Chapter 5
Multiple Deposit Creation and
the Money Supply Process
1
Players in the Money Supply Process

Central Bank

Banks (most important: depository banks;
also other financial intermediaries)

Depositors (households, firms)

Borrowers from banks (households, firms,
governments)
Behavior of each actor influences the money
supply.
2
Central Bank’s Balance Sheet
Central Bank
Assets
Liabilities
Government bonds
(Securities)
Currency in circulation
Discount loans
Reserves
3
Central Bank’s Balance Sheet

CB Liabilities


Currency in circulation—paper money &
coins held by the nonfinancial sector (firms &
households)
Reserves—commercial banks’ deposits at the
CB and vault cash (cash held in ATM machines
and branches of commercial banks). CB
requires banks to hold a minimum level of
reserves at the CB as a percentage of total
deposits ”required reserve ratio”. But banks
may choose to hold excess reserves
4
Central Bank’s Balance Sheet

CB Assets


Government bonds (securities)—CB holds
Treasury bonds as a policy instrument to
increase or decrease the money supply
Discount loans—CB extends discount loans to
commercial banks at an interest rate called
“the discount rate” in the US or “marginal
lending rate” in Turkey and Europe.

(Today, instead of direct lending, most CB’s mostly
conduct operations in the repo market as their
primary policy tool. See Ch.6)
5
Monetary Base
MB = C + R
MB: Monetary Base
C: Currency in circulation
R: Reserves

The CB controls the monetary base by
“open market operations”.
6
Open Market Purchase
Banking System
Assets
Liabilities
Securities
-TL100
Reserves
+TL100


Central Bank
Assets
Securities
+TL100
Liabilities
Reserves
+TL100
CB buys bonds worth 100 TL from a
commercial bank (banking system). In
return, it writes a check to the com. bank. The
com. bank could either deposit the check in its
CB account or cash the check.
In either case, reserves increase by 100 TL
7
Open Market Purchase


Currency in circulation does not change because
the cash in banks’ vaults or ATM machines is not
included in “currency in circulation”.
Monetary base increases by 100 TL

An open market purchase increases the
monetary base by the amount of the purchase.

When monetary base increases by 1 TL, money
supply increases by much more than 1 TL
(money supply increases by “money multiplier” x
1TL). Because the banking system creates
additional money through credit creation. See
below.
8
Open Market Sale
Banking System
Assets
Liabilities
Securities
+TL100
Reserves
-TL100


Central Bank
Assets
Securities
Liabilities
-TL100
Reserves
-TL100
Just the opposite of “OM Purchase”. CB sells
bonds of value 100 TL to a commercial
bank. The com. Bank pays from its account at
the CB.
Reserves decrease by the amount of the sale.
Therefore monetary base decreases by the
amount of the sale.
9
Open Market Sale
 When monetary base decreases by 1 TL,
money supply decreases by much more
than 1 TL. Money supply decreases by
“money multiplier” x 1TL. Because the
banking system is left with less reserves
to create money.
10
Shifts from Deposits into Currency

If some depositors (who are firms or
households from the “nonfinancial sector”
or “nonbank public”), choose to withdraw
part or all of their deposits, then reserves
decrease, currency in circulation
increases, monetary base is unchanged.

Money goes under the pillow maybe because
depositors lose confidence. Banking system
shrinks.
11
Shifts from Deposits into Currency
Nonbank Public
Assets
Checkable
deposits
Currency
Banking System
Liabilities
Assets
-TL100
Reserves
-TL100
Checkable
deposits
-TL100
+TL100
Net effect
Central Bank
Assets
Liabilities
on monetary liabilities
Liabilities
Currency in
circulation
+TL100
Reserves
-TL100
is zero
Reserves are changed
by random fluctuations
Monetary base
is a more stable variable
12
CB Making a Discount Loan to the
Banking System
Banking System
Assets
Reserves
+TL100
Central Bank
Liabilities
Discount
loans
+TL 100
Assets
Discount
loan
+TL100
Liabilities
Reserves
+TL100
(borrowing from CB)


When the CB extends discount loans to the
banking system, Both Assets and Liabilities of the
CB increases by 100 TL
Monetary Base also increases by 100 TL.
13
Banks Create Deposit in a Fractional
Reserve System
When the CB injects 1 TL reserve into the
banking system through OMOs or disc.
loans, money supply increases by more
than 1 TL.
 This is because the required reserve ratio
(RRR) is less than 100% of deposits. A
smaller RRR leads to a greater expansion
of the money supply for 1 TL injection.
 First let us assume banks do not hold
excess reserves.

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Deposit Creation: Single Bank



When CB makes an open market purchase
from First National Bank (FNB), FNB’s reserves
increase, securities decrease by 100 TL.
Since FNBs deposits don’t change, this 100 TL is
excess reserve for FNB and it lends all of this
money to a firm. Opens a checking account for
the firm, loans and checkable deposits of FNB
increase by 100 TL.
When the borrower spends the credit, reserves
and checkable deposits disappear on FNB’s Taccount.
15
Deposit Creation: Single Bank
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-TL100
Securities
-TL100
Reserves
+TL100
Reserves
+TL100
Loans
+TL100
First National Bank
Assets
Securities
-TL100
Loans
+TL100
Liabilities
Checkable
deposits
+TL100
Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
16
Deposit Creation:
The Banking System


When the firm X spends the credit, assuming that
nobody wants to keep extra cash, 100 TL spent is
deposited in a checking account at another bank,
Bank A. Then Bank A’s reserves and checkable
deposits increase by 100 TL.
Bank A must hold 10% required reserves, but
can lend the rest: 90 TL. When firm Y who
borrowed this 90 TL spends this loan, reserves
are deposited to another bank: Bank B.
17
Deposit Creation:
The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+TL100
Checkable
deposits
+TL100
Assets
Reserves
+TL10
Loans
+TL90
Bank B
Assets
Reserves
Checkable
deposits
+TL100
Bank B
Liabilities
+TL90
Liabilities
Checkable
deposits
+TL90
Assets
Reserves
Loans
Liabilities
+TL9
Checkable
deposits
+TL90
+TL81
18
Deposit Creation:
The Banking System
Bank B’s checkable deposits and reserves
increase by 90 TL. Bank B must hold 9 TL
as required reserves but can lend 81 TL to
another firm Z. This firm Z can spend the
credit and proceeds are deposited to
another bank: Bank C.
 Bank C’s checkable deposits increase by
81 TL. Bank C also keeps 10% reserves
and lends the rest (72.9 TL).

19
Deposit Creation:
The Banking System
Everytime new credit is creat ed, money
supply increases by:
100+90+81+72.9+….
= 100 (1+0.9+(0.9)2+(0.9)3+….)
=100.(1/10)
=1000 TL

 As
required reserve ratio(r) increases
(decreases), money multiplier 1/r
decreases (incr.) and money creation
slows down (accelerates).
20
21
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
R
r
Taking the change in both sides yields
1
D =  R
r
D=
22
Critique of the Simple Model
1. In the simple model, we assumed banks do
not hold any excess reserves. In reality, they
may choose to hold some excess reserves for
precautionary purposes. They may not use all
of their excess reserves to make loans or buy
securities. This slows down money creation
process and gives us a smaller money
multiplier than 1/r. But we do not know
how much excess reserves they choose
to hold at any time. When uncertainty
increases in the market, they hold more
excess reserves.
23
Critique of the Simple Model
2.
If depositors or borrowers choose to hold
their money in cash instead of
depositing, this slows down the money
creation process. What percentage of
deposits and bank loans do
depositors and borrowers want to
hold as cash instead of holding them
in their accounts? We assumed 0%. In
reality, this is positive.
24
Critique of the Simple Model

Results:


Money multiplier in reality is smaller
than 1/r. For example, while r is around
10% on average in Turkey, money
multiplier is around 5, not 10. In some
countries like the UK, CB stopped
enforcing required reserves. But this does
not make m. multiplier infinite.
For the Central Bank, it is easier to
control the monetary base but not easy to
control the money supply.
25