Deposit Creation and the Money
Supply Process – Part I
Chapter 13
Deposit Creation
• Who is involved?
–
–
–
–
Fed
Banks
Depositors
Borrowers
The Fed’s Balance Sheet
•
•
•
•
•
•
Assets
Security holdings
Loans
Gold and SDRs
Cash Items
Coin
• Other Assets
– Physical and For. Cur.
Liabilities
Notes
Reserve Deposits
Treasury deposits
For. & Agency Deposits
Deferred Availability Cash
Items
Other Lia. & Capital
Monetary base or high-powered
money
• MB = Fed notes + Treasury currency – coin
+ bank reserves
• MB = C + R
• Uses of base are C + R
Sources of base
Federal Reserve Credit
Securities
Discount Lending
Float
Gold and SDR’s
Other Fed assets
Treasury currency
Monetary Base
• Monetary Base
• Currency
• Reserves
– Vault Cash (Reserves)
– Deposits
• Surplus Vault Cash
• Clearing Balances
$
$
$
$
$
$
$
808.8b
742.7b
45.4b
34.7b
10.7b
13.5b
7.2b
Bank Reserves
• Total Reserves
– Required
– Excess
• Borrowed Reserves
– Primary
– Seasonal
$ 45.4b
$ 43.6b
$ 1.8b
$ 175m
$ 24m
$ 151m
Data as of May 2006
Controlling the Monetary Base
• Open Market Operations
• Lending to Financial Institutions
• Fed has better control of base than of
reserves
Open Market Operations
• Open market purchase
• Buy securities from bank or public
• Example: Purchase from bank
Bank
Assets
Liabilities
Securities -$100
Reserves +$100
Fed
Assets
Securities +$100
Liabilities
Reserves +$100
Open Market Operations
• Next, assume security purchased from
nonbank public
Pat Public
Assets
Securities -$100
Dem.Dep+$100
Liabilities
Pat’s Bank
Assets
Reserves +$100
Liabilities
Dem.Dep. +$100
Fed
Assets
Securities
+$100 Reserves
Liabilities
+$100
Open Market Operations
• Result differs if Pat holds currency
• In both cases, monetary base increases, but
reserves increase only when funds deposited
in bank
Pat Public
Assets
Securities
Currency
Liabilities
-$100
+$100
Fed
Assets
Securities +$100
Liabilities
Currency +$100
Open Market Operations
• Open Market Sale
Pat Public
Assets
Securities
Currency
Liabilities
+$100
-$100
Fed
Assets
Securities -$100
Liabilities
Currency
-$100
Increase in Currency
• Shifts from deposits to currency reduce
bank reserves but leaves base unchanged
Pat Public
Assets
Liabilities
Demand Deposits -$100
Currency
+$100
Fed
Assets
Assets
Reserves
-$100
Banks
Liabilities
Demand
Deposits -$100
Liabilities
Reserves -$100
Currency +$100
Foreign Exchange Intervention
• Purchases and sale of foreign currency has
same effect as security purchases and sales
Discount Loans
• Bank borrows reserves from Fed
Bank
Assets
Reserves
+$100 Loans
Liabilities
+$100
Fed
Assets
Loans
+$100 Reserves
Liabilities
+$100
Discount Loans
• Bank repays loan
Bank
Assets
Reserves
-$100
Loans
Liabilities
-$100
Fed
Assets
Loans
-$100 Reserves
Liabilities
-$100
Float and Treasury deposits
• Float and Treasury deposits affect monetary
base.
• Fed can still control base by engaging in
offsetting open market operations.
Multiple Deposit Creation
• Fractional reserve banking – hold a fraction
of deposits as reserves
• Assume bank sells security to Fed, reserves
increase.
• Also assume no excess reserves or currency.
• Required reserves are 10%
Multiple Deposit Creation
• Bank 1 sells security, gains reserves
Bank 1
Assets
Securities
Reserves
Liabilities
-$100
+$100
Multiple Deposit Creation
• Bank 1 has $100 of excess reserves, makes
loan of $100
Bank 1
Assets
Securities
Reserves
Loan
Liabilities
-$100 Demand Deposits +$100
+$100
+$100
Multiple Deposit Creation
• Borrower writes check, spends loan
Bank 1
Assets
Securities
Loan
Liabilities
-$100
+$100
Funds deposited in Bank 2
Bank 2
Assets
Reserves
+$100
Liabilities
Demand Deposits +$100
Multiple Deposit Creation
• Bank 2 has required reserves of $10 (10%
0f $100), and excess reserves of $90. Loans
$90.
Bank 2
Assets
Reserves
Loans
+$100
+ $90
Liabilities
Demand Deposits +$100
Demand Deposits + $90
Note that deposits of $90 created. Total deposits
$190.
Multiple Deposit Creation
• Borrower spends proceeds of loan, which
are deposited in Bank 3
Bank 2
Assets
Reserves
Loans
Liabilities
+$10 Demand Deposits +$100
+ $90
Bank 3
Assets
Liabilities
Reserves
+$90 Demand Deposits +$90
Multiple Deposit Creation
• Bank 3 has excess reserves of $81 (10% of
$90), which it uses to make loan
Bank 3
Assets
Reserves
+$90
Loan
+$81
Liabilities
Demand Deposits +$90
Demand Deposits +$81
Process continues
Deposit Creation
Multiple Deposit Creation
• Result for banking system
Banking System
Assets
Securities
Reserves
Loans
-$100
+$100
+$1000
Liabilities
Demand Deposits +$1000
If banks purchase securities instead of making
loans, deposit expansion is the same.
Simple deposit multiplier
• Multiplier reflects increase in deposits for a given
increase in reserves
D = 1/r x R
• Change in demand deposits equals one divided by
required reserve ratio times change in reserves
• In levels
D = 1/r x R
• Total demand deposits equals one divided by
reserve ratio times total reserves.
Multiple Contraction
• Loss of reserves results in multiple
contraction of deposits
• Assume bank buys security and reduces
reserves
Bank A
Assets
Securities
Reserves
Liabilities
+$100
-$100
Multiple Contraction
• Bank is short of reserves of $100, assuming
no excess reserves
• When loan is repaid, bank gains reserves,
and has no shortage
• Loan paid from a check on Bank B, which
is now short of reserves
Bank B
Assets
Reserves
Liabilities
-$100 Demand Deposits -$100
Multiple Contraction
• Bank B is short $90 of reserves (since DD
down $100)
• Bank B can replenish reserves by reducing
loans by $90
Bank B
Assets
Reserves
Loans
-$10
-$90
Liabilities
Demand Deposits -$100
Multiple Contraction
• For system as a whole, deposits fall by
multiple of drop in reserves
Banking System
Assets
Securities
Reserve
Loans
+$100
-$100
-$1000
Liabilities
Demand Deposits -$1000
Limitations of analysis: Assumes no currency or excess reserves
Changing these assumptions changes multiplier