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.

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Central Bank’s Balance Sheet

Assets Government bonds (Securities) Discount loans

Central Bank

Liabilities Currency in circulation 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: R: Currency in circulation Reserves

 The CB controls the monetary base by

“open market operations”.

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Open Market Purchase

Banking System

Assets Liabilities Securities Reserves -TL100 +TL100 Assets

Central Bank

Liabilities Securities +TL100 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.

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Open Market Sale

Banking System

Assets Liabilities Securities +TL100 Assets

Central Bank

Liabilities Securities -TL100 Reserves -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.

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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.

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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.

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Shifts from Deposits into Currency

Nonbank Public

Assets Liabilities Checkable deposits Currency -TL100 +TL100

Banking System

Assets Liabilities Reserves -TL100 Checkable deposits -TL100 Assets

Central Bank

Liabilities Currency in circulation Reserves +TL100 -TL100 Net effect on monetary liabilities 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

Assets

Banking System

Liabilities Reserves +TL100 Discount loans +TL 100 (borrowing from CB) Assets

Central Bank

Liabilities Discount loan +TL100 Reserves +TL100   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.

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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 T account.

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Deposit Creation: Single Bank

First National Bank First National Bank

Assets Liabilities Assets Liabilities Securities -TL100 Securities +TL100 Reserves +TL100 Reserves Loans -TL100 Checkable deposits +TL100 +TL100 Securities Loans

First National Bank

Assets -TL100 +TL100 Liabilities 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 Bank A

Assets Reserves Liabilities +TL100 Checkable deposits Assets +TL100 Reserves Loans Liabilities +TL10 Checkable deposits +TL100 +TL90 Reserves Assets

Bank B Bank B

Liabilities +TL90 Checkable deposits Assets +TL90 Reserves Loans +TL81 Liabilities +TL9 Checkable deposits +TL90 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).

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21

The Formula for Multiple Deposit Creation

Assuming banks do not hold excess reserves Required Reserves (

RR RR

Substituting

r



R

Dividing both s ides by

r D

= 1 

R r

Taking the change in both sides yields 

D

= 1

r R

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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.

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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.

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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