Chapter 18 Bank Reserves and the Money Supply

Key Ideas  Process of check clearing and its impact on the balance sheets of:  Commercial banks  Federal Reserve  Deposit Creation by a Banks.

Banks Balance Sheet  Like any other business, Asset = liability + Equity  Demand deposit  An asset for the depositor  but a liability of a banks  On bank’s balance sheet,  Assets are posted on the left  Liabilities and Equity are posted on the right

Banks Balance Sheet Some other assets include:  Cash and currencies  Deposit in Fed (also known as Reserve)  Treasury Bonds (also known as secondary reserve)  Loans and mortgages  Fixed assets (glass buildings, vaults, and land)

Banks Balance Sheet Some liabilities include:  Demand deposit (also known as checkable deposit)  Savings and time deposits  Certificate of deposits  Overnight loans  Loans from other branches  Discount loans

Check Clearing and Collection Sequence of events when a check is deposited in bank (A) drawn on bank (B),  For Bank A  Demand deposits (liabilities) increase by the amount of check.  Assets (check in process of collection) also rises by the same amount.  All checks deposited in Bank A are sent to regional Fed.  Fed’s check clearing system  Increases Bank A’s “deposits in Fed” by the amount of the check  There is a corresponding decrease in the deposits of Bank B which is made by the Fed

Check Clearing and Collection When the checks clear:  Demand deposits (liability) in Bank B decrease  Deposit in Fed (Asset) for Bank A increase  Demand deposits (liability) in Bank A also rise  Therefore, the Federal Reserve neither gains or loses deposits, only transfers ownership from one bank to another Summary  When a bank receives a check drawn on another bank, it gains reserves equal to the amount of the check  The bank on which the check was drawn loses reserves of the same amount

Check Clearing and Collection  This sequence of events occur for all:  Member banks who have account with Fed  Non members who either:  Have an account  Or, have an account with a correspondence bank that has an account with Fed.  If the banks are in different Federal Reserve regions, the two regional banks have a clearing account which permits the transfer of reserves between regions

Introduction Examine the relationship between bank reserves and the money supply Money supply (M1) is composed mostly of demand deposits in commercial banks and other financial institutions Bank reserves play a crucial role in creating demand deposits By regulating bank reserves, Federal reserve gets leverage to control amount of demand deposits and thereby nation’s money supply

Check Clearing and Collection (Cont.) Federal Reserve is primary collection vehicle for checks Check clearing is accomplished by adding or subtracting reserves held on deposit by the bank at its regional Federal Reserve bank

Check Clearing and Collection (Cont.) The balance sheet of Bank A (as shown in the text) reflects the following changes: –Demand deposits have increased by $2,000,000 –Deposits in Fed (reserves) have increased by $2,000,000 –Bank A’s total reserves now equal $3,000,000 ($100,000 cash, plus $2,900,000 deposit in Fed) –Since the bank is required to hold 10% of demand deposits as required reserves, Bank A’s excess reserves now total $2,800,000 ($3,000,000 - $200,000)

Deposit Expansion: The Single Bank How much a bank safely can loan depends on: –Amount of excess reserves –What happens when a loan is made When a bank lends, the borrower receives a checking account (demand deposit) –Both sides of balance rise, increase in “demand deposits” (liability) and increase in “loans” (asset) –Since demand deposits are part of the money supply, when banks create demand deposits through lending, there is an increase in the money supply

Deposit Expansion: The Single Bank (Cont.) A bank can safely lend up to the amount of its excess reserves –When proceeds of the loan are withdrawn and the reserves are reduced by the amount of the check, all the excess reserves will be used up. –If the bank tries to lend more, there will be insufficient reserves as soon as the borrower withdraws the proceeds from the loan. If the bank purchases government securities equal to the amount of excess reserves, it loses excess reserves when its check clears

Deposit Expansion: The Single Bank (Cont.) Conclusion of the section –A single bank can safely lend (or purchase securities) up to an amount equal to its excess reserves –An individual bank can create money (demand deposits) only if it has excess reserves. –As soon as it creates this money, it loses it to another bank when the money is spent

Deposit Expansion: The Banking System Although the initial bank lost its excess reserves, another bank gained these excess reserves which permits them to expand their lending and increase the money supply However, ability of the next bank to extend loans is reduced by 10% since some of gain in reserves must be held on deposit with Fed Process will continue with each successive bank being able to lend only 90% of gained excess reserves and 10% placed on deposit with Fed

Deposit Expansion: The Banking System (Cont.) Banking system creating money –The banking system will have demand deposits that are a multiple of the initial injection of excess reserves into the system. –The Fed will have additional required reserves on deposit equal to the initial injection of excess reserves into the system –The final state is reached not by shrinking reserves, as in the case of a single bank, but by expanding deposits

Deposit Expansion: The Banking System (Cont.) Banking system creating money (Cont.) –When one bank loses reserves, another bank gains the excess and lends out 90% –As banks lend more and more, demand deposit liabilities grow, thereby reducing excess reserves –Whereas a single bank can lend the amount of excess reserves, banking system can create demand deposits up to a multiple of original change in reserves –The process of deposit expansion can continue until all excess reserves become require reserves because of growth of demand deposits

Deposit Expansion: The Banking System (Cont.) The demand deposit expansion simple multiplier is always the reciprocal of the reserve requirement ratio Here, is the simple multiplier

Deposit Contraction If a bank starts with deficient reserves, potential change in demand deposits is negative rather than positive Money is destroyed as bank loans are repaid or securities sold The potential multiple contraction in demand deposits (money supply) follows the same principles as expansion of demand deposits

Deposit Contraction (Cont.) Downward multiple change in demand deposits could conceivably take place in one single bank, but more likely would be a result of action by entire banking system trying to acquire reserves to make up for the deficiency

Deposit Contraction (Cont.) Very important asymmetry in the creation or contraction of reserves/money supply –When banks have deficient reserves, they must reduce their demand deposits which reduces the money supply –When banks have excess reserves, they may lend more and increase the money supply. –Usually assume banks will want to lend out all their excess reserves and expand demand deposits to the maximum because they earn interest on the loans.

Appendix THE COMPLETE MONEY SUPPLY PROCESS

Appendix—The Complete Money Supply Process Actual change in demand deposits will reach the maximum amount indicated by the simple multiplier if banks lend all excess reserves. Any leakages of cash out of the multiple expansion cycle will result in a smaller expansion of the money supply Federal Reserve can control additional excess reserves but leakages are outside their control and may adversely affect their attempt to expand the money supply

Appendix—The Complete Money Supply Process (Cont.) Shifts between Currency and Checking Deposits –Monetary base (B)—total reserves held by banks plus currency held by nonbanking public –When the Federal Reserve injects reserves, it is really adding to the monetary base –Public may elect to hold some of the excess reserves as cash instead of demand deposits –Figure 18A.1 shows this ratio varies over time –Draining of currency into the hands of the public depletes bank’s excess reserves

FIGURE 18A.1 The currency ratio (c/dd) has varied considerably over time.

Appendix—The Complete Money Supply Process (Cont.) Shifts between Currency and Checking Deposits (Cont.) –Although cash held by the nonbanking public becomes part of the money supply, it reduces the banking system’s ability to expand demand deposits –Due to the uncertainty of the public’s reaction to additional reserves and desire to hold cash, the Fed has more control over the monetary base than total reserves

Appendix—The Complete Money Supply Process (Cont.) Shifts between time deposits and checking accounts –The public may desire to hold time deposits rather than demand deposits –Since the required reserves for time deposits is smaller than for demand deposits, placing of funds in time deposits will increase the banking system’s ability to expand credit.

Appendix—The Complete Money Supply Process (Cont.) Shifts between time deposits and checking accounts (Cont.) –However, since time deposits are not part of M1, movement of funds into time deposits will reduce the expansion of the money supply (M1) –This suggests that the reserve multiplier consequences for broader money supply definitions are more complicated than for M1

Appendix—The Complete Money Supply Process (Cont.) The role of interest rates –Banks not being able or willing to lend all their excess reserves –These funds may remain idle in the bank –Since banks will be more inclined to lend or purchase securities at higher interest rates, this raises the possibility that the money supply (multiplier) is a function of interest rate levels –Figure 18A.2—excess reserves as a percentage of demand deposits tends to be high when interest rates are low

FIGURE 18A.2 Excess reserves as a percent of checking deposits tend to be high when the level of the three-month Treasury bill is low, and vice versa.

Appendix—The Complete Money Supply Process (Cont.) Implication of the three complications –The Federal Reserve’s ability to control the money supply is not precise –It must deal with leakages of money from the demand deposit expansion cycle, factors that are generally determined by public preferences