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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. AssetsLiabilities Security holdingsNotes Loans Reserve Deposits Gold and SDRsTreasury deposits - PowerPoint PPT Presentation
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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