Chapter 13 Multiple Deposit Creation and the Money Supply Process 1 Dr. Reyadh Faras

Money Supply (MS) Process Definition: The mechanism that determines the money supply, or the implementation of monetary policy. It is important to understand the MS Process to understand exactly how do the tools of monetary policy change the money supply, and thereby affect economic indicators (e.g. interest rates, inflation, output, employment). 2 Dr. Reyadh Faras

THE FOUR PLAYERS IN THE MS PROCESS 1. The central bank The most important player since it ultimately controls the supply of money in the economy. 2. Commercial banks Depository institutions that accept deposits and make loans. 3. Depositors Bank customers (individuals, companies and institutions) holding bank deposits. 4. Borrowers from banks Bank customers (individuals, companies, etc) who borrow money from banks. 3 Dr. Reyadh Faras

CENTRAL BANK'S BALANCE SHEET AND THE MONETARY BASE Monetary policy works by affecting the Central bank's balance sheet. Assets 1. Securities: Most of the assets are government securities. 2. Discount Loans: Loans that the central bank makes to banks. 4 Dr. Reyadh Faras

Liabilities 1. Currency in Circulation: Cash in the hands of the public, outside the banking system. 2. Reserves: Which are in the form of either: a) bank deposits at the central bank (RR), or b) cash at commercial banks (ER). Reserves are a liability of the Central Bank and an asset for commercial banks 5 Dr. Reyadh Faras

The Federal Reserve’s Balance Sheet Dr. Reyadh Faras 6

Monetary Base Known also as high-powered money because an increase in it leads to multiple increases in the money supply. Consists of central bank notes outstanding, coins and reserves. Central bank notes outstanding and coins can be defined as currency in circulation (C), thus the monetary base is defined as: MB = C (currency) + R (reserves) 7 Dr. Reyadh Faras

CONTROL OF THE MONETARY BASE (MB) Open market operations: Definition: The purchase and sale of government securities by the Central Bank. Expansionary monetary policy: When the Central Bank wants to stimulate the economy, it increases the MS through an open market purchase of securities, or discount loans. Contractionary monetary policy: When the Central Bank wants to slowdown the economy, it reduces the MS through an open market sale of securities, or increasing (RRR). 8 Dr. Reyadh Faras

Open Market Operations Open Market Purchase from a Bank The C.B. buys government securities from a bank. The bank gives the C.B. $100 government securities. The C.B. pays for the securities by increasing the bank’s reserves by $ Dr. Reyadh Faras

The bank: reserves increase by $100 while its holdings of securities decline by $100. The T-account for the bank is: Commercial Bank AssetsLiabilities 10 Dr. Reyadh Faras

Central Bank: liabilities increase by $100 because of the increase in __________, while its assets increase by $100 because of the increase in its ___________. The T-account for the central bank is: The Central Bank Result: Reserves and MB increased by $100 (amount of OMO), but money supply increased by more than $100 (Why?). AssetsLiabilities 11 Dr. Reyadh Faras

Open Market Purchase from Non-bank Public Non-bank public: Any natural or judicial person other than commercial banks. There are two possible cases: CASE 1:The central bank buys a ($100) government security from the non-bank public, and the seller makes a bank deposit. The T-account for the non-bank public is: Non-Bank Public AssetsLiabilities 12 Dr. Reyadh Faras

When the commercial bank receives the check, it credits the depositor's account with $100 and then deposits the check at its account at the central bank who increases its _______ by $_____. The T-account for the commercial bank is: Commercial Bank AssetsLiabilities 13 Dr. Reyadh Faras

The central bank's holdings of _______ increase by $____, while the _______ increase by $____. The Central Bank Similar to the case of purchasing securities from a bank (increase in ____, _____ and ____) AssetsLiabilities 14 Dr. Reyadh Faras

CASE 2: The central bank buys a ($100) T-Bond from the non-bank public, and the person cashes the check. The T-account for the non-bank public is: Non-Bank Public AssetsLiabilities 15 Dr. Reyadh Faras

The central bank's holdings of _______increase by $____, while _________ increase by $____. The Central Bank Result: Reserves unchanged, while (C) and (MB) increased by the amount of the OMO. AssetsLiabilities 16 Dr. Reyadh Faras

General Result for purchases: The effect of open market purchase is to increase the MB by the amount of the OMO whether the seller keeps the proceeds in deposits or in currency. 17 Dr. Reyadh Faras

Open Market Sale If the central bank sells $100 of bonds to a bank or non-bank public, the monetary base declines by $100. If the buyer pays for the bonds with currency, his T- account is: Non-Bank Public AssetsLiabilities 18 Dr. Reyadh Faras

The central bank lowers its holdings of securities and currency by $100. Its T-account is: The Central Bank AssetsLiabilities Result Open market sale reduces MB by the same amount, although reserves are unchanged (Why?) 19 Dr. Reyadh Faras

General result for sale and purchases The effect of OMOs on MB is more certain than its effect on reserves. Thus, the central bank can control MB more effectively than reserves by using OMOs. 20 Dr. Reyadh Faras

Discount Loans Commercial Bank The Central Bank AssetsLiabilities AssetsLiabilities Result If the Central Bank makes a discount loan, (R) and (MB) increase by the same amount. 21 Dr. Reyadh Faras

Shifts from Deposits into Currency Commercial Bank The Central Bank AssetsLiabilities AssetsLiabilities Result Has no effect on the central bank liabilities because the increase in (C) is cancelled out by a decline in (R). 22 Dr. Reyadh Faras

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL Assumptions: The commercial bank holds no excess reserves. The public don’t hold cash. The required reserve ratio is 10%. 23 Dr. Reyadh Faras

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL Deposit Creation: The Single Bank Assume that the central bank conducts Open Market Purchase of $100 from a bank. The T-account is: 1) Open Market Purchase AssetsLiabilities 24 Dr. Reyadh Faras

25 2) Making a loan AssetsLiabilities 3) The bank deposits the loan in the borrower’s account AssetsLiabilities Dr. Reyadh Faras

AssetsLiabilities 4) The borrower withdraws the amount of the loan 5) The final effect on the bank’s balance sheet AssetsLiabilities 26 Dr. Reyadh Faras

Result: The initial increase in reserves from the open market purchase has been converted by the bank into $100 of additional loans and $100 of deposits. 27 Dr. Reyadh Faras

Deposit Creation: The Banking System 1) Assume the $100 deposit (created by the loan) is deposited at bank (A), the T-account is: Bank A AssetsLiabilities  Bank (A)’s required reserves equal $______, and excess reserves equal $______  The maximum amount of loans the bank can make is $______. 28 Dr. Reyadh Faras

2) Bank (A) makes a loan Bank A AssetsLiabilities The borrower from Bank (A) uses the money to make purchases 3) The seller deposits the amount of the purchase in his bank (B) Bank B AssetsLiabilities 29 Dr. Reyadh Faras

Bank (B) now has $___ of reserves. It only needs $____ as required reserves, it can lend $_____. Bank (B) creates a new loan of $____ and a new deposit of $___ for the borrower. When check clears, R= $___, L= $ ___ and D= $ ___. T-account of Bank B is: Bank (B) AssetsLiabilities The $ ____ spent by the borrower (from Bank B) will be deposited in another bank (Bank C). 30 Dr. Reyadh Faras

Result: The initial increase in reserves in the banking system of $____, so far has increased checkable deposits in the system by $ 271 (= ____+ ____ +____). As a result, if all banks make loans for the full amount of their excess reserves, the total increase in deposits will be $ In general, deposits increase as follows: ∆ D = (1/RRR) x ∆ R = (1/____) x (_____) = $______ Where ∆ D = change in checkable bank deposits (D) RRR = required reserve ratio ∆ R = change in Reserves (R) 31 Dr. Reyadh Faras

Deposit Creation 32 Dr. Reyadh Faras

The Money Supply Expansion and Contraction Processes 33 Dr. Reyadh Faras

Simple Deposit Multiplier The multiple increase in deposits generated from an increase in the banking system's reserves. The simple multiple deposit creation process depends on two factors to get full potential deposit expansion of the Simple Deposit Multiplier on D, e.g. 10X: 1. Banks hold NO excess reserves (ER) 2. No cash (C) is held by the public Note: The central bank directly controls the MB, but can't directly control MS, it is influenced by public's behavior (cash demand) and bank's behavior (holding excess reserves). 34 Dr. Reyadh Faras