HKCE Macroeconomics
Chapter 4: Deposit Creation and Money
Supply
By Mr. LAU san-fat
CH4-Deposit Creation & MS
1
Assets and Liabilities of a bank
Assets:



Anything owned by a bank is an asset.
Liquid assets are easily converted into cash,
e.g. cash and short-term loans.
Illiquid/Fixed assets cannot be converted
into cash within a short period of time, e.g.
estate and office premises.
Liabilities:

Anything borrowed from others is liability.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Assets & Liabilities: Examples
Assets
Liabilities
Amount due from
Amount due to
authorized institutions
authorized institutions
Cash
Deposits from customers
Negotiable CD held
Negotiable CD
outstanding
Bonds
Investment in shareholdings Amount due to banks
Interest in land & buildings abroad
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Deposits & Money Supply
Bank deposits are the largest
component of money supply.
Banks increase money supply by
engaging in deposit creation.
Money supply will however be
contracted if banks engage in deposit
withdrawals.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
4
The Fractional Reserve System
A fractional reserve system means that banks
are required by law to keep a given fraction
of their total deposits (Dd) as required or
legal reserves.
(Minimum) Required reserves (RR) are the
minimum amount of liquid assets (e.g. cash &
CDs) that must be kept in banks for
withdrawals or emergency purposes.
Excess reserves (ER) are the amount in
excess of the required reserves.
Thus, Dd=RR+ER, RR=Dd-ER, & ER=Dd-RR
By Mr. LAU san-fat
CH4-Deposit Creation & MS
5
The Fractional Reserve System


The minimum required reserve ratio
(RRR) is the the minimum fraction of a
bank's total deposits required by law to be
kept in the form of cash or other liquid
assets. Thus, RRR=RR/Dd.
However, for the prudent/conservative
purpose or insufficient loan demand, the
actual reserves (AR) kept by a bank may
eventually more than the required amount.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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The Fractional Reserve System
The actual reserves ratio (ARR) is
found by dividing actual reserves by
total deposits. Thus, ARR=AR/Dd.
 If the actual reserves is larger than
the required reserves, excess
reserves were actually kept in the
banking system.
 Excess reserves actually kept=AR-RR

By Mr. LAU san-fat
CH4-Deposit Creation & MS
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An Exercise
Below is a bank's balance sheet with the
RRR=20%.
Assets($)
Liabilities($)
Cash
Loans & Advances
40 Deposits
60
100
Find:
 RR=RRRXDd=0.2X100=20
 AR=liquid assets kept in the bank=40
 ARR=AR/Dd=40/100=0.4
 AER(or excess reserves)=AR-RR=40-20=20
By Mr. LAU san-fat
CH4-Deposit Creation & MS
8
The Fractional Reserve System



Cash reserve ratio specifies the
minimum fraction of a bank's total deposits
that is required by law to be kept in the
form of cash.
Liquidity ratio = (short-term liquid
assets/short-term liabilities)X100%
In HK, all authorized institutions are
required to meet the minimum monthly
average liquidity ratio of 25%.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Assumptions behind Deposits
Creation
1. Fractional reserve banking system
2.
3.
4.
5.
exists.
No banks keep excess reserves.
No cash leakage.
Sufficient loan demand exists.
There is only demand deposits.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Deposits Creation: An
Illustration
Assumptions:



There are 3 banks: Bank A, B & C.
An initial amount of $1 000 was deposited
in Bank A.
The min. reserve ratio is 0.25.
The Question:

What will be the maximum amount of
deposits created out of the initial deposits
of $1 000?
By Mr. LAU san-fat
CH4-Deposit Creation & MS
11
Deposits Creation: An
Illustration
Step 1: $1 000 was deposited in Bank A.
Bank A's balance sheet
Assets($)
Cash
By Mr. LAU san-fat
Liabilities($)
+1000 Deposits
CH4-Deposit Creation & MS
+1000
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Deposits Creation: An
Illustration
Step 2: Bank A kept 25% of $1 000 as
required reserves & loans out the rest.
Bank A's balance sheet
Assets($)
Cash
Loans
By Mr. LAU san-fat
Liabilities($)
250 Deposits
+750
CH4-Deposit Creation & MS
+1000
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Deposits Creation: An
Illustration
Step 3: Suppose the loan of $750 was
finally deposited in Bank B.
Bank B's balance sheet
Assets($)
Cash
By Mr. LAU san-fat
Liabilities($)
+750 Deposits
CH4-Deposit Creation & MS
+750
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Deposits Creation: An
Illustration
Step 4: Bank B has to keep 25% of the
total deposits as its required reserves
and used the rest for loans.
Bank B's balance sheet
Assets($)
Cash
Loans
By Mr. LAU san-fat
Liabilities($)
187.5 Deposits
+562.5
CH4-Deposit Creation & MS
750
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Deposits Creation: An
Illustration
Step 5: Let Bank C receive $562.5. After
keeping 25% of the new deposits,
$421.9 will be loaned out.
Bank C's balance sheet
Assets($)
Cash
Loans
By Mr. LAU san-fat
Liabilities($)
+140.6 Deposits
+421.9
CH4-Deposit Creation & MS
+562.5
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Deposits Creation: An
Illustration
Step 6: Total deposits being created by Banks
A, B & C=$(1 000+750+562.5)=$2 312.5
Another bank follows the same suit: receiving
a certain amount of new deposits, keeping
the min. required reserves, & lending the rest.
The process goes on until the decreasing
deposits becomes zero.
Deposits is said to be created in the sense of
accounting.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Deposits Creation: Theoretical
Process
Step 1: Under the fractional reserves system,
a bank will keep a fraction as the required
reserves of a new deposits and lend the rest.
Step 2: The amount of loans will finally be redeposited into the same or another bank.
That bank will also keep a fraction as the
required reserves and loan the rest out.
Step 3: The process of receiving new deposits,
keeping the required reserves and lending the
rest will go on and on, until the decreasing
deposits becomes zero.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
18
Banking Multipliers
Maximum banking/money multiplier,
k=1/RRR
Actual banking multiplier=1/ARR
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Remarks on Deposits Creation
Maximum deposits being created =initial
deposits X (1/RRR)
However, if banks keep excess reserves, the
maximum deposits being created is lesser as
less money is lent out and re-deposited.
Thus, the total deposits being actually
created =initial deposits X (1/ARR)
Total change in deposits in the banking
system =deposits created + original total
deposits
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Remarks on Deposits Creation
Maximum loans/credit being created
=excess reserves X (1/RRR)
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Limitations of Deposits Creation
Cash leakage will reduce the amount of
deposits being created.
Banks keep excess reserves will also reduce
the deposits being created.
Insufficient demand for loans will decrease
the amount of deposits being created.
Full reserves baking system will, however,
prohibit the process multiple creation of
deposits from happening. Then the deposits
being created is equal to the initial deposits.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
22
Withdrawals/Contraction of
Deposits
Step 1: If there is a withdrawal of deposits
from a bank, the bank reserves will fall short
of the legal requirement.
Step 2: The bank will then call back loans or
sell assets to get enough reserves.
Step 3: To repay the loans or to buy assets,
customers will further withdraw deposits from
the other banks.
Step 4: Withdrawals make bank reserves less
than the legal requirement. Banks continue to
call back loans. The process goes on and on.
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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Remarks on Deposits
Contraction
Maximum deposits being withdrawn
=initial withdrawal X (1/RRR)
However, if banks keep excess reserves, the
maximum deposits being contracted is less
than expected.
Thus, the total deposits being withdrawn
=initial withdrawal X (1/ARR)
Total change in deposits in the banking
system
= original total deposits - deposits withdrawn
By Mr. LAU san-fat
CH4-Deposit Creation & MS
24
Deposits Creation and Change
in Money Supply
If the initial deposits comes from currency
in public circulation or cash, the change
in deposits will be larger than the change in
money supply.
Thus, change in M1
=deposits created – fall in cash
Example:
 if the initial deposits=$100, RRR=0.2; then
 Change in Deposits = $100X(1/0.2)=$500
 Change in M1 = $500 - $100 = $400
By Mr. LAU san-fat
CH4-Deposit Creation & MS
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