economics_of_money_banking__financial_markets

Deposit Creation:

The Single Bank

reserves, deposits increase by a multiple of this amountÑa process called multiple deposit creation.

Suppose that the $100 open market purchase described earlier was conducted with the First National Bank. After the Fed has bought the $100 bond from the First National Bank, the bank finds that it has an increase in reserves of $100. To analyze what the bank will do with these additional reserves, assume that the bank does not want to hold excess reserves because it earns no interest on them. We begin the analysis with the following T-account:

Deposit Creation:

The Banking

System

C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 367

The final T-account of the First National Bank is:

The increase in reserves of $100 has been converted into additional loans of $100 at the First National Bank, plus an additional $100 of deposits that have made their way to other banks. (All the checks written on accounts at the First National Bank are deposited in banks rather than converted into cash, because we are assuming that the public does not want to hold any additional currency.) Now letÕs see what happens to these deposits at the other banks.

To simplify the analysis, let us assume that the $100 of deposits created by First National BankÕs loan is deposited at Bank A and that this bank and all other banks hold no excess reserves. Bank AÕs T-account becomes:

BANK A

If the required reserve ratio is 10%, this bank will now find itself with a $10 increase in required reserves, leaving it $90 of excess reserves. Because Bank A (like the First National Bank) does not want to hold on to excess reserves, it will make loans for the entire amount. Its loans and checkable deposits will then increase by $90, but when the borrower spends the $90 of checkable deposits, they and the reserves at Bank A will fall back down by this same amount. The net result is that Bank AÕs T-account will look like this:

BANK A

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creation of deposits can also be derived directly using algebra. We obtain the same answer for the relationship between a change in deposits and a change in reserves, but more quickly.

Our assumption that banks do not hold on to any excess reserves means that the total amount of required reserves for the banking system RR will equal the total reserves in the banking system R:

RR R

The total amount of required reserves equals the required reserve ratio r times the total amount of checkable deposits D:

RR r D

Substituting r D for RR in the first equation:

r D R

and dividing both sides of the preceding equation by r gives us:

D 1r R

Taking the change in both sides of this equation and using delta to indicate a change:

D 1r R

which is the same formula for deposit creation found in Equation 1.

This derivation provides us with another way of looking at the multiple creation of deposits, because it forces us to look directly at the banking system as a whole rather than one bank at a time. For the banking system as a whole, deposit creation (or contraction) will stop only when all excess reserves in the banking system are gone; that is, the banking system will be in equilibrium when the total amount of required reserves equals the total amount of reserves, as seen in the equation RR R. When r D is substituted for RR, the resulting equation R r D tells us how high checkable deposits will have to be in order for required reserves to equal total reserves. Accordingly, a given level of reserves in the banking system determines the level of checkable deposits when the banking system is in equilibrium (when ER 0); put another way, the given level of reserves supports a given level of checkable deposits.

7A formal derivation of this formula follows. Using the reasoning in the text, the change in checkable deposits is $100 ( R 1) plus $90 [ R (1 r)] plus $81 [ R (1 r)2 and so on, which can be rewritten as:

D R [1 (1 r) (1 r)2 (1 r)3 . . .]

Using the formula for the sum of an infinite series found in footnote 5 in Chapter 4, this can be rewritten as:

Critique of the

Simple Model

C H A P T E R 1 5 Multiple Deposit Creation and the Money Supply Process 371

In our example, the required reserve ratio is 10%. If reserves increase by $100, checkable deposits must rise to $1,000 in order for total required reserves also to increase by $100. If the increase in checkable deposits is less than this, say $900, then the increase in required reserves of $90 remains below the $100 increase in reserves, so there are still excess reserves somewhere in the banking system. The banks with the excess reserves will now make additional loans, creating new deposits, and this process will continue until all reserves in the system are used up. This occurs when checkable deposits have risen to $1,000.

We can also see this by looking at the T-account of the banking system as a whole (including the First National Bank) that results from this process:

BANKING SYSTEM

The procedure of eliminating excess reserves by loaning them out means that the banking system (First National Bank and Banks A, B, C, D, and so on) continues to make loans up to the $1,000 amount until deposits have reached the $1,000 level. In this way, $100 of reserves supports $1,000 (ten times the quantity) of deposits.

Our model of multiple deposit creation seems to indicate that the Federal Reserve is able to exercise complete control over the level of checkable deposits by setting the required reserve ratio and the level of reserves. The actual creation of deposits is much less mechanical than the simple model indicates. If proceeds from Bank AÕs $90 loan are not deposited but are kept in cash, nothing is deposited in Bank B, and the deposit creation process stops dead in its tracks. The total increase in checkable deposits is only $100Ñconsiderably less than the $1,000 we calculated. So if some proceeds from loans are used to raise the holdings of currency, checkable deposits will not increase by as much as our streamlined model of multiple deposit creation tells us.

Another situation ignored in our model is one in which banks do not make loans or buy securities in the full amount of their excess reserves. If Bank A decides to hold on to all $90 of its excess reserves, no deposits would be made in Bank B, and this would also stop the deposit creation process. The total increase in deposits would again be only $100 and not the $1,000 increase in our example. Hence if banks choose to hold all or some of their excess reserves, the full expansion of deposits predicted by the simple model of multiple deposit creation does not occur.

Our examples rightly indicate that the Fed is not the only player whose behavior influences the level of deposits and therefore the money supply. BanksÕ decisions regarding the amount of excess reserves they wish to hold, depositorsÕ decisions regarding how much currency to hold, and borrowersÕ decisions on how much to borrow from banks can cause the money supply to change. In the next chapter, we stress the behavior and interactions of the four players in constructing a more realistic model of the money supply process.

1.There are four players in the money supply process: the central bank, banks (depository institutions), depositors, and borrowers from banks.

2.Four items in the FedÕs balance sheet are essential to our understanding of the money supply process: the two liability items, currency in circulation and reserves, which together make up the monetary base, and the two asset items, government securities and discount loans.

3.The Federal Reserve controls the monetary base through open market operations and extension of discount loans to banks and has better control over the monetary base than over reserves. Although float and Treasury deposits with the Fed undergo substantial short-run fluctuations, which complicate control of the monetary base, they do not prevent the Fed from accurately controlling it.

4.A single bank can make loans up to the amount of its excess reserves, thereby creating an equal amount of

deposits. The banking system can create a multiple expansion of deposits, because as each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make loans and create additional deposits. In the simple model of multiple deposit creation in which banks do not hold on to excess reserves and the public holds no currency, the multiple increase in checkable deposits (simple deposit multiplier) equals the reciprocal of the required reserve ratio.

5.The simple model of multiple deposit creation has serious deficiencies. Decisions by depositors to increase their holdings of currency or of banks to hold excess reserves will result in a smaller expansion of deposits than the simple model predicts. All four playersÑthe Fed, banks, depositors, and borrowers from banksÑare important in the determination of the money supply.

QUIZ Questions and Problems

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

1.If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

*2. If the Fed sells $2 million of bonds to Irving the Investor, who pays for the bonds with a briefcase filled

with currency, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

*3. If the Fed lends five banks an additional total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

4.The First National Bank receives an extra $100 of reserves but decides not to lend any of these reserves

out. How much deposit creation takes place for the entire banking system?

Unless otherwise noted, the following assumptions are made in all the remaining problems: The required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the publicÕs holdings of currency do not change.

*5. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed lends an additional $1 million to the First National Bank.

6.Using T-accounts, show what happens to checkable deposits in the banking system when the Fed sells $2 million of bonds to the First National Bank.

*7. Suppose that the Fed buys $1 million of bonds from the First National Bank. If the First National Bank and all other banks use the resulting increase in reserves to purchase securities only and not to make loans, what will happen to checkable deposits?

8.If the Fed buys $1 million of bonds from the First National Bank, but an additional 10% of any deposit is held as excess reserves, what is the total increase in checkable deposits? (Hint: Use T-accounts to show what happens at each step of the multiple expansion process.)

*9. If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves and checkable deposits?

10.If reserves in the banking system increase by $1 billion as a result of discount loans of $1 billion and

checkable deposits increase by $9 billion, why isnÕt the banking system in equilibrium? What will continue to happen in the banking system until equilibrium is reached? Show the T-account for the banking system in equilibrium.

*11. If the Fed reduces reserves by selling $5 million worth of bonds to the banks, what will the T-account of the banking system look like when the banking system is in equilibrium? What will have happened to the level of checkable deposits?

12.If the required reserve ratio on checkable deposits increases to 20%, how much multiple deposit creation will take place when reserves are increased by $100?

*13. If a bank decides that it wants to hold $1 million of excess reserves, what effect will this have on checkable deposits in the banking system?

14.If a bank sells $10 million of bonds back to the Fed in order to pay back $10 million on the discount loan it owes, what will be the effect on the level of checkable deposits?

*15. If you decide to hold $100 less cash than usual and therefore deposit $100 in cash in the bank, what effect will this have on checkable deposits in the banking system if the rest of the public keeps its holdings of currency constant?

Web Exercises

1.Go to www.federalreserve.gov/boarddocs/rptcongress/ and find the most recent annual report of the Federal Reserve. Read the first section of the annual report that summarizes Monetary Policy and the Economic Outlook. Write a one-page summary of this section of the report.

2.Go to www.federalreserve.gov/releases/h6/hist/ and find the historical report of M1, M2, and M3. Compute the growth rate in each aggregate over each of the last 3 years (it will be easier to do if you move the data into Excel as demonstrated in Chapter 1). Does it appear that the Fed has been increasing or decreasing the rate of growth of the money supply? Is this consistent with what you understand the economy needs? Why?

Assets

Just as any other bank has a balance sheet that lists its assets and liabilities, so does the Fed. We examine each of its categories of assets and liabilities because changes in them are an important way the Fed manipulates the money supply.

1.Securities. These are the FedÕs holdings of securities, which consist primarily of Treasury securities but in the past have also included bankerÕs acceptances. The total amount of securities is controlled by open market operations (the FedÕs purchase and sale of these securities). As shown in Table 1, ÒSecuritiesÓ is by far the largest category of assets in the FedÕs balance sheet.

2.Discount loans. These are loans the Fed makes to banks. The amount is affected by the FedÕs setting the discount rate, the interest rate that the Fed charges banks for these loans.

These first two Fed assets are important because they earn interest. Because the liabilities of the Fed do not pay interest, the Fed makes billions of dollars every yearÑ its assets earn income, and its liabilities cost nothing. Although it returns most of its earnings to the federal government, the Fed does spend some of it on Òworthy causes,Ó such as supporting economic research.

Liabilities

3.Gold and SDR certificate accounts. Special drawing rights (SDRs) are issued to governments by the International Monetary Fund (IMF) to settle international debts and have replaced gold in international financial transactions. When the Treasury acquires gold or SDRs, it issues certificates to the Fed that are claims on the gold or SDRs and is in turn credited with deposit balances at the Fed. The gold and SDR accounts are made up of these certificates issued by the Treasury.

4.Coin. This is the smallest item in the balance sheet, consisting of Treasury currency (mostly coins) held by the Fed.

5.Cash items in process of collection. These arise from the FedÕs check-clearing process. When a check is given to the Fed for clearing, the Fed will present it to the bank on which it is written and will collect funds by deducting the amount of the check from the bankÕs deposits (reserves) with the Fed. Before these funds are collected, the check is a cash item in process of collection and is a Fed asset.

6.Other Federal Reserve assets. These include deposits and bonds denominated in foreign currencies as well as physical goods such as computers, office equipment, and buildings owned by the Federal Reserve.

1.Federal Reserve notes (currency) outstanding. The Fed issues currency (those green-and-gray pieces of paper in your wallet that say ÒFederal Reserve noteÓ at the top). The Federal Reserve notes outstanding are the amount of this currency that is in the hands of the public. (Currency held by depository institutions is also a liability of the Fed but is counted as part of the reserves liability.)

Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities, but unlike most liabilities, they promise to pay back the bearer solely with Federal Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if you bring a $100 bill to the Federal Reserve and demand payment, you will receive two $50s, five $20s, ten $10s, or one hundred $1 bills.

People are more willing to accept IOUs from the Fed than from you or me because Federal Reserve notes are a recognized medium of exchange; that is, they are accepted as a means of payment and so function as money. Unfortunately, neither you nor I can convince people that our IOUs are worth anything more than the paper they are written on.1

2.Reserves. All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes. As shown in the chapter, an increase in reserves leads to an increase in the level of deposits and hence in the money supply.

1The ÒFederal Reserve notes outstandingÓ item on the FedÕs balance sheet refers only to currency in circulation, the amount in the hands of the public. Currency that has been printed by the U.S. Bureau of Engraving and Printing is not automatically a liability of the Fed. For example, consider the importance of having $1 million of your own IOUs printed up. You give out $100 worth to other people and keep the other $999,900 in your pocket. The $999,900 of IOUs does not make you richer or poorer and does not affect your indebtedness. You care only about the $100 of liabilities from the $100 of circulated IOUs. The same reasoning applies for the Fed in regard to its Federal Reserve notes.

For similar reasons, the currency component of the money supply, no matter how it is defined, includes only currency in circulation. It does not include any additional currency that is not yet in the hands of the public. The fact that currency has been printed but is not circulating means that it is not anyoneÕs asset or liability and thus cannot affect anyoneÕs behavior. Therefore, it makes sense not to include it in the money supply.