Multiple Deposit Creation: Introducing the Money Supply Process
So far, the focus of the course has been on interest rate (the cost of borrowing and lending).
However, we know from our discussion at the beginning of the semester and later with Keynes’
liquidity preference framework that there is a relationship between money supply and interest
rate. We have assumed so far that the Federal Reserve System is solely responsible for changing
the money supply in the economy. In this section, we will begin our discussion on how the
money supply is affected in the economy (i.e. the money supply process). We will see that the
Fed is a key player in the money supply process but not the only player.
There are 4 major players in the money supply process:
(1) The Federal Reserve System
(2) The banking system (i.e. depository institutions)
(3) Depositors
(4) Borrowers
We will discuss the roles and functions of the Fed in detail in a later section. However, since the
Fed plays a key role in the money supply process, we will provide a brief overview of the Fed in
this section.
Brief overview on the functions and structure of the Fed
The Fed has 3 key functions:
(1) It conducts monetary policies using one of its three major tools (open market operation,
reserve requirement, and discount window lending).
(2) It clears checks for member banks.
(3) It serves as a regulatory body for overseeing banks.
We will look at the Fed’s balance sheet (in the form of a T-account) to see what are some of its
components that can affect the economy’s money supply. In this simplified version of the Fed’s
T-account, we will focus on only 4 items: government securities, discount loans, currency in
circulation, and reserves.
Chapter 7-1
Federal Reserve System’s T-account
Assets
Government securities
Liabilities
Currency in circulation
Discount loans
Reserves
I. Assets
1. Government securities: The Fed holds government (i.e. Treasury) securities for two reasons:
(i) buying and selling of Treasury securities is one of the Fed’s major tool (known as OMO)
in controlling the economy’s money supply, and (ii) holding Treasury securities provides a
return.
2. Discount loans: The Fed makes loans to banks through its discount window operation. The
Fed does not encourage banks from borrowing through its discount window on a regular
basis since the Fed is acting as a lender of last resort for the banks.
II. Liabilities
1. Currency in circulation: The Federal Reserve notes circulating in the economy are liabilities
for the Fed. They are basically IOUs from the government issued by the Fed. For example, if
the government wants to buy $100,000 worth of machine, how would it pay for it? Simply
pay for it with $100,000 in Federal Reserve notes.
2. Reserves: All member banks of the Fed have to keep a certain percentage of the deposits
accepted in very liquid assets (i.e. the reserve requirement). The banks can do so in two
ways:
(a) All member banks are required to open an account with the Fed and they can maintain
their reserves by making a deposit into that account.
(b) The banks can keep cash in the vault (i.e. vault cash).
The amount of money a bank has in the account with the Fed and in the vault represents the
bank’s reserve. We can further break that reserve into two components:
(i) Required reserve: This is the amount of money a bank needs to keep by law. This is
determined by the reserve requirement ratio (expressed as a percentage of a bank’s total
deposit) set by the Fed.
Chapter 7-2
(ii) Excess reserve: This is the additional amount of money a bank chooses to hold for
liquidity reason.
It is important to note that the Fed’s currency in circulation and the Treasury’s currency in
circulation (i.e. the coins) and the reserves make up the monetary base.
A simple model of creating (and shrinking) the money supply
We will see in this simple model that an increase in the banks’ reserves will lead to an increase in
the economy’s money supply. It is important to point out that this simple model works only if the
banks hold no excess reserves. In other words, a bank will only keep the required amount of
money as required reserves, and use the excess money to make loans. This assumption is
plausible because a bank earns no interest on its reserve but does on a loan.
We will discuss shortly that there is a direct relationship between money supply in the economy
and the reserves in the banking system, i.e. when the reserves go up, the money supply also goes
up. There are two ways the Fed can alter the reserves of a bank or the banking system: (i) buying
and selling securities to the banks, and (ii) making and recalling discount loans from banks.
(i) Buying and selling securities to banks
When we compare the balance sheets of the Fed and a typical bank, we know that Treasury
securities represent an asset and the reserve represents a liability for the Fed. On the other hand,
Treasury securities and reserve both represent assets for a depository institution.
In this simple model, we will assume that the Fed deals only with the banks, and the banks deal
with the public. We will demonstrate in the following example how the purchase/sale of
government securities to a bank will affect that bank’s reserve.
Suppose the Fed decides to buy $1,000 worth of government securities to the LaSalle Talman
Bank (LTB) in Elmhurst. The following table shows the results of that particular transaction on
the Fed’s and LTB’s T-accounts.
When the Fed buys the government securities from LTB, the value of the securities in its
portfolio increases by $1,000. And it pays for it simply by crediting (or transferring money into)
Chapter 7-3
the bank’s account at the Fed. (Keep in mind that the reserve of a bank represents a liability of
the Fed.) As a result, the reserve of the Fed (as a form of liability) and the bank (as a form of
asset) increase due to the purchase of government securities by the Fed from LaSalle Talman
Bank.
Federal Reserve
Assets
Securities +$1000
LTB
Liabilities
Reserve +$1,000
Assets
Securities -$1,000
Liabilities
Reserve +$1,000
In the above example, we can see that the purchase of government securities by the Fed will
result in an increase in reserve equivalent to the value of the securities. Similarly, we can easily
observe with a similar example how the sale of government securities by the Fed will result in a
decrease in reserve equivalent to the value of the securities.
(ii) Making and recalling discount loans
In the above scenario, we have seen that when the Fed buys/sells government securities, the
change in reserve is equivalent to the value of the securities. In this section, we will examine how
the Fed’s discount window operation will affect the reserve. Keep in mind that discount loans are
loans made by the Fed to commercial banks through its discount window operation. It is
important to remember that discount loans represent assets for the Fed but represent liabilities for
a depository institution.
We will demonstrate the impact of the Fed’s discount window operation on the reserve with the
following example. Suppose the Fed made a $1,000 loan to LaSalle Talman Bank through its
discount window. The following table shows the results of that particular action on the Fed’s and
LTB’s T-accounts.
When the Fed makes the $1,000 discount loan (DL) to LaSalle Talman Bank (LTB), that
represents an increase of $1,000 in its asset (since a discount loan represents an asset to the Fed).
And the Fed simply “deposit” the money in LTB’s account with the Fed. In other words, the Fed
simply credits LTB’s account (i.e. the reserve goes up $1,000).
Chapter 7-4
Federal Reserve
Assets
DL +$1000
LTB
Liabilities
Reserve +$1,000
Assets
Reserve +$1,000
Liabilities
DL +$1,000
In the above example, we see that when the Fed makes a discount loan to a bank, the reserve will
increase by the amount of the loan. Similarly, we can easily verify that when the Fed recalls a
discount loan from a bank, the reserve will go down by the amount of the loan.
Money creation process (or deposit creation process)
In the above two scenarios, we have seen that the Fed can change the reserve of a bank simply by
buying/selling Treasury securities and making/recalling loans. With these two scenarios in mind,
we will proceed to examine the impact of such changes in a bank’s reserve on the economy’s
money supply.
To understand the impact of the changes in a bank’s reserve (due to the Fed’s actions) on the
economy’s money supply, we will illustrate with the following example. Before we proceed, it is
important to note that this example is based on a very simple model with the following two
assumptions:
(a) Banks hold no excess reserve because excess reserve earns no return (and they are not
required by law).
(b) Individuals prefer to hold checking deposits than hold cash (i.e. individuals conduct all
transactions with checks and not cash).
We will begin this example with the scenario where the Fed bought $1,000 worth of government
securities from Bank of America (BA). In this case, the Fed simply credits BA’s account.
Federal Reserve
Assets
Securities +$1000
BA
Liabilities
Reserve +$1,000
Assets
Securities -$1,000
Liabilities
Reserve +$1,000
Since the increase in Bank of America’s reserve is a result of a sale of government securities to
the Fed and not an acceptance of deposit, it does not need to keep any of it as required reserve.
Chapter 7-5
Hence, the $1,000 increase in reserve represents a $1,000 increase in excess reserve. Since
reserve earns no return for the bank, it is assumed that the bank will “get rid” of the excess
reserves by using them to make loans.
To simply our scenario, we will assume that Bank of America makes a loan of $1,000 to Bob.
Since Bob does not have an account with BA, the bank will write out a check of $1,000 to Bob.
As a result, the $1,000 in excess reserve of BA will be drawn down and that money will be
converted into the loan made to Bob.
BA
Bob
Assets
Securities -$1,000
Liabilities
Assets
Check +$1,000
Liabilities
Loan +$1,000
Reserve +$0
Loan +$1,000
Although Bob does not have an account with BA, he does have an account with the National
Bank of Chicago (NBC). So he takes the check of $1,000 and deposits it with NBC. As a result,
the deposit at NBC has gone up by $1,000.
NBC
Assets
Reserve +$1,000
Bob
Liabilities
Deposits +$1,000
Assets
Check +$0
Liabilities
Loan +$1,000
Deposits +$1,000
Suppose the reserve requirement for the banks has been set at 10%. In this case, NBC is required
to keep $100 from Bob’s deposit as required reserve (RR). The rest of the deposit (i.e. $900)
represents the bank’s excess reserve (ER).
NBC
Assets
RR +$100
ER +$900
Bob
Liabilities
Deposits +$1,000
Assets
Check +$0
Deposits +$1,000
Chapter 7-6
Liabilities
Loan +$1,000
Since NBC is earning return for holding excess reserve, it will make a $900 loan to Mary. In this
example, Mary does not have an account with NBC so NBC will write out a check of $900 to
her.
NBC
Assets
RR +$100
Mary
Liabilities
Deposits +$1,000
Assets
Check +$900
Liabilities
Loan +$900
ER +$0
Loan +$900
Once again, Mary, a customer of the Second National Bank (SNB), will take the check of $900
and deposit it with SNB. We know SNB needs only keep $90 of Mary’s deposit as reserve and
loan out the other $810.
SNB
Assets
RR +$90
Mary
Liabilities
Deposits +$900
ER +$0
Assets
Check +$0
Liabilities
Loan +$900
Deposit +$900
Loan +$810
It is important to note at this point that a bank cannot make a loan that is greater than the amount
of excess reserves it has.
In this particular example, the $810 loan made by Second National Bank will go to an individual
who has an account with another bank. That individual will deposit the check from Second
National Bank into his/her account. This action will allow the individual’s bank to make loan
with part of the deposit. This process will continue from one bank to another bank. We realized
that the amount of loan a bank can make decreases in size (or amount) as the process continues.
It will get to a point where banks are making very small size loans. The following table
summarizes what has happen when the Fed initially bought $1,000 worth of securities from the
Bank of America.
Chapter 7-7
 in deposits
 in reserves
0
0
+$1,000
+$1,000
+$100
+$900
2. Second National Bank
+$900
+$90
+$810
3. First Chicago Bank
+$810
+$81
+$729
Bank
1. Bank of America
2. National Bank of Chicago
 in loans
.
.
.
.
.
.
.
.
+$10,000
+$1,000
+$10,000
Total
Based on the above scenario, we have seen that the purchase of Treasury securities of $1,000 by
the Fed resulted in an increase of $10,000 of checkable deposits in the economy. This is due to
the money creation process “conducted” by the banking system. It is important to note that the
above scenario is possible only if (i) the banks do not keep excess reserves, and (ii) all the loans
are deposited in checking accounts and not taken out as cash. In addition, since individuals
conduct all their transactions with checks, all the deposits created exist only in digital (or
electronic) form and not in physical form. This is crucial in the money creation process.
The money multiplier and the money creation process
We can determine the amount of money (or deposits) created by the Fed by changing the reserves
of the banking system. We can do this by determining the simple deposit multiplier for this
simple model. The simple deposit multiplier is defined as:
m
1
rD
Hence, we can determine the amount of deposits created by the banking system as follows:
D  m  R 
R
rD
In our earlier example, we have seen that the Fed’s action resulted in an increase in reserve by
$1,000. Since the reserve requirement is 10%, we know the total amount of deposits created is as
follows using the above formula:
D 
1
1000  $10,000
0.1
Chapter 7-8
Since individuals hold only checking accounts and no currency, the money supply in the
economy (as defined by M1) consists solely of checking deposits. As a result, we know in this
simple model, the Fed’s action of buying $1,000 government securities from Bank of America
resulted in an increase of $10,000 in money supply in the economy.
So far, we have seen how the banking system is able to create deposits based on an initial
increase in reserves (by selling securities to the Fed or taking a loan from the Fed). The same
situation can easily be applied to the case when the Fed reduces the reserves by selling securities
to the banks or recalling loans from the banks. It is important to note that the simple deposit
multiplier developed above also applies to this situation.
Problems with the simple model
There are several problems with this simple model of determining the impacts of the Fed’s
actions on the economy’s money supply. This model assumes that (i) banks do not like to keep
excess reserves and like to loan out any money that they are not required to keep, and (ii)
individuals have preference for checkable deposits over currency. However, this is not the case in
the real world. There are many reasons why a bank would like to keep excess reserves and why
an individual would like to have currency rather than checkable deposit. In the next section, we
will develop a model that takes such behaviors of banks and individuals into consideration.
Chapter 7-9