Chapter 5
Multiple Deposit Creation and
the Money Supply Process
1
Players in the Money Supply
Process




Central Bank (Federal Reserve System)
Banks (depository institutions; financial
intermediaries)
Depositors (individuals and institutions)
Borrowers from banks (individuals and
institutions)
2
Central Bank’s Balance Sheet
Central Bank
Assets

Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Monetary Liabilities


Currency in circulation—notes in the hands of the
public
Reserves—commercial bank deposits at the CB and
vault cash (cash in ATM machines and branches of
commercial banks). CB requires banks to hold a
minimum level of reserves at the CB as a fraction of
total deposits. But banks may hold excess
reserves
3
Central Bank’s Balance Sheet

Assets


Government securities—CB holds Treasury
bonds as a policy instrument to increase or
decrease the money supply
Discount loans—lend reserves to commercial
banks and earn the discount rate
4
Monetary Base (Highpowered money)
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system

The CB controls the monetary base by
“open market operations”.
5
Open Market Purchase
Banking System
Assets
Liabilities
Securities
-TL100
Reserves
+TL100




Central Bank
Assets
Securities
Liabilities
+TL100 Reserves
+TL100
CB buys 100 TL bond from a commercial bank. In
return writes a check. The commercial bank could
either deposit the check in CB or cash the check.
Net result is that reserves have increased
by 100 TL
No change in currency. (Cash in banks’ vaults or ATM
machines is not included in C)
Monetary base increases by 100 TL
6
Open Market Purchase:
Summary


The effect of an open market purchase
always increases the monetary base by
the amount of the purchase.
When monetary base increases by 1 TL,
money supply increases by more than 1
TL (increases by the money multiplier).
7
Open Market Sale
Banking System
Assets



Liabilities
Securities
+TL100
Reserves
-TL100
Central Bank
Assets
Securities
Liabilities
-TL100 Reserves
-TL100
CB sells 100 TL bond to a commercial bank. Deducted
from bank’s account at CB in return.
Reserves decrease by the amount of the sale.
Monetary base decreases by the amount of the sale. In
any open market sale, Monetary Base decreases.
8
Open Market Sale
Summary
 In any open market sale, Monetary Base
decreases by the amount of the sale.
 When monetary base decreases by 1 TL,
money supply decreases by more than 1
TL. This amount is called the money
multiplier.
9
Shifts from Deposits into Currency
Nonbank Public
Assets
Banking System
Liabilities
Checkable
deposits
-TL100
Currency
+TL100
Assets
Reserves
-TL100 Checkable
deposits
-TL100
Net effect
Central Bank
Assets
Liabilities
Liabilities
Currency in
circulation
+TL100
Reserves
-TL100
on monetary liabilities
is zero
Reserves are changed
by random fluctuations
Monetary base
is a more stable variable
10
CB Making a Discount Loan to a
Bank
Banking System
Assets
Reserves
Central Bank
Liabilities
+TL100 Discount
loans
+TL 100
(borrowing from CB)


Assets
Discount
loan
Liabilities
+TL100 Reserves
+TL100
(borrowing from CB)
Monetary liabilities of the CB have increased by
100 TL
Monetary Base also increases by 100 TL.
11
Banks Create Deposit in a
Fractional Reserve System



When the CB injects 1 TL reserve into the
banking system, deposits increase by more
than 1 TL.
This is because required reserve ratio (RRR) is
less than 100% of deposits. A smaller RRR leads
to greater expansion of monetary base for 1 TL
injection.
First let us assume banks do not hold excess
reserves.
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Deposit Creation: Single Bank
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-TL100
Securities
Reserves
+TL100
Reserves
+TL100
Loans
+TL100
First National Bank
Assets
Securities
-TL100
Loans
+TL100
Liabilities
-TL100 Checkable
deposits
+TL100
Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
13
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.
100 TL is excess reserve for FNB and it lends
this money to a firm. Opens a checking account
for the borrower, loans and checkable deposits
increase by 100 TL.
When the borrower spends the credit, reserves
and checkable deposits disappear on FNB’s Taccount.
14
Deposit Creation:
The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+TL10 Checkable
0 deposits
Assets
+TL100 Reserves
+TL10 Checkable
deposits
Loans
Reserves
+TL100
+TL90
Bank B
Assets
Liabilities
Bank B
Liabilities
+TL90 Checkable
deposits
Assets
+TL90 Reserves
Loans
Liabilities
+TL9 Checkable
deposits
+TL90
+TL81
15
Deposit Creation:
The Banking System


When the borrower spends the credit, assuming
that nobody wants to keep extra cash, 100 TL
spent is deposited in a checking account at 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 borrower spends
this loan, reserves are deposited to another
bank: Bank B.
16
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. This firm 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).
17
Deposit Creation:
The Banking System
If there are many banks, checkable deposits and
of course 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, 1/r
decreases and money creation is slower.
18
19
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=
20
Critique of the Simple Model



If borrowers & depositors hold their money in
cash instead of depositing, this stops the
money creation process. What fraction of bank
loans is held in cash? We assumed zero.
Banks may not use all of their excess reserves
to make loans or buy securities. They may
choose to hold excess reserves for precaution
purposes. This also slows down money
creation.
Result is that it is not easy to control money
supply (MB). It is easier to control the
monetary base.
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