Money, Banking, and Financial Markets about the deposit expansion process: the simple analytics

1. Chapter 14 Banks & The creation of Bank Deposits
Banking System
The Deposit Expansion
Process: The Simple
Macroeconomic Variables
Analytics Credit availability
1. Output
2. Employment
& The Money Supply
3. Price Level
©Thomson/South-Western 2006 1 2
Banks And The Creation Of Bank
1. Writing a Check
Deposits
T-accounts A $10,000 check drawn on her account at Hometown Bank is
A T-account indicates the change in the balance sheet of sent to a shoe manufacturer in St. Louis.
the depository institution resulting from a given event. When the check is deposited in a St. Louis bank and clears,
Demand deposits in the St. Louis bank have increased by $10,000.
Suppose your hometown bank lends $10,000 to a local Demand deposits in the Hometown Bank have decreased by $10,000.
shoe-store owner for the purpose of increasing her
The main point: Whenever banks increase their loans--
inventories. whether in the form of currency or in the form of a demand
deposit entry on the banks' books--the nation’s money supply
Hometown bank has created $10,000 in new money: increases by the amount of the loan.
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1. Writing a Check 2. A Bank Buys Securities
The main point: Whenever banks increase Hometown Bank purchases $200,000 of U.S. government
securities from a dealer located in New York City.
their loans--whether in the form of currency or Hometown Bank sends a $200,000 check drawn on its
in the form of a demand deposit entry on the account with the Federal Reserve.
banks' books--the nation’s money supply After the security dealer deposits the check in a New York
bank, the check is processed and cleared by the Federal
increases by the amount of the loan. Reserve System.
When the dealer deposits the check in its New York bank, the
nation’s money supply rises by $200,000.
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2. Money Creation Recall
Banks create demand deposits whenever The reserve requirement is a percentage figure set by the
Federal Reserve, applicable to demand deposits in banks.
banks
Make Loans Required reserves are the dollar amount of reserves a bank
must maintain or exceed.
Purchase Securities
Loans and Securities are profitable (Earning Excess reserves are the difference between reserves and
Assets) required reserves. If reserves exceed required reserves,
banks have positive excess reserves.
Are banks limited in the amount they can
make loans / buy securities? Once a bank has no excess reserves, it cannot afford to lose
any reserves.
Yes, banks have to maintain “Reserves”
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Multiple Expansion of Bank
Banks & The Creation of Bank Deposits
Deposits
Reserves Reserves Reserves
Required Federal reserve banking system requires that banks
Reserves
maintain only a small portion of their demand
deposit liabilities in the form of reserves (cash and
Securities
Securities
deposits in the banking system).
Securities New reserves can support deposits that are a
multiple of the amount of these new reserves.
Loans Loans
Loans Banking system can generate new loans and
investment in securities by a multiple of the excess
reserves in the system.
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Illustration of the Deposit
Illustration Continued
Multiplier
Assume:
Each bank in the nation desires to rid itself of all its excess
Suppose a bank initially has no excess reserves. reserves.
The reserve requirement for all banks is 10 percent.
Then:
Suppose explorers discover a sunken ship off the Bank A has excess reserves of $4.5 million.
Bank A loans it all to real estate developers who buy land from
coast of Florida that contains $5 million in coins. If customers of Bank B.
the coins are placed in a Florida bank (Bank A):
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3. Illustration Continued Illustration Continued
Bank B received demand deposits and reserves of 4.5 million Suppose Bank B buys U.S. government securities from a
Bank B has required reserves = 10% of 4.5 million deposits = New York securities dealer.
0.45 million
Excess reserves = reserve – required reserve = 4.5 – 0.45 = Bank C can now grant loans and/or purchase securities in the
4.05 million amount of its excess reserves, $3.645 million.
Bank B can use this reserves to make loans, buy securities.
….and so on
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Table 14-1 Maximum Expansion of Deposits
Induced Expansion of Deposits in the Banking
System
1
Initial Excess reserves x
percentage reserve requirement
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Your turn (p.332) Banking system and Money Supply
Q: Suppose the reserve requirement is 20%, you find Money Supply increases when
$1million of currency in your grandmother’s attic
and deposit into her bank checking account. Bank makes loans
Calculate: Bank purchases securities
1. The change in reserves in her bank
2. The change in required reserves in her bank
3. The change in excess reserves in her bank
Money Supply decreases when
4. The maximum amount by which her bank can expand its Bank calls back loans
loans Bank sells securities
5. The maximum amount the entire banking system can
expand its loans
6. The potential expansion in the nation’s deposits
7. The potential exansion in M1
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4. Bank Q Reacts and Starts a
Multiple Contraction of Deposits
Stampede
A withdrawal of reserves from the banking system Bank Q can alleviate its reserve deficiency by selling
precipitates a multiple contraction of deposits. $6.3 million in securities, by demanding repayment of
Suppose customers of Bank Q obtain $7 million in currency $6.3 million worth of loans, or by some combination
by drawing down their bank demand deposits. of those two actions.
Bank Q's required reserves decline by $0.7 million,
Actual reserves fall by the full $7 million.
Bank Q’s reserves are deficient by $6.3 million. Bank Q simply shifts its reserve deficiency to another
Bank Q initially exhibit excess reserves of negative $6.3 bank, Bank R.
million.
Bank R becomes deficient in reserves and must
liquidate loans or securities, thereby shifting the hot
potato to another bank, Bank S.
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How The Federal Reserve Gets A
The Result and Conclusion Grip On The Money Supply
With its unlimited authority to purchase or sell government securities in the open
The banking system cannot control its own reserves. market, the Fed can easily swamp any influence of outside forces and thereby
control the supply of reserves in the banking system.
The public influences reserves by depositing or When the Fed purchases securities (say $900m) in the open market:
withdrawing currency from banks.
The Federal Reserve System influences reserves by
buying and selling securities in the open market and by
lending to banks.
When the Fed sells securities to individuals, firms, or banks, aggregate reserves
are withdrawn from the banking system.
Multiple expansion of deposits results when Fed injects excess reserves into
banking system.
Multiple contraction of deposits result when Fed withdraw reserves from banking
system.
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Study Question
Suppose the reserve requirement is 10%. The
Fed buys $1,000 million worth of securities
from the dealer.
1. What is the initial (direct) change in the
reserves (money supply)?
2. What is the ultimate effect on the money
supply?
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