Creating Money Through the Banking System

Creating Money Through the Banking System Multiple Deposit Creation

Money and Banking • The largest component of the money supply is bank deposits. • To understand how the Central Bank influences the supply of money in the economy, we need to examine the linkages between: • The Central Bank • The private banking system • Depositors • Borrowers • The interactions between these four groups have direct effects on the money supply

The Fed’s Balance Sheet • We first look at the Central Bank’s (Fed) assets and liabilities • Assets • The Fed purchases securities (mostly those issued by the U.S. Treasury) from private banks and the non-bank public • The Fed makes discount loans to private banks that are repaid at the discount rate • Liabilities • Currency in circulation is currency held by the public • Bank reserves refer to currency held by private banks in their own vaults or at the Fed.

The Monetary Base • We define the monetary base as the Federal Reserve’s liabilities: • MB = Currency in Circulation + Reserves = C + R • The Fed can increase or decrease MB by engaging in Open Market Operations, the buying and selling of bonds from/to the public. • To increase MB, the Fed will buy bonds from the public, replacing a non-monetary asset (bonds) with a monetary one (currency) • To decrease MB, the Fed will sell bonds from the public, exchanging a monetary public asset (currency) for a non-monetary asset (bonds)

Increasing MB through an Open Market Purchase • The Fed buys a $100 bond from a bank and pays with a $100 check. • The bank cashes the check and places the $100 in its vault as reserves. • The monetary base has increased by $100 with the conversion of the privately held security into currency (and then into bank reserves)

Open Market Purchase from the Public • Suppose the Fed wanted to increase the monetary base and bought a $100 treasury bill from you. • You now have two things you can do with your money: • Hold it as currency • Deposit it at the bank. • Suppose you hold onto the $100 as currency. • The Fed’s balance sheet now looks like: • The monetary base has increased

Open Market Purchase from the Public • Now what would happen if you deposited your $100 in the bank? • The bank takes your $100 and places it in reserve • The monetary base still increases by $100, only now because reserves went up:

Open Market Sale • The Fed sells a bond to the public for $100 • Reduces the monetary base by the amount of the sale • Reserves remain unchanged • The effect of open market operations on the monetary base is much more certain than the effect on reserves

Making a Discount Loan to a Bank • A bank borrows $100 from the Fed’s discount window • Monetary liabilities of the Fed have increased by $100 • Monetary base also increases by this amount

Paying off a Discount Loan from the Fed • The bank pays back $100 to the Fed (assume no interest) • Net effect on monetary base is a reduction • Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System

Fractional Reserve Banking • So far we have been assuming that banks hold the entire amount of their deposits in reserve. • Clearly this is a false assumption as banks rarely ever have enough currency in their vaults (or on reserve at the Fed) to cover all deposits made with them. • The banking system operates as a fractional reserve system in which only a portion of the banks deposits are held in reserve. • The Fed sets a lower limit for the fraction of deposits that must be held in reserve: the reserve requirement ratio • Since banks earn profit by lending at higher interest rates than they give on deposits, the reserve requirement is generally a binding limit.

Reserve Requirement Ratio • One way the Fed influences the money supply is by changing the reserve requirement ratio (r) • As r increases, bank loans will fall, money in circulation falls • Suppose you deposit $100 into your account at Bank of America • The reserve requirement ratio is 20%. • Bank of America has the following balance sheet: • The money supply is equal to the $100 deposited in the bank plus the $80 in currency circulating as a loan  M = $180

Reserve Requirement Ratio • Suppose the $100 is deposited in Bank of America, but now the bank maintains a 10% reserve ratio, lending the remaining 90% of deposits. • Bank of America’s financial statement would then be: • The money supply has increased • There is $90 of currency in circulation and $100 worth of deposits. • The money supply has increased to $190 • Despite the increase in the money supply, there has been no increase in wealth. New money has been created, but so has debt. • Now suppose that the borrower who got the $90 loan uses that currency to make a purchase.

Reserve Requirement Ratio • Suppose the borrower uses that $90 to buy tickets to an Atlanta Braves playoff game. • Ticketmaster will then deposit this $90 in their bank, SunTrust. • Suppose SunTrust maintains a 10% reserve ratio as well: • Of the $90 deposited at SunTrust, only 10% ($9) is held as reserves. The remaining 90% ($81) is loaned out. • There has been a further increase in the money supply. • The new value for M is Deposits at Bank of America + Deposits at SunTrust + Currency in Circulation = $100+$90+$81=$271

Reserve Requirement Ratio • Now SunTrust bank loans out $81 to another borrower who uses that money to buy books from the UCSD bookstore. • The bookstore deposits this $81 in Wachovia Bank, who also maintain a 10% reserve ratio. • The money supply has increased again: • M1 = Deposits at BoA + Deposits at SunTrust + Deposits at Wachovia + Currency = $100 + $90 + $81 + $72.90 = $343.90 • Each time money is deposited and a bank loan is created, more money is created. • The amount of money the banking system generates with each dollar of reserves is known as the moneymultiplier.

The Formula for Multiple Deposit Creation

Critique of the Simple Model • Holding cash stops the process • Banks may not use all of their excess reserves to buy securities or make loans

Creating Money Through the Banking System