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Chapter 5

Multiple Deposit Creation and the Money Supply Process

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Players in the Money Supply Process Central Bank

Banks (most important: depository banks; also other financial intermediaries)

Depositors (households, firms)

Borrowers from banks (households, firms, governments)

Behavior of each actor influences the money supply.

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Central Bank’s Balance Sheet

Central Bank

Assets Liabilities

Government bonds (Securities)

Currency in circulation

Discount loans Reserves

Central Bank’s Balance Sheet

CB Liabilities Currency in circulation—paper money &

coins held by the nonfinancial sector (firms & households)

Reserves—commercial banks’ deposits at the CB and vault cash (cash held in ATM machines and branches of commercial banks). CB requires banks to hold a minimum level of reserves at the CB as a percentage of total deposits ”required reserve ratio”. But banks may choose to hold excess reserves

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Central Bank’s Balance Sheet CB Assets

Government bonds (securities)—CB holds Treasury bonds as a policy instrument to increase or decrease the money supply

Discount loans—CB extends discount loans to commercial banks at an interest rate called “the discount rate” in the US or “marginal lending rate” in Turkey and Europe.

(Today, instead of direct lending, most CB’s mostly conduct operations in the repo market as their primary policy tool. See Ch.6)

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Monetary Base

The CB controls the monetary base by “open market operations”.

MB = C + RMB = C + RMB: MB: Monetary BaseMonetary BaseC:C: Currency in circulation Currency in circulation R: R: ReservesReserves

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Open Market Purchase

CB buys bonds worth 100 TL from a commercial bank (banking system). In return, it writes a check to the com. bank. The com. bank could either deposit the check in its CB account or cash the check.

In either case, reserves increase by 100 TL

Banking System Central Bank

Assets Liabilities Assets Liabilities

Securities -TL100 Securities +TL100 Reserves +TL100

Reserves +TL100

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Open Market Purchase Currency in circulation does not change because

the cash in banks’ vaults or ATM machines is not included in “currency in circulation”.

Monetary base increases by 100 TL

An open market purchase increases the monetary base by the amount of the purchase.

When monetary base increases by 1 TL, money supply increases by much more than 1 TL (money supply increases by “money multiplier” x 1TL). Because the banking system creates additional money through credit creation. See below.

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Open Market SaleBanking System Central Bank

Assets Liabilities Assets Liabilities

Securities +TL100 Securities -TL100 Reserves -TL100

Reserves -TL100

Just the opposite of “OM Purchase”. CB sells bonds of value 100 TL to a commercial bank. The com. Bank pays from its account at the CB.

Reserves decrease by the amount of the sale. Therefore monetary base decreases by the amount of the sale.

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Open Market Sale When monetary base decreases by 1 TL,

money supply decreases by much more than 1 TL. Money supply decreases by “money multiplier” x 1TL. Because the banking system is left with less reserves to create money.

Shifts from Deposits into Currency If some depositors (who are firms or

households from the “nonfinancial sector” or “nonbank public”), choose to withdraw part or all of their deposits, then reserves decrease, currency in circulation increases, monetary base is unchanged. Money goes under the pillow maybe because

depositors lose confidence. Banking system shrinks.

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Shifts from Deposits into Currency

Net effect

on monetary liabilities

is zero

Reserves are changed

by random fluctuations

Monetary base

is a more stable variable

Nonbank Public Banking System

Assets Liabilities Assets Liabilities

Checkable deposits

-TL100 Reserves -TL100 Checkable deposits

-TL100

Currency +TL100

Central Bank

Assets Liabilities

Currency in circulation

+TL100

Reserves -TL100

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CB Making a Discount Loan to the Banking System

When the CB extends discount loans to the banking system, Both Assets and Liabilities of the CB increases by 100 TL

Monetary Base also increases by 100 TL.

Banking System Central Bank

Assets Liabilities Assets Liabilities

Reserves +TL100 Discount loans

+TL 100 Discount loan

+TL100 Reserves +TL100

(borrowing from CB)

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Banks Create Deposit in a Fractional Reserve System When the CB injects 1 TL reserve into the

banking system through OMOs or disc. loans, money supply increases by more than 1 TL.

This is because the required reserve ratio (RRR) is less than 100% of deposits. A smaller RRR leads to a greater expansion of the money supply for 1 TL injection.

First let us assume banks do not hold excess reserves.

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Deposit Creation: Single Bank When CB makes an open market purchase from

First National Bank (FNB), FNB’s reserves increase, securities decrease by 100 TL.

Since FNBs deposits don’t change, this 100 TL is excess reserve for FNB and it lends all of this money to a firm. Opens a checking account for the firm, loans and checkable deposits of FNB increase by 100 TL.

When the borrower spends the credit, reserves and checkable deposits disappear on FNB’s T-account.

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Deposit Creation: Single Bank

Excess reserves increase

Bank loans out the excess reserves

Creates a checking account

Borrower makes purchases

The money supply has increased

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Securities -TL100 Securities -TL100 Checkable deposits

+TL100

Reserves +TL100 Reserves +TL100

Loans +TL100

First National Bank

Assets Liabilities

Securities -TL100

Loans +TL100

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Deposit Creation: The Banking System When the firm X spends the credit, assuming that

nobody wants to keep extra cash, 100 TL spent is deposited in a checking account at another bank, Bank A. Then Bank A’s reserves and checkable deposits increase by 100 TL.

Bank A must hold 10% required reserves, but can lend the rest: 90 TL. When firm Y who borrowed this 90 TL spends this loan, reserves are deposited to another bank: Bank B.

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Deposit Creation: The Banking System

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +TL100 Checkable deposits

+TL100 Reserves +TL10 Checkable deposits

+TL100

Loans +TL90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +TL90 Checkable deposits

+TL90 Reserves +TL9 Checkable deposits

+TL90

Loans +TL81

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Deposit Creation: The Banking System

Bank B’s checkable deposits and reserves increase by 90 TL. Bank B must hold 9 TL as required reserves but can lend 81 TL to another firm Z. This firm Z can spend the credit and proceeds are deposited to another bank: Bank C.

Bank C’s checkable deposits increase by 81 TL. Bank C also keeps 10% reserves and lends the rest (72.9 TL).

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Deposit Creation: The Banking System Everytime new credit is creat ed, money

supply increases by: 100+90+81+72.9+…. = 100 (1+0.9+(0.9)2+(0.9)3+….)=100.(1/10) =1000 TL As required reserve ratio(r) increases

(decreases), money multiplier 1/r decreases (incr.) and money creation slows down (accelerates).

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The Formula for Multiple Deposit Creation

Assuming banks do not hold excess reserves

Required Reserves ( ) = Total Reserves ( )

= Required Reserve Ratio ( ) times the total amount

of checkable deposits ( )

Substituting

=

Dividing both s

RR R

RR r

D

r D Rides by

1 =

Taking the change in both sides yields

1 =

r

D Rr

D Rr

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Critique of the Simple Model

1. In the simple model, we assumed banks do not hold any excess reserves. In reality, they may choose to hold some excess reserves for precautionary purposes. They may not use all of their excess reserves to make loans or buy securities. This slows down money creation process and gives us a smaller money multiplier than 1/r. But we do not know how much excess reserves they choose to hold at any time. When uncertainty increases in the market, they hold more excess reserves.

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Critique of the Simple Model2. If depositors or borrowers choose to hold

their money in cash instead of depositing, this slows down the money creation process. What percentage of deposits and bank loans do depositors and borrowers want to hold as cash instead of holding them in their accounts? We assumed 0%. In reality, this is positive.

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Critique of the Simple Model Results:

Money multiplier in reality is smaller than 1/r. For example, while r is around 10% on average in Turkey, money multiplier is around 5, not 10. In some countries like the UK, CB stopped enforcing required reserves. But this does not make m. multiplier infinite.

For the Central Bank, it is easier to control the monetary base but not easy to control the money supply.