary check-clearing asset Purchase of foreign bonds, currency Decrease the MB: Liabilities Treasury/Foreign Deposits Other Federal Reserve Liabilities Capital liabilities

Term Review Reserves: deposits at the fed plus currency physically held by banks Required Reserve Ratio: fraction of DEPOSITS that must be held as currency Discount Rate: the interest rate charged to banks for discount loans from the Fed

Controlling MB Daily changes out of Fed’s control Tools to control MB Treasury Deposits Float Tools to control MB Open-Market Operations Discount Loans Reserve Ratio (probably not, not as useful)

Open Market Operations Purchase of bonds by Fed (open market purchase) T-account examples O.M purchase from a bank O M. Purchase from public Federal Reserve check deposited Federal Reserve check cashed In each case, MB is increased BUT, effect on reserves (R) in ambiguous!! Depends on whether the check is deposited or cashed

Two more examples Shifts from reserves to currency Discount Loans MB are not changed Reserves ARE changed Fed again has less control over reserves Discount Loans

Multiple Deposit Creation/Expansion FR increase in reserves usually leads to an increase in MS several times as large Say Fed buys bonds from 1st nat. bank 1st national can now loan out $100 because RR hasn’t changed The act of lending has created money! Bank can’t lend out more than its excess reserves 3) Borrower spends money (writes check on other bank) DD in First National go out Vendor puts earnings of $100 in Bank A

Expansion Continues 4) With reserve ratio at 10%, Bank A can RELOAN $90 of the deposit! 2nd borrower spends money 2nd Vendor deposits at Bank B At 10% RR, Bank B loans out $81 3rd Vendor deposits in Bank C At 10% RR, Bank C loans out $72.90 9) 3rd Vendor deposits in Bank D Etc., etc. Infinite series

Simple Deposit Multiplier ∆DD = (1/rr) ∆ R Applies to changes in entire banking system Equilibrium when no excess reserves exist in the banking system But doesn’t work if… Banks keep new funds as excess reserves Borrowers/Vendors keep cash, don’t redeposit

Review Three ways Fed changes MS Buying/selling bonds Discount Loans Sets multiplier in motion FOMC Discount Loans Same as buying/selling bonds, increases or decreases a banks reserves Board of Governors Reserve ratio Determines the magnitude of the multiplier effect