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Economics

Economics. Chapter 4 Bank Credit and Monetary Policy. Banks. Central bank Special functions in the economy Commercial banks Profit making financial institutes. Deposit. Loan. A. B. Deposit withdrawal + Interest. Loan payment + Interest payment. Money Supply.

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Economics

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  1. Economics Chapter 4 Bank Credit and Monetary Policy

  2. Banks • Central bank • Special functions in the economy • Commercial banks • Profit making financial institutes Deposit Loan A B Deposit withdrawal+ Interest Loan payment + Interest payment

  3. Money Supply • M1 = Cash held by the public + Demand deposits in LBs • M2 = M1 + Savings and time deposits in LBs + NCD issued by LBs which held by the public • M3 = M2 + Deposits & NCD in RBs & DTCs

  4. Money Supply • MS = M1 = $1,000 • (M1 = Cash = $1,000) • MS= M2 = $1,000 • (M1 = Cash = $0) • (M2 = M1 + Deposit in LB from Mr. A= $1,000) • MS= M2 = $1,000 • Cash = $0 • Mr. A’s deposit = $1,000 • MS = M2 = $2,000 • Cash = $1,000 • Mr. A’s deposit = $1,000 • MS = M2 = $2,000 • Cash = $0 • Mr. A & B’s deposit = $2,000 • Mr. A has $1,000 cash • Mr. A saves his $1,000 cash into saving deposit • The bank agrees to lend $1,000 to Mr. B (agreement made) • Mr. B cash out his loan $1,000 from the bank • Mr. B saves his $1,000 into the bank

  5. Deposit creation • Through making saving and lending process • Bank gains from difference in interest • Loan  will lead to • Deposit  • Money supply  (from $1,000 to $2,000 in above case) • The process is know as • Deposit creation or • Credit creation

  6. The reserve system of banks • In order to protect depositors, banks • Cannot lend out all the deposits • Keep enough cash in case of withdrawal • Cash held by bank = Reserve (儲備) • Reserve ratio = Reserve-to-deposit Reserve ratio = x 100%

  7. Calculation of reserve ratio • Bank’s balance sheet • Cash: Assets held by the bank • Deposits: Liabilities that the bank owes the depositors • Case 1 • With cash reserves equals total deposits • Reserve ratio = ($1000/$1000) x 100% = 100%

  8. Calculation of reserve ratio • Case 2 • The bank loan out $500 • Cash reserves = $1,000-$500 = $500 • Reserve ratio = ($500/$1000) x 100% = 50%

  9. Calculation of reserve ratio • Case 3 • The bank loan out $1,000 • Cash reserves = $1,000-$1,000 = $0 • Reserve ratio = ($0/$1000) x 100% = 0%

  10. Calculation of reserve ratio Try this: • Given the deposit = $5,000 • The bank loan out $3,000 • Cash reserves = $5,000-$3,000 = $2,000 • Reserve ratio = ($2,000/$5,000) x 100% = 40%

  11. The minimum reserve requirement • The Gov’t sets a lowest limit to the reserve ratio • To protect public interests • Maintain stability of the financial system • Required reserve ratio (RRR) or Minimum reserve ratio • In US, RRR=10%, • i.e. for every $100 saving • the bank must keep $10 for cash reserve • and the bank can loan out $90 for profit marking

  12. The fractional reserve system • Fractional reserve system • Banks are required to hold only a portion of their deposits as reserves. • No need to hold all the deposits as reserve. • Can be loaned out for making profit.

  13. The fractional reserve system and RRR

  14. Excess reserve • Additional reserve apart from the required or • Reserve hold by banks which is in excess of the required reserve. • Excess reserve = Actual reserve – Required reserve • Example • Given RRR = 20% and deposit = $1,000 Required reserve = $1,000 x 20% = $200 If the bank hold reserve = $500 Excess reserve = $500 - $200 = $300 • This $300 excess reserve is not required to hold by the gov’t • The bank decides to hold more in case of risk of cash withdrawal • However, maximum loan drops from $800 to $500

  15. Excess reserve • Pros • More protection to depositor • If bad debt, the bank cannot get back the loan • More confidence • Low reserve ratio  If any rumours, easy to have bank run • Cons • Cash reserve makes no interest • Unable to earn from making loans • Less ability to earn • Unfavourable to attract investors • Whether holding excess reserve or not? Risk vs. Return

  16. Money supply with 100% reserve ratio • In an economy without bank • MS = Cash only • If gov’t issues $1,000 cash, MS = $1,000 • Having a bank with 100% reserve • $1,000 cash can be saved as deposits • MS = $1,000 • No loans can be made  No additional deposit • MS remains unchanged Deposit $0 Cash $1,000 Money Supply $1,000 Deposit $1,000 Cash $0 Money Supply $1,000

  17. Money supply with 100% reserve ratio • Conclusion With 100% reserve ratio • Deposit is kept totally as cash reserve in bank • Bank has no further money to make loan • No loan  No additional deposit • MS remains unchanged • With 100%-reserve banking, • the existence of banks does not affect the money supply. • It only changes its composition. • In other words • with reserve ratio < 100% • MS

  18. A model of deposit creation under a fractional reserve system • Assumptions ** • Minimum reserve ratio < 100% • No excess cash reserve, • bank loan out all the reserves in excess of the legal requirement • Sufficient demand of loan • the public is willing to borrow money from the bank • Public doesn’t hold cash • people deposit their loan into the bank • No cash drain or leakage

  19. A model of deposit creation under a fractional reserve system Illustration • Given required reserve ratio = 20% • Assume Mr. A deposits $1,000 cash in a bank • Balance sheet of the bank after the initial deposit :

  20. A model of deposit creation under a fractional reserve system Illustration • 20% of deposit is reserved = $200 • 80% of deposit can be loan out = $800 • Balance sheet of the bank after the initial deposit (w/ loan): • Money supply = $1,000

  21. A model of deposit creation under a fractional reserve system Illustration • Suppose Mr. B apply $800 loan from the bank • Then he deposit the $800 into the bank • Balance sheet of the bank after the second deposit:

  22. A model of deposit creation under a fractional reserve system Illustration • 20% of deposit is reserved = $200 + $160 = $360 • 80% of deposit can be loan out = $800 + $640 = $1440 • Balance sheet of the bank after the second deposit (w/ loan): • Money supply = $1,800

  23. A model of deposit creation under a fractional reserve system Illustration • Suppose Mr. C apply $640 loan from the bank • Then he deposit the $640 into the bank • Balance sheet of the bank after the third deposit:

  24. A model of deposit creation under a fractional reserve system Illustration • 20% of deposit is reserved = $200 + $160 + $128 = $488 • 80% of deposit can be loan out = $800 + $640 + $512 = $1,952 • Balance sheet of the bank after the third deposit (w/ loan): • Money supply = $2,440

  25. A model of deposit creation under a fractional reserve system Illustration • Suppose Mr. D apply $512 loan from the bank • Then he deposit the $512 into the bank • Balance sheet of the bank after the fourth deposit: • Money supply = $2,952

  26. A model of deposit creation under a fractional reserve system

  27. A model of deposit creation under a fractional reserve system Total deposits:

  28. A model of deposit creation under a fractional reserve system Total deposits = $1,000 + $1,000(0.8) + $1,000(0.82) + $1,000(0.83) +… By geometric progression = $1,000 x = $1,000 x  [ i.e. Initial deposit x ] = $5,000

  29. A model of deposit creation under a fractional reserve system Given that reserve ratio = 20% • meaning that 80% of deposits can be loaned out Total loans = Total deposits – required reserve = $5,000 - $5,000 x 20% = $5,000 x (1 – 20%) = $5,000 x 80% = $4,000

  30. A model of deposit creation under a fractional reserve system Illustration • After many deposits and loans • The final status of the bank’s balance sheet: • Money supply increase from $1,000 to $5,000 • i.e. MS = $4,000

  31. Deposit creation and the banking multiplier Given reserve ratio = 20% Reserves = Deposits x Reserve ratio Deposits = Reserves x = Reserves x Banking multiplier = Initial deposit x Banking multiplier • Money supply increase from $1,000 to $5,000 • i.e. MS = $4,000 $5,000 x 20% $1,000 $1,000 x $5,000 $1,000 x 5

  32. Deposit creation and the bank multiplier The banking multiplier Banking multiplier = Minimum reserve ratio (RRR) is the lowest reserve ratio Max banking multiplier = = • Money supply increase from $1,000 to $5,000 • i.e. MS = $4,000

  33. Deposit-creation ability and the banking multiplier Deposits = Reserve x Max. Deposits = Reserve Example 1: Given the RRR is 20%. If a person saves $1,000 into the bank and the bank keeps the required reserves and loans out the remaining part, what is the maximum increase in deposits? Solution: Max. Deposits = Reserve x = $1,000 x = $5,000 • Money supply increase from $1,000 to $5,000 • i.e. MS = $4,000

  34. Example 2 Below shows the balance sheet of a bank • Suppose there is no excess reserves, calculate • the required reserve ratio and • The maximum banking multiplier. • Suppose $500 cash is deposited into the bank, calculate the change in deposit.

  35. Example 2 Below shows the balance sheet of a bank. • Suppose there is no excess reserves, calculate • The required reserve ratio = x 100% = 20% • The maximum banking multiplier = = 5 • Suppose $500 cash is deposited into the bank, calculate the change in deposit. The change in deposit = Reserve = $500 x = $2500

  36. Example 3 Below shows the balance sheet of a banking system. Suppose the required reserve ratio is 20% and the public do not hold cash. Determine whether the following statements are true or false. • The bank reserve ratio is 20%. • The maximum amount of deposits is $12,500. • The bank hold excess reserves of $100 • The bank can increase its loans by at most $1,000.

  37. Example 3 • The bank reserve ratio = x 100% = 28% (The bank reserve ratio is 20%” is false.) • The maximum amount of deposits = Reserve = $700 x = $3500 ( The maximum amount of deposits is $12,500” is false) • Excess reserves held by the banks = Actual reserve - Required reserve = $700 – ($2,500 x 20%) = $700 - $500 = $200 ( “The bank hold excess reserves of $100” is false.)

  38. Example 3 • Since excess reserve = $200 The banks can loan out the excess reserve. The max. increase in loan = Additional loan x banking multiplier = $200 x = $1000 (‘ The bank can increase its loans by at most $1,000’ is correct.)

  39. Example 4 Fill in the balance sheet below to show the final situation if $1,000 cash in deposited into the banking system with required reserve ratio 25% without excess reserve. Think about: • What is the banking multiplier? = 4 • The initial $1,000 deposit dollars is kept and used to support the final deposit. Then what is the meaning of this $1,000 in the balance sheet? Reserves • How much is the max deposit can be supported by this $1,000 in the banking system? $1,000 x 4 = $4,000

  40. Deposit-creation and money supply MS= Cash held by the public (C) + Deposit (D)  MS= C + D Given RRR = 20% If the public save $1,000 cash into the bank • Currency in circulation:  $1,000 [i.e. C = - $1,000] • Deposits: $5,000 [i.e. D = $1,000 x = $5,000] • MS= C + D = -$1,000 + $5,000 = $4,000

  41. HKCEE 2009/Paper 1/Q.6 Study the following balance sheet of a banking system. Suppose the legal reserve ratio is 20%. • Calculate the excess reserve of the banking system. (2 marks) Excess reserve = $300 – ($1000 x 20%) = $100 • Suppose all excess reserve is loaned out. Calculate the maximum possible amount of total deposits in the banking system. (2 marks) Max. deposits = $300 x = $1500 • Hence, calculate the change in money supply. (2 marks) Change in money supply = Change in cash (held by the public)+ Change in deposit = $0 + ($1500 - $1000) = $500

  42. Monetary base ( 貨幣基礎 / 銀根 ) MS= Cash held by the public + Total Deposit MS= Cash held by the public+ Initial deposits x Monetary base Total Deposit = Initial deposit x Banking multiplier = Reserves x Banking multiplier = Reserves x

  43. Example Given RRR = 20%, Cash held by the public = $500 and Initial deposit = $1000. Find i. Monetary base & ii. Money supply Solution: i. Monetary base = Cash held by the public + Initial deposits = $500 + $1000 = $1500 ii. Money supply = Cash held by the public + Deposits = Cash held by the public + Reserves x = $500 + $1000 x 1/0.2 = $5,500

  44. HKDSE Practice Paper 2/Q.14 The following table shows the balance sheet of the banking system of an economy: Suppose the public in this economy always holds $500 million cash and the banking system never holds excess reserves. • Calculate the monetary base and money supply of the economy. (2 marks) • Suppose the central bank lowers the minimum reserve ratio of the banking system by 5%. • Explain whether the monetary base of the economy changes. (2 marks) • Calculate the new money supply. Show your working. (4 marks)

  45. HKDSE Practice Paper 2/Q.14 The following table shows the balance sheet of the banking system of an economy: • Monetary base = $1 000 million + $500 million = $1 500 million (1)Money supply = $4 000 million + $500 million = $4 500 million (1) • (i) No, because (1) the policy affects neither the amount of reserves nor the cash held by the general public. (1) (ii) Before the policy change, the minimum reserve ratio = $4 000million / $1 000million = 0.25 (1) The new minimum reserve ratio = 0.25 – 0.05 = 0.2 (1) The banks will lend out the excess reserves. New deposits = $1 000 million x = $5 000 million (1) New money supply = $500 million + $5 000 million = $5 500 million (1)

  46. No. of banks and the form of loans do not affect deposit creation • In reality, many banks • Do not affect deposit creation • Loan from Bank A  Deposit to Bank B • Loan from Bank B  Deposit to Bank C • … • For details, read p.110 Deposit as a whole is not affected

  47. Realistic assumption • Assumptions of maximum deposit creation • Banks adopts fractional reserve system • No excess reserves held by banks • Sufficient demand of loans • No cash drain / leakage • In real world: • Only assumption 1 is true. •  Assumption 2. Reason: for risk management •  Assumption 3. Reason: interest rate   loans  •  Assumption 4. Reason: the public need cash

  48. Violations of assumption • Violation of assumption 2: Excess reserve • Banks usually hold excess reserve to reduce risk •  Actual reserve ratio   Banking multiplier  • Violation of assumption 3: Insufficient demand of loan • High reserves  Less amount for loan  Banks’ profit  interest rate   Demand of loan  • Violation of assumption 4: Cash leakage • The public holds cash •  less loan get back to the banks as deposit •  Deposit  •  Loan •  Deposit creation can’t be maximized

  49. Conclusion:Model of deposit creation Necessary condition for deposit creation Necessary conditions for maximizing deposit

  50. Reserve shortage • What happen if Mr. A withdraws $100 from the bank? • Total deposit = $5,000 - $100 = $4,900

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