Chapter 15 Multiple Deposit Creation and the Money Supply Process Money Supply Process • It is important to understand how the money supply is determined because movements in the money supply affect interest rates and the overall health of the economy. • How the money supply is determined? • Who controls it? • What causes it to change? • How might control of it be improved? © 2004 Pearson Addison-Wesley. All rights reserved 15-2 Four Players in the Money Supply Process 1. Central bank: the Fed 2. Banks 3. Depositors 4. Borrowers from banks Federal Reserve System 1. Conducts monetary policy 2. Clears checks 3. Regulates banks © 2004 Pearson Addison-Wesley. All rights reserved 15-3 The Fed’s Balance Sheet Federal Reserve System Assets Liabilities Government securities Currency in circulation Discount loans Reserves Monetary Base (or high-powered money), MB = C + R © 2004 Pearson Addison-Wesley. All rights reserved 15-4 Central Bank’s Balance Sheet LIABILITIES • Currency in Circulation: The amount of currency in the hands of the public. • Reserves : Consist of banks’ deposits at the central bank plus currency that is physically held by banks. ASSETS • Government Securities : Central bank’s holdings of securities issued by the government • Discount Loans : Reserves provided by the central bank to the banking system © 2004 Pearson Addison-Wesley. All rights reserved 15-5 Control of the Monetary Base Open Market Purchase from Bank The Banking System Assets Liabilities The Fed Assets Liabilities Securities – $100 Reserves + $100 Open Market Purchase from Public Public Assets Liabilities Securities + $100 Reserves + $100 Assets Liabilities Securities – $100 Deposits + $100 Banking System Assets Liabilities Securities + $100 Reserves + $100 Reserves + $100 The Fed Checkable Deposits + $100 Result: R $100, MB $100 © 2004 Pearson Addison-Wesley. All rights reserved 15-6 If Person Cashes Check Public Assets The Fed Liabilities Assets Liabilities Securities – $100 Securities + $100 Currency + $100 Result: R unchanged, MB $100 Effect on MB certain, on R uncertain Currency + $100 Shifts From Deposits into Currency Public Assets The Fed Liabilities Deposits – $100 Currency + $100 Assets Liabilities Currency + $100 Reserves – $100 Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R $100, MB unchanged © 2004 Pearson Addison-Wesley. All rights reserved 15-7 An OMO on the monetary base is much more certain than the effect on reserves • The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits • The effect of an open market purchase on the monetary base is always the same whether the seller of the bonds keeps the proceeds in deposits or in currency. © 2004 Pearson Addison-Wesley. All rights reserved 15-8 Discount Loans Banking System Assets Liabilities Reserves Discount + $100 loan + $100 The Fed Assets Discount loan + $100 Liabilities Reserves + $100 Result: R $100, MB $100 Conclusion: Fed has better ability to control MB than R © 2004 Pearson Addison-Wesley. All rights reserved 15-9 Multiple Deposit Creation: A Simple Model • Multiple deposit creation Sum of an Infinite Series D = R ×[1+(1-r)+(1-r)**2+(1-r)**3+……] D = R ×1/[1-(1-r)] =1/r R © 2004 Pearson Addison-Wesley. All rights reserved 15-10 Deposit Creation: Single Bank Assets Securities Reserves Assets Securities Reserves Loans Assets Securities Loans First National Bank Liabilities – $100 + $100 First National Bank Liabilities – $100 + $100 + $100 Deposits + $100 First National Bank Liabilities – $100 + $100 Deposits + $100 15-11 Deposit Creation: Banking System Assets Reserves Assets Reserves Loans Assets Reserves Assets Reserves Loans + $100 + $10 + $90 + $90 +$9 + $81 © 2004 Pearson Addison-Wesley. All rights reserved Bank A Liabilities Deposits + $100 Bank A Liabilities Deposits + $100 Bank B Liabilities Deposits + $90 Bank B Liabilities Deposits + $90 15-12 Deposit Creation © 2004 Pearson Addison-Wesley. All rights reserved 15-13 Deposit Creation If Bank A buys securities with $90 check Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same Whether bank makes loans or buys securities, get same deposit expansion © 2004 Pearson Addison-Wesley. All rights reserved 15-14 Deposit Multiplier Simple Deposit Multiplier 1 D = R r Deriving the formula R = RR = r D D= 1 r R D = 1 r R © 2004 Pearson Addison-Wesley. All rights reserved 15-15 Deposit Creation: Banking System as a Whole Banking System Assets Liabilities Securities – $100 Deposits Reserves + $100 Loans + $1000 © 2004 Pearson Addison-Wesley. All rights reserved + $1000 15-16 Critique of Simple Model Deposit creation stops if: 1. Proceeds from loan kept in cash (borrowers) 2. Bank holds excess reserves (banks) • Central bank is not the only player whose behavior influences the level of deposits and the money supply---borrowers, depositors, and banks also have the influence on money supply. © 2004 Pearson Addison-Wesley. All rights reserved 15-17