Transcript Chapter # 13

Chapter 13
Multiple Deposit Creation
and the Money Supply Process
Dr. Reyadh Faras
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Money Supply (MS) Process


Definition: The mechanism that determines the
money supply, or the implementation of monetary
policy.
It is important to understand the MS Process to
understand exactly how do the tools of monetary
policy change the money supply, and thereby affect
economic indicators (e.g. interest rates, inflation,
output, employment).
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THE FOUR PLAYERS IN THE MS PROCESS
1. The central bank
The most important player since it ultimately
controls the supply of money in the economy.
2. Commercial banks
Depository institutions that accept deposits and
make loans.
3. Depositors
Bank customers (individuals, companies and
institutions) holding bank deposits.
4. Borrowers from banks
Bank customers (individuals, companies, etc) who
borrow money from banks.
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CENTRAL BANK'S BALANCE SHEET AND
THE MONETARY BASE
Monetary policy works by affecting the Central
bank's balance sheet.
Assets
1. Securities:
Most of the assets are government securities.
2. Discount Loans:
Loans that the central bank makes to banks.
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Liabilities
1. Currency in Circulation:
Cash in the hands of the public, outside the banking
system.
2. Reserves:
Which are in the form of either:
a) bank deposits at the central bank (RR), or
b) cash at commercial banks (ER).
Reserves are a liability of the Central Bank and an
asset for commercial banks
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The Federal Reserve’s Balance Sheet
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Monetary Base



Known also as high-powered money because an
increase in it leads to multiple increases in the
money supply.
Consists of central bank notes outstanding, coins
and reserves.
Central bank notes outstanding and coins can be
defined as currency in circulation (C), thus the
monetary base is defined as:
MB = C (currency) + R (reserves)
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
CONTROL OF THE MONETARY BASE
(MB)
Open market operations:
Definition: The purchase and sale of government
securities by the Central Bank.


Expansionary monetary policy: When the Central
Bank wants to stimulate the economy, it increases
the MS through an open market purchase of
securities, or discount loans.
Contractionary monetary policy: When the
Central Bank wants to slowdown the economy, it
reduces the MS through an open market sale of
securities, or increasing (RRR).
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Open Market Operations
Open Market Purchase from a Bank



The C.B. buys government securities from a bank.
The bank gives the C.B. $100 government securities.
The C.B. pays for the securities by increasing the
bank’s reserves by $100.
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The bank: reserves increase by $100 while its
holdings of securities decline by $100.

The T-account for the bank is:
Commercial Bank
Assets
Liabilities
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Central Bank: liabilities increase by $100 because of the
increase in __________, while its assets increase by $100
because of the increase in its ___________.
The T-account for the central bank is:
The Central Bank
Assets
Liabilities
Result:
Reserves and MB increased by $100 (amount of OMO),
but money supply increased by more than $100 (Why?).
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Open Market Purchase from Non-bank Public
Non-bank public: Any natural or judicial person other
than commercial banks.
There are two possible cases:
CASE 1:The central bank buys a ($100) government
security from the non-bank public, and the seller
makes a bank deposit.
The T-account for the non-bank public is:
Non-Bank Public
Assets
Liabilities
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When the commercial bank receives the check, it
credits the depositor's account with $100 and then
deposits the check at its account at the central bank
who increases its _______ by $_____.
The T-account for the commercial bank is:
Commercial Bank
Assets
Liabilities
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The central bank's holdings of _______ increase by
$____, while the _______ increase by $____.
The Central Bank
Assets
Liabilities
Similar to the case of purchasing securities from a
bank (increase in ____, _____ and ____)
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CASE 2: The central bank buys a ($100) T-Bond from
the non-bank public, and the person cashes the check.
The T-account for the non-bank public is:
Non-Bank Public
Assets
Liabilities
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The central bank's holdings of _______increase by $____,
while _________ increase by $____.
Assets
The Central Bank
Liabilities
Result:
Reserves unchanged, while (C) and (MB) increased by the
amount of the OMO.
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General Result for purchases:
The effect of open market purchase is to increase the
MB by the amount of the OMO whether the seller
keeps the proceeds in deposits or in currency.
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Open Market Sale
If the central bank sells $100 of bonds to a bank or
non-bank public, the monetary base declines by $100.
If the buyer pays for the bonds with currency, his Taccount is:
Non-Bank Public
Assets
Liabilities
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The central bank lowers its holdings of securities and
currency by $100. Its T-account is:
The Central Bank
Assets
Liabilities
Result
Open market sale reduces MB by the same amount,
although reserves are unchanged (Why?)
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General result for sale and purchases
The effect of OMOs on MB is more certain than
its effect on reserves.
Thus, the central bank can control MB more
effectively than reserves by using OMOs.
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Discount Loans
Commercial Bank
Assets
Liabilities
The Central Bank
Assets
Liabilities
Result
If the Central Bank makes a discount loan, (R) and
(MB) increase by the same amount.
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Shifts from Deposits into Currency
Commercial Bank
Assets
Liabilities
The Central Bank
Assets
Liabilities
Result
Has no effect on the central bank liabilities because the increase
in (C) is cancelled out by a decline in (R).
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MULTIPLE DEPOSIT CREATION:
A SIMPLE MODEL
Assumptions:
The commercial bank holds no excess reserves.
 The public don’t hold cash.
 The required reserve ratio is 10%.

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MULTIPLE DEPOSIT CREATION:
A SIMPLE MODEL
Deposit Creation: The Single Bank
Assume that the central bank conducts Open Market
Purchase of $100 from a bank. The T-account is:
1) Open Market Purchase
Assets
Liabilities
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2) Making a loan
Assets
Liabilities
3) The bank deposits the loan in the borrower’s account
Assets
Liabilities
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4) The borrower withdraws the amount of the loan
Assets
Liabilities
5) The final effect on the bank’s balance sheet
Assets
Liabilities
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Result:
The initial increase in reserves from the open
market purchase has been converted by the bank
into $100 of additional loans and $100 of deposits.
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Deposit Creation: The Banking System
1) Assume the $100 deposit (created by the loan) is
deposited at bank (A), the T-account is:
Bank A
Assets
Liabilities
 Bank (A)’s required reserves equal $______, and
excess reserves equal $______
 The maximum amount of loans the bank can make
is $______.
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2) Bank (A) makes a loan
Bank A
Assets
Liabilities
The borrower from Bank (A) uses the money to make
purchases
3) The seller deposits the amount of the purchase in his
bank (B)
Bank B
Assets
Liabilities
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

Bank (B) now has $___ of reserves. It only needs
$____ as required reserves, it can lend $_____.
Bank (B) creates a new loan of $____ and a new
deposit of $___ for the borrower. When check clears,
R= $___, L= $ ___ and D= $ ___. T-account of Bank
B is:
Bank (B)
Assets
Liabilities
The $ ____ spent by the borrower (from Bank B) will be
deposited in another bank (Bank C).
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Result:
 The initial increase in reserves in the banking system
of $____, so far has increased checkable deposits in
the system by $ 271 (= ____+ ____ +____).
 As a result, if all banks make loans for the full
amount of their excess reserves, the total increase in
deposits will be $ 1000.
 In general, deposits increase as follows:
∆ D = (1/RRR) x ∆ R
= (1/____) x (_____) = $______

Where ∆ D = change in checkable bank deposits (D)
RRR = required reserve ratio
∆ R = change in Reserves (R)
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Deposit Creation
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The Money Supply Expansion and Contraction Processes
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Simple Deposit Multiplier
The multiple increase in deposits generated from an
increase in the banking system's reserves.
 The simple multiple deposit creation process depends
on two factors to get full potential deposit expansion of
the Simple Deposit Multiplier on D, e.g. 10X:
1. Banks hold NO excess reserves (ER)
2. No cash (C) is held by the public
Note:
 The central bank directly controls the MB, but can't
directly control MS, it is influenced by public's
behavior (cash demand) and bank's behavior (holding
excess reserves).

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