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?
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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
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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
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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
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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
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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
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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.
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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
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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
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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
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Bank A
Liabilities
Deposits
+ $100
Bank A
Liabilities
Deposits
+ $100
Bank B
Liabilities
Deposits
+ $90
Bank B
Liabilities
Deposits
+ $90
15-12
Deposit Creation
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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
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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
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15-15
Deposit Creation:
Banking System as a Whole
Banking System
Assets
Liabilities
Securities – $100
Deposits
Reserves + $100
Loans
+ $1000
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+ $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.
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15-17