1. Creating Money Through the Banking System
Multiple Deposit Creation

2. Money and Banking
The largest component of the money supply is bank deposits.
To understand how the Central Bank influences the supply of money in the economy, we need to examine the linkages between:
The Central Bank
The private banking system
Depositors
Borrowers
The interactions between these four groups have direct effects on the money supply

3. The Fed’s Balance Sheet
We first look at the Central Bank’s (Fed) assets and liabilities
Assets
The Fed purchases securities (mostly those issued by the U.S. Treasury) from private banks and the non-bank public
The Fed makes discount loans to private banks that are repaid at the discount rate
Liabilities
Currency in circulation is currency held by the public
Bank reserves refer to currency held by private banks in their own vaults or at the Fed.
Assets
Liabilities
Government Securities
Currency in Circulation
Discount Loans
Reserves

4. The Monetary Base
We define the monetary base as the Federal Reserve’s liabilities:
MB = Currency in Circulation + Reserves = C + R
The Fed can increase or decrease MB by engaging in Open Market Operations, the buying and selling of bonds from/to the public.
To increase MB, the Fed will buy bonds from the public, replacing a non-monetary asset (bonds) with a monetary one (currency)
To decrease MB, the Fed will sell bonds from the public, exchanging a monetary public asset (currency) for a non-monetary asset (bonds)

5. Increasing MB through an Open Market Purchase
Federal Reserve
Assets
Liabilities
Securities $100
Reserves $100
Banking System
Assets
Liabilities
Securities $100
Reserves $100
The Fed buys a $100 bond from a bank and pays with a $100 check.
The bank cashes the check and places the $100 in its vault as reserves.
The monetary base has increased by $100 with the conversion of the privately held security into currency (and then into bank reserves)

6. Open Market Purchase from the Public
Suppose the Fed wanted to increase the monetary base and bought a $100 treasury bill from you.
You now have two things you can do with your money:
Hold it as currency
Deposit it at the bank.
Suppose you hold onto the $100 as currency.
The Fed’s balance sheet now looks like:
The monetary base has increased
Federal Reserve
Assets
Liabilities
Securities $100
Currency in Circulation +$100

7. Open Market Purchase from the Public
Now what would happen if you deposited your $100 in the bank?
The bank takes your $100 and places it in reserve
The monetary base still increases by $100, only now because reserves went up:
Federal Reserve
Assets
Liabilities
Securities $100
Reserves +$100
Banking System
Assets
Liabilities
Reserves $100
Checkable Deposits +$100

8. Federal Reserve System
Open Market Sale
Nonbank Public
Federal Reserve System
Assets
Liabilities
Securities
+$100
-$100
Currency in circulation
Currency
The Fed sells a bond to the public for $100
Reduces the monetary base by the amount of the sale
Reserves remain unchanged
The effect of open market operations on the monetary base is much more certain than the effect on reserves

9. Making a Discount Loan to a Bank
Banking System
Federal Reserve System
Assets
Liabilities
Reserves
+$100
Discount loans
Discount loan
A bank borrows $100 from the Fed’s discount window
Monetary liabilities of the Fed have increased by $100
Monetary base also increases by this amount

10. Paying off a Discount Loan from the Fed
Banking System
Federal Reserve System
Assets
Liabilities
Reserves
-$100
Discount loans
The bank pays back $100 to the Fed (assume no interest)
Net effect on monetary base is a reduction
Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System

11. Fractional Reserve Banking
So far we have been assuming that banks hold the entire amount of their deposits in reserve.
Clearly this is a false assumption as banks rarely ever have enough currency in their vaults (or on reserve at the Fed) to cover all deposits made with them.
The banking system operates as a fractional reserve system in which only a portion of the banks deposits are held in reserve.
The Fed sets a lower limit for the fraction of deposits that must be held in reserve: the reserve requirement ratio
Since banks earn profit by lending at higher interest rates than they give on deposits, the reserve requirement is generally a binding limit.

12. Reserve Requirement Ratio
One way the Fed influences the money supply is by changing the reserve requirement ratio (r)
As r increases, bank loans will fall, money in circulation falls
Suppose you deposit $100 into your account at Bank of America
The reserve requirement ratio is 20%.
Bank of America has the following balance sheet:
The money supply is equal to the $100 deposited in the bank plus the $80 in currency circulating as a loan  M = $180
BANK OF AMERICA
Assets
Liabilities
Reserves
$20.00
Deposits
$100
Loans
$80.00

13. Reserve Requirement Ratio
Suppose the $100 is deposited in Bank of America, but now the bank maintains a 10% reserve ratio, lending the remaining 90% of deposits.
Bank of America’s financial statement would then be:
The money supply has increased
There is $90 of currency in circulation and $100 worth of deposits.
The money supply has increased to $190
Despite the increase in the money supply, there has been no increase in wealth. New money has been created, but so has debt.
Now suppose that the borrower who got the $90 loan uses that currency to make a purchase.

14. Reserve Requirement Ratio
Suppose the borrower uses that $90 to buy tickets to an Atlanta Braves playoff game.
Ticketmaster will then deposit this $90 in their bank, SunTrust.
Suppose SunTrust maintains a 10% reserve ratio as well:
Of the $90 deposited at SunTrust, only 10% ($9) is held as reserves. The remaining 90% ($81) is loaned out.
There has been a further increase in the money supply.
The new value for M is Deposits at Bank of America + Deposits at SunTrust + Currency in Circulation = $100+$90+$81=$271

15. Reserve Requirement Ratio
Now SunTrust bank loans out $81 to another borrower who uses that money to buy books from the UCSD bookstore.
The bookstore deposits this $81 in Wachovia Bank, who also maintain a 10% reserve ratio.
The money supply has increased again:
M1 = Deposits at BoA + Deposits at SunTrust + Deposits at Wachovia + Currency = $100 + $90 + $81 + $72.90 = $343.90
Each time money is deposited and a bank loan is created, more money is created.
The amount of money the banking system generates with each dollar of reserves is known as the money multiplier.

17. The Formula for Multiple Deposit Creation

18. Critique of the Simple Model
Holding cash stops the process
Banks may not use all of their excess reserves to buy securities or make loans