Lecture 26: Multiple deposit creation

1. Lecture 26: Multiple deposit creation Mishkin Ch 13 – part B page 341-349

2. Review • Monetary base (MB) = currency in circulation (C) + reserves (R) • Open market operations • Open market purchase  increase MB • Open market sale  decrease MB • Discount loans • Fed has more control over MB than over reserves

3. Introduction • money supply = monetary base * money multiplier. How can high-powered money be multiplied? • How deposits are created? A simple model of multiple deposit creation. • When the Fed supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount, this is called multiple deposit creation.

4. Deposit creation: single bank • First national bank gained $100 additional reserves from selling bonds to the Fed. • make $100 loans to a borrower who deposit this $100 in checking account. • The bank creates deposits by lending: money supply.

5. Deposit creation: single bank – cont’d • The borrower may use the $100 to purchase goods and services. • When the borrower uses $100 by writing checks, the $100 reserves leaves First National bank.

6. Summary of single bank case

7. Deposit creation: the banking system • Suppose the $100 of deposit created by First national bank’s loan is deposited at bank A which keeps no excess reserves. • If the required reserve ratio is 10%, Bank A can make $90 loan.

8. Deposit creation: the banking system – cont’d • If the borrower deposit the $90 to another bank B, then checkable deposits in the banking system increase by another $90. • But bank B can again make new loans of $81. • Bank C …

10. Summary of multiple banks case • If all banks make loans for the full amount of their excess reserves, initial $100 increase in reserves will result in $1000 in deposit. • The increase is tenfold, the reciprocal of 10%, the reserve requirement. • If banks use excess reserves to purchase securities, the effect is the same as making loans.

11. Formula for multiple deposit creation

12. A comparison • When we have only one bank, it can create deposits equal only to the amount of its excess reserves. • However, in a system of multiple banks, there is a multiple expansion of deposits, because when a bank loses its excess reserves, these reserve do not leave the banking system but are used to make additional loans and create additional deposits.

13. Why this is useful? • If the Fed can set the level of reserves (R) and the required reserve ratio (r), then can Fed control the level of checkable deposit (D)?

14. Critique of the simple model • Banks may not use all of their excess reserves to buy securities or make loans • Holding cash stops the process