Chapter 18
Bank Reserves and the
Money Supply
Key Ideas
 Process of check clearing and its
impact on the balance sheets of:
 Commercial banks
 Federal Reserve
 Deposit Creation by a Banks.
Banks Balance Sheet
 Like any other business,
Asset = liability + Equity
 Demand deposit
 An asset for the depositor
 but a liability of a banks
 On bank’s balance sheet,
 Assets are posted on the left
 Liabilities and Equity are posted on the
right
Banks Balance Sheet
Some other assets include:
 Cash and currencies
 Deposit in Fed (also known as Reserve)
 Treasury Bonds (also known as secondary
reserve)
 Loans and mortgages
 Fixed assets (glass buildings, vaults,
and land)
Banks Balance Sheet
Some liabilities include:
 Demand deposit (also known as checkable





deposit)
Savings and time deposits
Certificate of deposits
Overnight loans
Loans from other branches
Discount loans
Check Clearing and
Collection
Sequence of events when a check is deposited
in bank (A) drawn on bank (B),
 For Bank A
 Demand deposits (liabilities) increase by the amount
of check.
 Assets (check in process of collection) also rises by
the same amount.
 All checks deposited in Bank A are sent to
regional Fed.
 Fed’s check clearing system
 Increases Bank A’s “deposits in Fed” by the amount
of the check
 There is a corresponding decrease in the deposits of
Bank B which is made by the Fed
Check Clearing and
Collection
When the checks clear:




Demand deposits (liability) in Bank B decrease
Deposit in Fed (Asset) for Bank A increase
Demand deposits (liability) in Bank A also rise
Therefore, the Federal Reserve neither gains or
loses deposits, only transfers ownership from
one bank to another
Summary
 When a bank receives a check drawn on another
bank, it gains reserves equal to the amount of
the check
 The bank on which the check was drawn loses
reserves of the same amount
Check Clearing and
Collection
 This sequence of events occur for all:
 Member banks who have account with Fed
 Non members who either:
 Have an account
 Or, have an account with a correspondence bank
that has an account with Fed.
 If the banks are in different Federal
Reserve regions, the two regional banks
have a clearing account which permits
the transfer of reserves between regions
Introduction
• Examine the relationship between bank
reserves and the money supply
• Money supply (M1) is composed mostly of
demand deposits in commercial banks and
other financial institutions
• Bank reserves play a crucial role in
creating demand deposits
• By regulating bank reserves, Federal
reserve gets leverage to control amount of
demand deposits and thereby nation’s money
supply
Check Clearing and Collection
(Cont.)
• Federal Reserve is primary collection
vehicle for checks
• Check clearing is accomplished by
adding or subtracting reserves held
on deposit by the bank at its
regional Federal Reserve bank
Check Clearing and Collection
(Cont.)
• The balance sheet of Bank A (as shown in
the text) reflects the following changes:
– Demand deposits have increased by $2,000,000
– Deposits in Fed (reserves) have increased by
$2,000,000
– Bank A’s total reserves now equal $3,000,000
($100,000 cash, plus $2,900,000 deposit in Fed)
– Since the bank is required to hold 10% of
demand deposits as required reserves, Bank A’s
excess reserves now total $2,800,000
($3,000,000 - $200,000)
Deposit Expansion: The Single
Bank
• How much a bank safely can loan depends on:
– Amount of excess reserves
– What happens when a loan is made
• When a bank lends, the borrower receives a
checking account (demand deposit)
– Both sides of balance rise, increase in
“demand deposits” (liability) and increase in
“loans” (asset)
– Since demand deposits are part of the money
supply, when banks create demand deposits
through lending, there is an increase in the
money supply
Deposit Expansion: The Single
Bank (Cont.)
• A bank can safely lend up to the amount of
its excess reserves
– When proceeds of the loan are withdrawn and the
reserves are reduced by the amount of the
check, all the excess reserves will be used up.
– If the bank tries to lend more, there will be
insufficient reserves as soon as the borrower
withdraws the proceeds from the loan.
• If the bank purchases government securities
equal to the amount of excess reserves, it
loses excess reserves when its check clears
Deposit Expansion: The Single
Bank (Cont.)
• Conclusion of the section
– A single bank can safely lend (or
purchase securities) up to an amount
equal to its excess reserves
– An individual bank can create money
(demand deposits) only if it has excess
reserves.
– As soon as it creates this money, it
loses it to another bank when the money
is spent
Deposit Expansion: The Banking
System
• Although the initial bank lost its excess
reserves, another bank gained these excess
reserves which permits them to expand their
lending and increase the money supply
• However, ability of the next bank to extend
loans is reduced by 10% since some of gain
in reserves must be held on deposit with
Fed
• Process will continue with each successive
bank being able to lend only 90% of gained
excess reserves and 10% placed on deposit
with Fed
Deposit Expansion: The Banking
System (Cont.)
• Banking system creating money
– The banking system will have demand deposits
that are a multiple of the initial injection of
excess reserves into the system.
– The Fed will have additional required reserves
on deposit equal to the initial injection of
excess reserves into the system
– The final state is reached not by shrinking
reserves, as in the case of a single bank, but
by expanding deposits
Deposit Expansion: The Banking
System (Cont.)
• Banking system creating money (Cont.)
– When one bank loses reserves, another bank
gains the excess and lends out 90%
– As banks lend more and more, demand deposit
liabilities grow, thereby reducing excess
reserves
– Whereas a single bank can lend the amount of
excess reserves, banking system can create
demand deposits up to a multiple of original
change in reserves
– The process of deposit expansion can continue
until all excess reserves become require
reserves because of growth of demand deposits
Deposit Expansion: The Banking
System (Cont.)
• The demand deposit expansion simple
multiplier is always the reciprocal of
the reserve requirement ratio
1
 Demand Deposits =  Excess Re serv es x
Re serv e Ratio
1
Here,
is the simple multiplier
Re serve Ratio
Deposit Contraction
• If a bank starts with deficient
reserves, potential change in demand
deposits is negative rather than
positive
• Money is destroyed as bank loans are
repaid or securities sold
• The potential multiple contraction in
demand deposits (money supply)
follows the same principles as
expansion of demand deposits
Deposit Contraction (Cont.)
• Downward multiple change in demand
deposits could conceivably take place
in one single bank, but more likely
would be a result of action by entire
banking system trying to acquire
reserves to make up for the
deficiency
Deposit Contraction (Cont.)
• Very important asymmetry in the creation or
contraction of reserves/money supply
– When banks have deficient reserves, they must
reduce their demand deposits which reduces the
money supply
– When banks have excess reserves, they may lend
more and increase the money supply.
– Usually assume banks will want to lend out all
their excess reserves and expand demand
deposits to the maximum because they earn
interest on the loans.
Appendix
THE COMPLETE
MONEY SUPPLY
PROCESS
Appendix—The Complete Money
Supply Process
• Actual change in demand deposits will reach
the maximum amount indicated by the simple
multiplier if banks lend all excess
reserves.
• Any leakages of cash out of the multiple
expansion cycle will result in a smaller
expansion of the money supply
• Federal Reserve can control additional
excess reserves but leakages are outside
their control and may adversely affect
their attempt to expand the money supply
Appendix—The Complete Money
Supply Process (Cont.)
• Shifts between Currency and Checking
Deposits
– Monetary base (B)—total reserves held by banks
–
–
–
–
plus currency held by nonbanking public
When the Federal Reserve injects reserves, it
is really adding to the monetary base
Public may elect to hold some of the excess
reserves as cash instead of demand deposits
Figure 18A.1 shows this ratio varies over time
Draining of currency into the hands of the
public depletes bank’s excess reserves
FIGURE 18A.1 The currency ratio
(c/dd) has varied considerably over
time.
Appendix—The Complete Money
Supply Process (Cont.)
• Shifts between Currency and Checking
Deposits (Cont.)
– Although cash held by the nonbanking public
becomes part of the money supply, it reduces
the banking system’s ability to expand demand
deposits
– Due to the uncertainty of the public’s
reaction to additional reserves and desire to
hold cash, the Fed has more control over the
monetary base than total reserves
Appendix—The Complete Money
Supply Process (Cont.)
• Shifts between time deposits and
checking accounts
– The public may desire to hold time
deposits rather than demand deposits
– Since the required reserves for time
deposits is smaller than for demand
deposits, placing of funds in time
deposits will increase the banking
system’s ability to expand credit.
Appendix—The Complete Money
Supply Process (Cont.)
• Shifts between time deposits and
checking accounts (Cont.)
– However, since time deposits are not part
of M1, movement of funds into time
deposits will reduce the expansion of the
money supply (M1)
– This suggests that the reserve multiplier
consequences for broader money supply
definitions are more complicated than for
M1
Appendix—The Complete Money
Supply Process (Cont.)
• The role of interest rates
– Banks not being able or willing to lend all
their excess reserves
– These funds may remain idle in the bank
– Since banks will be more inclined to lend or
purchase securities at higher interest rates,
this raises the possibility that the money
supply (multiplier) is a function of interest
rate levels
– Figure 18A.2—excess reserves as a percentage
of demand deposits tends to be high when
interest rates are low
FIGURE 18A.2 Excess reserves as a percent of
checking deposits tend to be high when the level
of the three-month Treasury bill is low, and vice
versa.
Appendix—The Complete Money
Supply Process (Cont.)
• Implication of the three
complications
– The Federal Reserve’s ability to control
the money supply is not precise
– It must deal with leakages of money from
the demand deposit expansion cycle,
factors that are generally determined by
public preferences