Chapter 14

Multiple Deposit Creation and the Money Supply Process

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Meaning and Function of Money

Economist’s Meaning of Money1. Anything that is generally accepted in payment for goods and services2. Not the same as wealth or income

Functions of Money1. Medium of exchange2. Unit of account3. Store of value

Evolution of Payments System1. Precious metals like gold and silver2. Paper currency (fiat money)3. Checks4. Electronic means of payment5. Electronic money: Debit cards, Stored-value cards, Smart cards, E-cash

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Four Players in the Money Supply Process

1. Central bank: the Fed

2. Banks

3. Depositors

4. Borrowers from banks

Federal Reserve System

1. Conducts monetary policy

2. Clears checks

3. Regulates banks

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The Fed’s Balance Sheet

Federal Reserve System

Government securities

Discount loans

Currency in circulation

Reserves

Assets Liabilities

Monetary Base, MB = C + R

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Control of the Monetary Base

Open Market Purchase from Bank The Banking System The FedAssets Liabilities Assets Liabilities

Securities – $100 Securities + $100 Reserves + $100Reserves + $100Open Market Purchase from Public Public The FedAssets Liabilities Assets Liabilities

Securities – $100 Securities + $100 Reserves + $100Deposits + $100 Banking SystemAssets Liabilities

Reserves Checkable Deposits+ $100 + $100

Result: R $100, MB $100

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If Person Cashes Check

Public The FedAssets Liabilities Assets Liabilities

Securities – $100 Securities + $100 Currency + $100Currency + $100Result: R unchanged, MB $100Effect on MB certain, on R uncertain

Shifts From Deposits into Currency

Public The FedAssets Liabilities Assets Liabilities

Deposits – $100 Currency + $100Currency + $100 Reserves – $100

Banking SystemAssets Liabilities

Reserves – $100 Deposits – $100Result: R $100, MB unchanged

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Discount Loans

Banking System The Fed

Assets Liabilities Assets Liabilities

Reserves Discount Discount Reserves

+ $100 loan + $100 loan + $100 + $100

Result: R $100, MB $100

Conclusion: Fed has better ability to control MB than R

15-8

Deposit Creation: Single Bank

First National BankAssets Liabilities

Securities – $100Reserves + $100

First National BankAssets Liabilities

Securities – $100 Deposits + $100Reserves + $100Loans + $100

First National BankAssets Liabilities

Securities – $100 Deposits + $100Loans + $100

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Deposit Creation: Banking System

Bank A

Assets Liabilities

Reserves + $100 Deposits + $100

Bank A

Assets Liabilities

Reserves + $10 Deposits + $100Loans + $90

Bank B

Assets Liabilities

Reserves + $90 Deposits + $90

Bank B

Assets Liabilities

Reserves + $ 9 Deposits + $90Loans + $81

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Deposit Creation

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Deposit Creation

If Bank A buys securities with $90 check

Bank A

Assets Liabilities

Reserves + $10 Deposits + $100

Securities + $90

Seller deposits $90 at Bank B and process is same

Whether bank makes loans or buys securities, get same deposit expansion

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Deposit Multiplier

Simple Deposit Multiplier

1D = R

r

Deriving the formulaR = RR = r D

1D = R

r

1D = R

r

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Deposit Creation:Banking System as a Whole

Banking System

Assets Liabilities

Securities – $100 Deposits + $1000

Reserves + $100

Loans + $1000

Critique of Simple Model

Deposit creation stops if:

1. Proceeds from loan kept in cash

2. Bank holds excess reserves

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Money Multiplier

M = m MB

Deriving Money Multiplier

R = RR + ER

RR = r D

R = (r D) + ER

Adding C to both sides

R + C = MB = (r D) + ER + C

1. Tells us amount of MB needed support D, ER and C

2. $1 of MB in ER, not support D or C

MB = (r D) + (e D) + (c D)

= (r + e + c) D

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1D = MB

r + e + c

M = D + (c D ) = (1 + c) D

1 + cM = MB

r + e + c

1 + cm =

r + e + c

m < 1/r because no multiple expansion for currency and because as D ER

Full Model

M = m (MBn + DL)

15-16

Excess Reserves Ratio

Determinants of e1. i , relative Re on ER (opportunity cost ), e 2. Expected deposit outflows, ER insurance worth more, e

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Factors Determining Money Supply

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Deposits at Failed Banks: 1929–33

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e, c: 1929–33

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Money Supply and Monetary Base: 1929–33