Deposit Creation and the Money Supply Process – Part I

Chapter 13

Deposit Creation

• Who is involved?– Fed– Banks– Depositors– Borrowers

The Fed’s Balance Sheet

• Assets Liabilities• Security holdings Notes• Loans Reserve Deposits• Gold and SDRs Treasury deposits• Cash Items For. & Agency Deposits• Coin Deferred Availability Cash

Items• Other Assets Other Lia. & Capital

– Physical and For. Cur.

Monetary base or high-powered money

• MB = Fed notes + Treasury currency – coin + bank reserves

• MB = C + R• Uses of base are C + R

Sources of base

Federal Reserve CreditSecurities Discount LendingFloat

Gold and SDR’sOther Fed assetsTreasury currency

Monetary Base

• Monetary Base $ 808.8b• Currency $ 742.7b• Reserves $ 45.4b

– Vault Cash (Reserves)$ 34.7b– Deposits $ 10.7b

• Surplus Vault Cash $ 13.5b• Clearing Balances $ 7.2b

Bank Reserves

• Total Reserves $ 45.4b– Required $ 43.6b– Excess $ 1.8b

• Borrowed Reserves $ 175m– Primary $ 24m– Seasonal $ 151m

Data as of May 2006

Controlling the Monetary Base

• Open Market Operations• Lending to Financial Institutions• Fed has better control of base than of

reserves

Open Market Operations

• Open market purchase• Buy securities from bank or public• Example: Purchase from bank

BankAssets Liabilities Securities -$100Reserves +$100

FedAssets LiabilitiesSecurities +$100 Reserves +$100

Open Market Operations

• Next, assume security purchased from nonbank public

Pat PublicAssets LiabilitiesSecurities -$100Dem.Dep+$100 Pat’s Bank

Assets LiabilitiesReserves +$100 Dem.Dep. +$100

FedAssets LiabilitiesSecurities +$100 Reserves +$100

Open Market Operations

• Result differs if Pat holds currency • In both cases, monetary base increases, but

reserves increase only when funds deposited in bank Pat Public

Assets LiabilitiesSecurities -$100Currency +$100

FedAssets Liabilities

Securities +$100 Currency +$100

Open Market Operations

• Open Market SalePat Public

Assets LiabilitiesSecurities +$100Currency -$100

FedAssets LiabilitiesSecurities -$100 Currency -$100

Increase in Currency

• Shifts from deposits to currency reduce bank reserves but leaves base unchanged

Pat PublicAssets LiabilitiesDemand Deposits -$100Currency +$100

BanksAssets LiabilitiesReserves -$100 Demand

Deposits -$100

FedAssets Liabilities

Reserves -$100 Currency +$100

Foreign Exchange Intervention

• Purchases and sale of foreign currency has same effect as security purchases and sales

Discount Loans

• Bank borrows reserves from Fed Bank

Assets LiabilitiesReserves +$100 Loans +$100

FedAssets LiabilitiesLoans +$100 Reserves +$100

Discount Loans

• Bank repays loan Bank

Assets LiabilitiesReserves -$100 Loans -$100

FedAssets LiabilitiesLoans -$100 Reserves -$100

Float and Treasury deposits

• Float and Treasury deposits affect monetary base.

• Fed can still control base by engaging in offsetting open market operations.

Multiple Deposit Creation

• Fractional reserve banking – hold a fraction of deposits as reserves

• Assume bank sells security to Fed, reserves increase.

• Also assume no excess reserves or currency.

• Required reserves are 10%

Multiple Deposit Creation

• Bank 1 sells security, gains reserves

Bank 1Assets LiabilitiesSecurities -$100Reserves +$100

Multiple Deposit Creation

• Bank 1 has $100 of excess reserves, makes loan of $100

Bank 1Assets LiabilitiesSecurities -$100 Demand Deposits +$100Reserves +$100Loan +$100

Multiple Deposit Creation

• Borrower writes check, spends loan Bank 1

Assets LiabilitiesSecurities -$100Loan +$100

Funds deposited in Bank 2 Bank 2

Assets LiabilitiesReserves +$100 Demand Deposits +$100

Multiple Deposit Creation

• Bank 2 has required reserves of $10 (10% 0f $100), and excess reserves of $90. Loans $90.

Bank 2Assets LiabilitiesReserves +$100 Demand Deposits +$100Loans + $90 Demand Deposits + $90

Note that deposits of $90 created. Total deposits $190.

Multiple Deposit Creation

• Borrower spends proceeds of loan, which are deposited in Bank 3

Bank 2Assets LiabilitiesReserves +$10 Demand Deposits +$100Loans + $90

Bank 3Assets Liabilities

Reserves +$90 Demand Deposits +$90

Multiple Deposit Creation

• Bank 3 has excess reserves of $81 (10% of $90), which it uses to make loan Bank 3

Assets LiabilitiesReserves +$90 Demand Deposits +$90Loan +$81 Demand Deposits +$81

Process continues

Deposit Creation

Multiple Deposit Creation

• Result for banking system Banking System

Assets LiabilitiesSecurities -$100 Demand Deposits +$1000 Reserves +$100 Loans +$1000

If banks purchase securities instead of making loans, deposit expansion is the same.

Simple deposit multiplier

• Multiplier reflects increase in deposits for a given increase in reserves D = 1/r x R

• Change in demand deposits equals one divided by required reserve ratio times change in reserves

• In levelsD = 1/r x R

• Total demand deposits equals one divided by reserve ratio times total reserves.

Multiple Contraction

• Loss of reserves results in multiple contraction of deposits

• Assume bank buys security and reduces reserves

Bank AAssets LiabilitiesSecurities +$100Reserves -$100

Multiple Contraction

• Bank is short of reserves of $100, assuming no excess reserves

• When loan is repaid, bank gains reserves, and has no shortage

• Loan paid from a check on Bank B, which is now short of reserves

Bank BAssets LiabilitiesReserves -$100 Demand Deposits -$100

Multiple Contraction

• Bank B is short $90 of reserves (since DD down $100)

• Bank B can replenish reserves by reducing loans by $90

Bank BAssets LiabilitiesReserves -$10 Demand Deposits -$100Loans -$90

Multiple Contraction

• For system as a whole, deposits fall by multiple of drop in reserves

Banking SystemAssets LiabilitiesSecurities +$100 Demand Deposits -$1000Reserve -$100Loans -$1000

Limitations of analysis: Assumes no currency or excess reservesChanging these assumptions changes multiplier