Chapter 15
Multiple Deposit
Creation and
the Money
Supply Process
Players in the Money Supply Process
• Central bank - the government agency that oversees
the banking system and is responsible for the conduct
of monetary policy
• Banks (depository institutions) - financial
intermediaries that accept deposits from individuals
and institutions and make loans: commercial banks,
savings and loan associations, mutual savings banks,
and credit unions
• Depositors (individuals and institutions)
• Borrowers (individuals and institutions)
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13-2
Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
• Monetary Liabilities
 Currency in circulation—in the hands of the public
 Reserves—bank deposits at the Fed and vault cash

increases in either or both will lead to an increase in
the money supply (everything else being constant).
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13-3
Assets
• Government securities—holdings by the CB (Fed) of
securities issued by Treasury, that affect money supply
and earn interest
• Fed provides reserves to the banking system by
purchasing securities, thereby increasing its holdings of
these
• assets.

An increase in government securities held by the Fed
leads to an increase in the money supply.
• Discount loans—provide reserves to banks by making
discount loans to banks and earn the discount rate

An increase in discount loans can also be the source of an increase
in the money supply
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13-4
Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
The CB exercises control over the monetary base through its
purchases or sale of government securities in the open market,
called open market operations, and through its extension of
discount loans to banks.
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13-5
Open Market Purchase from a Bank
Banking System
Assets
Liabilities
Securities
-$100
Reserves
+$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Reserves
+$100
• Suppose that the Fed (CB) purchases $100 of bonds
from a bank and pays for them with a $100 check

Net result is that reserves have increased
by $100

No change in currency

Monetary base has risen by $100
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13-6
Open Market Purchase from
Nonbank Public I
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
+$100 Checkable
deposits
+$100
Assets
Securities
Liabilities
+$100 Reserves
+$100
• Person selling bonds to the Fed, deposits the
Fed’s check in the bank
• Identical result as the purchase from a bank
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13-7
Open Market Purchase from
Nonbank Public II
Nonbank Public
Assets
Liabilities
Securities
-$100
Currency
+$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Currency in +$100
circulation
• The person selling the bonds cashes the Fed’s check
• Reserves are unchanged
• Currency in circulation increases by the amount of the
open market purchase
• Monetary base increases by the amount of the open
market purchase
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13-8
Open Market Purchase: Summary
• 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 always increases
the base by the amount of the purchase
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13-9
Open Market Sale
Nonbank Public
Assets
Liabilities
Securities
+$100
Currency
-$100
Federal Reserve System
Assets
Securities
Liabilities
-$100 Currency in -$100
circulation
• if the Fed sells the bonds to an individual who pays for
them with currency, the buyer exchanges $100 of currency
for $100 of bonds
• Reduces the monetary base by the amount of the sale
• Reserves remain unchanged
• The effect of open market operations on the monetary base
is much more certain than the effect on reserves
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13-10
Shifts from Deposits into Currency
Nonbank Public
Assets
Banking System
Liabilities
Checkable
deposits
+$100
Currency
-$100
Assets
Reserves
Federal Reserve System
Assets
Liabilities
Currency in
circulation
+$100
Reserves
-$100
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Liabilities
-$100 Checkable
deposits
-$100
Net effect
on monetary liabilities
is zero
Reserves are changed
by random fluctuations
Monetary base
is a more stable variable
13-11
Making a Discount Loan to a Bank
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
+$100 Discount
loans
+$100
(borrowing from
Fed)
Assets
Discount
loan
Liabilities
+$100 Reserves
+$100
(borrowing from
Fed)
• When the Fed makes a $100 discount loan to the First
National Bank, the bank is credited with $100 of
reserves from the proceeds of the loan.
• Monetary liabilities of the Fed have increased by $100
• Monetary base also increases by this amount
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13-12
Paying Off
a Discount Loan from the Fed
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
-$100 Discount
loans
-$100
(borrowing from
Fed)
Assets
Discount
loans
Liabilities
-$100 Reserves
-$100
(borrowing from
Fed)
• Net effect on monetary base is a reduction
• Monetary base changes one-for-one with a
change in the borrowings from the Federal
Reserve System
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13-13
Other Factors
Affecting the Monetary Base
•
Float - When the Fed clears checks for banks, it often credits the
amount of the check to a bank that has deposited it (increases the
bank’s reserves) but only later debits (decreases the reserves of) the
bank on which the check is drawn. The resulting temporary net increase
in the total amount of reserves in the banking system (and hence in the
monetary base) occurring from the Fed’s check-clearing process
•
Treasury deposits at the Federal Reserve - Treasury moves deposits
from commercial banks to its account at the Fed, leading to a rise in
Treasury deposits at the Fed, it causes a deposit outflow at these banks
and thus causes reserves in the banking system and the monetary base
to fall
•
Interventions in the foreign exchange market - Decisions by the U.S.
Treasury to have the Fed intervene in the foreign exchange market also
affect the monetary base
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13-14
Deposit Creation: Single Bank
• Suppose that the $100 open market purchase
described earlier was conducted with the First
National Bank.
• After the Fed has bought the $100 bond from
the First National Bank, the bank finds that it
has an increase in reserves of $100
• assume that the bank does not want to hold
excess reserves because it earns no interest
on them.
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13-15
Deposit Creation: Single Bank
First National Bank
Assets
Liabilities
Securities
-$100
Reserves
+$100
First National Bank
Assets
Liabilities
Securities
-$100
Loans
+$100
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Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
13-16
Deposit Creation: Single Bank
First National Bank
Assets
Liabilities
Securities
-$100
Reserves
+$100
Loan
+$100
Checkable deposits
+$100
• Let’s say that the bank decides to make a loan equal in
amount to the $100 increase in excess reserves.
• When the bank makes the loan, it sets up a checking
account for the borrower and puts the proceeds of the loan
into this account.
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13-17
Deposit Creation: Single Bank
The borrower took out a loan not to leave $100 idle at the First National
Bank but to purchase goods and services from other individuals and
corporations. When the borrower makes these purchases by writing checks,
they will be deposited at other banks, and the $100 of reserves will leave
the First National Bank.
After the borrower taken the loan the balance sheet occur like this
A bank cannot safely make loans for an amount greater than the excess
reserves it has before it makes the loan.
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13-18
Deposit Creation:
The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Checkable
deposits
Assets
+$100 Reserves
Loans
Bank B
Assets
Reserves
Liabilities
+$10 Checkable
deposits
+$100
+$90
Bank B
Liabilities
+$90 Checkable
deposits
Assets
+$90 Reserves
Loans
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Liabilities
+$9 Checkable
deposits
+$90
+$81
13-19
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13-20
The Formula for Multiple Deposit Creation
Assuming banks do not hold excess reserves
Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r ) times the total amount
of checkable deposits (D)
Substituting
r × D=R
Dividing both sides by r
1
D= × R
r
Taking the change in both sides yields
1
∆D = × ∆R
r
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13-21
Critique of the Simple Model
• Holding cash stops the process
• Banks may not use all of their excess
reserves to buy securities or make loans
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13-22