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chapter 15

chapter 15. Multiple Deposit Creation and the Money Supply Process. Four Players in the Money Supply Process. 1. Central bank: the Bank of Canada 2. Banks 3. Depositors 4. Borrowers from banks Bank of Canada 1. Conducts monetary policy 2. Clears cheques 3. Regulates banks.

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chapter 15

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  1. chapter 15 Multiple Deposit Creation and the Money Supply Process

  2. Four Players in the Money Supply Process 1. Central bank: the Bank of Canada 2. Banks 3. Depositors 4. Borrowers from banks Bank of Canada 1. Conducts monetary policy 2. Clears cheques 3. Regulates banks

  3. Bank of Canada Balance Sheet

  4. The Monetary Base MB = Bank of Canada notes outstanding + Settlement balances + Coins outstanding = C + R Bank of Canada notes outstanding + Settlement balances = Securities and investments + Advances + Foreign assets + SPRAs – Government deposits – SRAs + Other assets (net) MB = Securities and investments + Advances + Foreign assets + SPRAs + Other assets (net) + Coins outstanding – Government deposits – SRAs

  5. Summary: Factors That Affect the Monetary Base

  6. Control of the Monetary Base MB = C + R Open Market Purchase from Bank The Banking System The Bank of Canada Assets Liabilities Assets Liabilities Securities – $100 Securities + $100 Reserves + $100 Reserves + $100 Open Market Purchase from Public Public The Bank of Canada Assets Liabilities Assets Liabilities Securities – $100 Securities + $100 Reserves + $100 Deposits + $100 Banking System Assets Liabilities Reserves Chequable Deposits + $100 + $100 Result:R $100, MB $100

  7. If Person Cashes Cheque Public The Bank of Canada Assets Liabilities Assets Liabilities Securities – $100 Securities + $100 Currency + $100 Currency + $100 Result: R unchanged, MB $100 Effect on MB certain, on R uncertain The effect of an open market purchase on R depends on whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency. The effect of an open market purchase on MB, however, is always the same whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency.

  8. Open Market Sale of Bonds MB = C + R Open Market Sale to a Bank The Banking System The Bank of Canada Assets Liabilities Assets Liabilities Securities + $100 Securities - $100 Reserves - $100 Reserves - $100 Open Market Sale to the Public Public The Bank of Canada Assets Liabilities Assets Liabilities Securities + $100 Securities - $100 Reserves - $100 Deposits - $100 Banking System Assets Liabilities Reserves Chequable Deposits - $100 - $100 Result:R $100, MB $100

  9. Open Market Purchase in the Foreign Exchange (FX) Market MB = C + R Open Market Purchase of foreign exchange from a bank The Banking System The Bank of Canada Assets Liabilities Assets Liabilities FX – $100 FX + $100 Reserves + $100 Reserves + $100 Open Market Purchase of foreign exchange from the Public Public The Bank of Canada Assets Liabilities Assets Liabilities FX – $100 FX + $100 Reserves + $100 Deposits + $100 Banking System Assets Liabilities Reserves Chequable Deposits + $100 + $100 Result:R $100, MB $100

  10. If Person Cashes Cheque Public The Bank of Canada Assets Liabilities Assets Liabilities FX – $100 FX + $100 Currency + $100 Currency + $100 Result: R unchanged, MB $100 Effect on MB certain, on R uncertain Again, the effect of an open market purchase on R depends on whether the seller of FX keeps the proceeds from the sale in deposits or in currency. The effect of an open market purchase of FX on MB, however, is always the same whether the seller of the FX keeps the proceeds from the sale in deposits or in currency.

  11. Open Market Sale in the FX Market MB = C + R Open Market Sale of FX to a bank The Banking System The Bank of Canada Assets Liabilities Assets Liabilities FX + $100 FX - $100 Reserves - $100 Reserves -$100 Open Market Sale of FX to the Public Public The Bank of Canada Assets Liabilities Assets Liabilities FX + $100 FX - $100 Reserves - $100 Deposits - $100 Banking System Assets Liabilities Reserves Chequable Deposits - $100 - $100 Result:R $100, MB $100

  12. Shifts from Deposits into Currency Even if the Bank of Canada does not conduct open market operations, a shift from deposits into currency will affect R. However, such a shift will have no effect on MB. Shifts From Deposits into Currency: Public The Bank of Canada Assets Liabilities Assets Liabilities Deposits – $100 Currency + $100 Currency + $100 Reserves – $100 Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R $100, MB unchanged

  13. Advances Banking System The Bank of Canada Assets Liabilities Assets Liabilities Reserves Advances Advances Reserves + $100 + $100 + $100 + $100 Result:R $100, MB $100 Conclusion: Bank of Canada has better ability to control MB than R

  14. Deposit Creation: Single Bank Consider a $100 open market purchase from First Bank First Bank Assets Liabilities Securities – $100 Reserves + $100 First Bank Assets Liabilities Securities – $100 Deposits + $100 Reserves + $100 Loans + $100

  15. Deposit Creation: Single Bank (continued) A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan. The final T-account of the First Bank is: First Bank Assets Liabilities Securities – $100 Loans + $100

  16. Deposit Creation: Banking System (rD = 10%) Bank A Assets Liabilities Reserves + $100 Deposits + $100 Bank A Assets Liabilities Reserves + $10 Deposits + $100 Loans + $90 Bank B Assets Liabilities Reserves + $90 Deposits + $90 Bank B Assets Liabilities Reserves + $ 9 Deposits + $90 Loans + $81

  17. Deposit Creation

  18. Banking System As a Whole Banking System Assets Liabilities Securities – $100 Deposits + $1000 Reserves + $100 Loans + $1000

  19. Same Result When Banks Invest Their ER in Securities If the banks choose to invest their ER in securities, the result is the same. If Bank A buys securities with $90 cheque, Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same. Hence, whether a bank chooses to use its ER to make loans or to buy securities, the effect on deposit expansion is the same.

  20. Simple Deposit Multiplier Simple Deposit Multiplier 1 D = R rD Deriving the formula R = DR = rDD 1 D = R rD 1 D = R rD

  21. Multiple Deposit Contraction The multiple deposit creation process should also work in reverse. When the Bank of Canada withdraws reserves from the banking system, there should be a multiple contraction of deposits. In fact, the contraction in deposits will be D = (1/ rD ) R For example, if R = -100 and (1/ rD ) = 10%, then D = -1000.

  22. $100 Open Market Sale to First Bank Consider a $100 open market sale to First Bank First Bank Assets Liabilities Securities + $100 Reserves - $100 The First Bank has lost $100 of R, and because it has not been holding any ER, it has a reserve deficiency. It can obtain the needed reserves by selling $100 of securities or by demanding repayment of $100 of loans. At the end the banking system’s D and L will decline by $1000, as shown in the next slide.

  23. Multiple Deposit Contraction: The Banking System Banking System Assets Liabilities Securities + $100 Deposits - $1000 Reserves - $100 Loans - $1000

  24. Critique of the Simple Model Our simple model seems to indicate that the Bank of Canada has complete control over D. It ignores, however, the fact that deposit creation stops if: 1. Proceeds from loan are kept in cash (in this case nothing is deposited in Bank B, and the deposit creation process stops). In this case D = 100, not 1000 we calculated earlier. 2. Banks hold more reserves. If Bank A decides to hold on to all $90 of ER, no deposits would be made to Bank B, and this would also stop the deposit creation process. Again, in this case D = 100, not 1000 we calculated earlier.

  25. Conclusion The Bank of Canada is not the only player whose behaviour influences D and M. D and M depend on: • the public’s decisions regarding how much C to hold • the banks’ decisions regarding the amount of R they wish to hold, and • borrowers’ decisions on how much to borrow from banks.

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