Chapter 13 Multiple Deposit Creation and the Money Supply Process

Introduction We have focused a lot on interest rates (the cost of borrowing) Liquidity preference framework there is a relationship between money supply and interest rate – Assumed only central banks are responsible for changing the money supply In this chapter, we will discuss how the money supply is affected in the economy

Money Supply Process There are 4 major players in the money supply process: (1) The Federal Reserve System (2) The banking system (i.e. depository institutions) (3) Depositors (4) Borrowers

The Federal Reserve The Fed has 3 key functions: (1) It conducts monetary policies using one of its monetary policy tools (2) It clears checks for member banks (3) It serves as a regulatory body for overseeing banks

The Federal Reserve Balance Sheet Federal Reserve System’s T-account AssetsLiabilities Government securitiesCurrency in circulation Discount loansReserves

The Federal Reserve’s Liabilities  Currency in Circulation  The Fed issues Federal Reserve Notes  Like a bond  Reserves  All banks are required to have an account at the Fed where they hold deposits  The Fed has to pay interest on those deposits  Reserves include all the money in that account plus money that is physically held in the bank vaults

The Federal Reserve Liabilities  Reserves = money in vault + money held in an account with the Federal Reserve  Earns no interest  2 categories of Reserves 1. Required Reserves – This is the amount of money a bank needs to keep by law 2. Excess Reserves – any additional amount held that is above the required reserves (liquidity)

The Federal Reserves Assets  Government Securities  Treasury bonds  The Fed holds Treasury securities for two reasons: (i) buying and selling of Treasury securities is one of the Fed’s major tool in controlling the economy’s money supply (ii) holding Treasury securities provides a return

The Federal Reserves Assets  Discount Loans  How banks borrow from the Fed  The Fed makes loans to banks through its discount window operation

How Deposits are Created  Today you will see how an increase in the banks’ reserves will lead to an increase in the economy’s money supply  Assuming that a bank will hold no excess reserves  A bank earns no interest on its excess reserves but does on a loan

How Deposits are Created  When the Fed wants to change the money supply it will change the required reserves of banks  There are two ways the Fed can alter the reserves of a bank or the banking system:  (i) buying and selling securities to the banks  (ii) making and recalling discount loans from banks

(i) Buying and selling securities to the banks  Demonstrate how the purchase/sale of government securities to a bank will affect that bank’s reserves  For the Fed, Treasury bonds are an asset and reserves are a liability  For banks, both Treasury bonds and reserves are an asset

(i) Buying and selling securities to the banks  In our example, the Fed is going to buy Treasury bonds from a bank for $1,000  For the bank, it just sold a Treasury bond to the Fed  Receive money from the Fed for the price of the bond which will go into reserves  Assets increases by $1,000  Treasury bond for the bank is an asset  Asset decreases by $1,000

(i) Buying and selling securities to the banks  In our example, the Fed is going to buy Treasury bonds from a bank for $1,000  For the Fed, it just received a $1,000 Treasury bond  Assets increase by $1,000

(i) Buying and selling securities to the banks Federal Reserve Bank AssetsLiabilitiesAssetsLiabilities Securities +$1000Reserve +$1,000Securities -$1,000 Reserve +$1,000 When the Fed buys/sells government securities, the change in reserve is equivalent to the value of the securities.

(ii) making and recalling discount loans from banks  Examine how the Fed’s discount window operation will affect bank’s reserves  Discount loans are loans made by the Fed to commercial banks through its discount window operation  For the Fed, discount loans are an asset  For banks, discount loans are a liability

(ii) making and recalling discount loans from banks  Suppose the Fed made a $1,000 loan to a bank through its discount window  For the Fed, making a loan represents an increase of $1,000 in its asset  Discount loan represents an asset to the Fed

(ii) making and recalling discount loans from banks  Suppose the Fed made a $1,000 loan to a bank through its discount window  The Fed will put the money into the bank’s reserve account  Reserve account is an asset for the bank  But the $1,000 is a loan that must be paid back  It is a liability for the bank

(ii) making and recalling discount loans from banks Federal ReserveBank AssetsLiabilitiesAssetsLiabilities DL +$1000Reserve +$1,000 DL +$1,000 When the Fed makes a discount loan to a bank, the reserve will increase by the amount of the loan. Or just the opposite... When the Fed recalls a discount loan from a bank, the reserve will go down by the amount of the loan

Money Creation Process  Just demonstrated that the Fed can change the reserve of a bank simply by buying/selling Treasury securities and making/recalling loans.  With these two scenarios in mind, we will proceed to examine the impact of such changes in a bank’s reserve on the economy’s money supply

Money Creation Process  It is important to note that in this next example is based on a very simple model with the following two assumptions:  Banks hold no excess reserve because excess reserve earns no return (and they are not required by law)  Individuals prefer to hold checking deposits than hold cash (i.e. individuals conduct all transactions with checks and not cash)

Money Creation Process Example  Fed bought $1,000 worth of government securities from Dumpling Bank Federal ReserveDumpling Bank AssetsLiabilitiesAssetsLiabilities Securities +$1000Reserve +$1,000Securities -$1,000 Reserve +$1,000

Money Creation Process Example  Required reserves is money that banks MUST keep in reserves  The only time banks have to put money in their reserves is if they accept money as a deposit from the Fed  In our example, the banks sold a Treasury bond to the Fed  The banks do not have to keep the money they received from the sale in their required reserves

Money Creation Process Example  If the reserve is not a required reserve than it is an ___________.  Excess reserve Federal ReserveDumpling Bank AssetsLiabilitiesAssetsLiabilities Securities +$1000Reserve +$1,000Securities -$1,000 Reserve +$1,000

Money Creation Process Example  One of our assumptions was that banks will hold NO excess reserves  Excess reserves earn NO return  Dumpling Bank will want to get rid of the $1,000 excess reserve  Make a loan and earn interest

Money Creation Process Example  So Dumpling Bank will make a loan of $1,000 to Jenny BAJenny AssetsLiabilitiesAssetsLiabilities Securities -$1,000 Reserve +$0 Loan +$1,000 Check +$1,000Loan +$1,000

Money Creation Process Example  Jenny does not have any accounts with Dumpling Bank – she just only got a loan from there  Jenny has accounts at National City Bank where she goes and deposits the $1,000

Money Creation Process Example  National City Bank deposits have increased by $1,000  That $1,000 also goes in its reserves National City BankJane AssetsLiabilitiesAssetsLiabilities Reserve +$1,000Deposits +$1,000Cash +$0 Deposits +$1,000 Loan +$1,000

Money Creation Process Example  Let’s say reserve requirement is 10% National City BankJenny AssetsLiabilitiesAssetsLiabilities Reserve +$1,000Deposits +$1,000Check +$0 Deposits +$1,000 Loan +$1,000 National City Bank Jenny AssetsLiabilitiesAssetsLiabilities RR +$100 ER +$900 Deposits +$1,000Check +$0 Deposits +$1,000 Loan +$1,000

Money Creation Process Example  Since National City Bank is NOT earning return for holding excess reserve, it will make a $900 loan to Mary National City BankMary AssetsLiabilitiesAssetsLiabilities RR +$100 ER +$0 Loan +$900 Deposits +$1,000Check +$900Loan +$900

Money Creation Process Example  Once again, Mary, does not have accounts at National City Bank  She will take the check of $900 and deposit it at her bank, Charter Bank

Money Creation Process Example  Reserve requirement is still 10%  The $810 loan made by Charter Bank will go to an individual who has an account with another bank. Charter BankMary AssetsLiabilitiesAssetsLiabilities RR +$90 ER +$0 Loan +$810 Deposits +$900Check +$0 Deposit +$900 Loan +$900

Money Creation Process Example  Notice that the amount of loan a bank can make decreases in size (or amount) as the process continues  $1,000  $900  $810  $729

Money Creation Process Example  The following table summarizes what has happen when the Fed initially bought $1,000 worth of securities from Dumpling Bank. Bank  in deposits  in reserves  in loans 1. Dumpling Bank00+$1, National City Bank+$1,000+$100+$ Charter Bank+$900+$90+$ First Chicago Bank+$810+$81+$ Total+$10,000+$1,000+$10,000

Money Creation Process Example  The purchase of Treasury securities of $1,000 by the Fed resulted in an increase of $10,000 of checkable deposits in the economy. Bank  in deposits  in reserves  in loans 1. Dumpling Bank00+$1, National City Bank+$1,000+$100+$ Charter Bank+$900+$90+$ First Chicago Bank+$810+$81+$ Total+$10,000+$1,000+$10,000

Money Creation Process  It is important to note that the above scenario is possible only if : (i) the banks do not keep excess reserves (ii) all the loans are deposited in checking accounts and not taken out as cash

Money Multiplier and the Money Creation Process  Simple Deposit Multiplier – multiple increase in deposits generated from an increase in the banking system’s reserves

Money Multiplier and the Money Creation Process

 In our earlier example, we have seen that the Fed’s action of buying a Treasury bond from Dumpling Bank resulted in an increase in reserve by $1,000  Since the reserve requirement is 10%, we know the total amount of deposits created is as follows using the formula below:

Money Creation Process Example Bank  in deposits  in reserves  in loans 1. Dumpling Bank00+$1, National City Bank+$1,000+$100+$ Charter Bank+$900+$90+$ First Chicago Bank+$810+$81+$ Total+$10,000+$1,000+$10,000