Multiple Deposit Creation: A Simple Model CH 15 Multiple Deposit Creation: A Simple Model

The question now is how deposits are created? When the Fed supplies the banking system with a ($1) of additional reserves (through what?), deposits increase by a multiple of this amount. This is called "Multiple deposit creation".

Deposit Creation: a single bank: Assume that open market purchase of a ($100) was conducted with bank (A). The bank reserves increased by ($100). How bank (A) will use the ($100) now? The ($100) can be seen as an additional reserves to bank (A); but assume that bank (A) does not want to hold any excess reserves (since no interest is paid on reserves):

Bank (A) A L Securities      -100 Reserves      +100

there is no increase in checkable deposits, therefore; required reserve remain the same. Bank (A) finds its excess reserves increased by the ($100). The bank can now make a loan equal in amount to the increase in excess reserves ($100). Assuming that the borrower opens a checking account at bank (A) recall that this is a case of a single bank;

Bank (A) A L Securities  -100 D   +100  Reserves    +100 Loans        +100

Therefore, the bank created a checkable deposit by lending the ($100). Since Checkable deposits are part of money supply, this action of lending the ($100) created money!

The borrower will spend the ($100) loan and the ($100) of reserves will leave bank (A). Result: A bank cannot safely make loans > its excess reserves it has before it make the loan. in our example, this is equal to ($100) since the amount of excess reserves the bank hold before the loan is equal to ($100):

Bank (A) A L Securities    -100  Loans     +100 

Deposit Creation: the banking system: Example: Deposit at bank (A) of ($100), all Banks hold no excess reserves:  Bank A A L Reserves  +100 Deposits  +100

If the “r” = 10%,   Bank A A L RR  +10 Checkable Deposits  +100 ER       +90

Since banks don’t want to hold excess reserves:  Bank A A L RR    +10 Loans    +90 Checkable Deposits  +100

Two cases: 1- Increase in loans and checkable deposits by ($90) 2- The borrower can spend the ($90): loans, checkable deposits, and reserves fall by ($90).

If the borrower deposited the ($90) into bank (B): A L R     +90 Deposits  +90  The total increase in banking deposits = $190

Applying the (%10) “r” to bank B: A L RR   +9 ER +81 Deposits  +90 

Bank (B) will hold no excess reserves: A L RR    +9                   Loans  +81 Checkable Deposits  +90

The ($81) loan may be spent and then deposited in bank (A), (B), or another bank:  Bank C A L RR        +8.1 ER        +72.9 Checkable Deposits  +81

Total increase in of checkable deposits =  100 + 90 + 81 = $271  If banks lend full amount of excess reserves,  Increase in deposits = $10,000 increase in Loans = $10,000 increase in reserves = $100

Reserves loans Deposits Bank 100 10 90 A 9 81 B 8.10 72.90 C 7.29 65.61 .. 1000 Total all Banks

The same result will apply if the bank purchased securities

Result: the usage of excess reserves to make loans or purchase securities leads to the same effect on deposit expansion  Remember: The single bank case: Can create deposits equal only to the amount of its excess reserves: cannot by itself generate multiple deposit expansion because when the bank loses its excess reserves, the reserves may leave the bank to another.

Single bank cannot make loans greater than its excess reserves.  The banking system: Can generate multiple deposit expansion because when the bank loses its excess reserves, the reserves do not leave the banking system (move from one bank to another).  This process continues until the initial increase in reserves results in multiple increases in deposits:  Simple Deposit Multiplier: the multiple increase in the banking system reserves.

Multiple expansion of deposits: ∆D=(1/r)(∆R) ∆D: change in total checkable deposits in the banking system. r: required reserve ratio. ∆R: change in reserves for the banking system. In our example: ∆D = (1/0.10)(100) = 1,000