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Chapter 14                                   Banks & The creation of Bank Deposits                                        ...
Money Creation                                                              RecallBanks create demand deposits whenever   ...
Illustration Continued                                           Illustration Continued     Bank B received demand deposit...
Bank Q Reacts and Starts a     Multiple Contraction of Deposits                                                           ...
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the deposit expansion process: the simple analytics

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the deposit expansion process: the simple analytics

  1. 1. Chapter 14 Banks & The creation of Bank Deposits Banking System The Deposit Expansion Process: The Simple Macroeconomic Variables Analytics Credit availability 1. Output 2. Employment & The Money Supply 3. Price Level ©Thomson/South-Western 2006 1 2 Banks And The Creation Of Bank 1. Writing a Check DepositsT-accounts A $10,000 check drawn on her account at Hometown Bank is A T-account indicates the change in the balance sheet of sent to a shoe manufacturer in St. Louis. the depository institution resulting from a given event. When the check is deposited in a St. Louis bank and clears, Demand deposits in the St. Louis bank have increased by $10,000. Suppose your hometown bank lends $10,000 to a local Demand deposits in the Hometown Bank have decreased by $10,000. shoe-store owner for the purpose of increasing her The main point: Whenever banks increase their loans-- inventories. whether in the form of currency or in the form of a demand deposit entry on the banks books--the nation’s money supplyHometown bank has created $10,000 in new money: increases by the amount of the loan. 3 4 1. Writing a Check 2. A Bank Buys SecuritiesThe main point: Whenever banks increase Hometown Bank purchases $200,000 of U.S. government securities from a dealer located in New York City.their loans--whether in the form of currency or Hometown Bank sends a $200,000 check drawn on itsin the form of a demand deposit entry on the account with the Federal Reserve.banks books--the nation’s money supply After the security dealer deposits the check in a New York bank, the check is processed and cleared by the Federalincreases by the amount of the loan. Reserve System. When the dealer deposits the check in its New York bank, the nation’s money supply rises by $200,000. 5 6 1
  2. 2. Money Creation RecallBanks create demand deposits whenever The reserve requirement is a percentage figure set by the Federal Reserve, applicable to demand deposits in banks.banks Make Loans Required reserves are the dollar amount of reserves a bank must maintain or exceed. Purchase SecuritiesLoans and Securities are profitable (Earning Excess reserves are the difference between reserves andAssets) required reserves. If reserves exceed required reserves, banks have positive excess reserves.Are banks limited in the amount they canmake loans / buy securities? Once a bank has no excess reserves, it cannot afford to lose any reserves.Yes, banks have to maintain “Reserves” 7 8 Multiple Expansion of Bank Banks & The Creation of Bank Deposits Deposits Reserves Reserves ReservesRequired Federal reserve banking system requires that banksReserves maintain only a small portion of their demand deposit liabilities in the form of reserves (cash and Securities Securities deposits in the banking system). Securities New reserves can support deposits that are a multiple of the amount of these new reserves. Loans Loans Loans Banking system can generate new loans and investment in securities by a multiple of the excess reserves in the system. 9 10 Illustration of the Deposit Illustration Continued Multiplier Assume: Each bank in the nation desires to rid itself of all its excessSuppose a bank initially has no excess reserves. reserves. The reserve requirement for all banks is 10 percent. Then:Suppose explorers discover a sunken ship off the Bank A has excess reserves of $4.5 million. Bank A loans it all to real estate developers who buy land fromcoast of Florida that contains $5 million in coins. If customers of Bank B.the coins are placed in a Florida bank (Bank A): 11 12 2
  3. 3. Illustration Continued Illustration Continued Bank B received demand deposits and reserves of 4.5 million Suppose Bank B buys U.S. government securities from a Bank B has required reserves = 10% of 4.5 million deposits = New York securities dealer. 0.45 million Excess reserves = reserve – required reserve = 4.5 – 0.45 = Bank C can now grant loans and/or purchase securities in the 4.05 million amount of its excess reserves, $3.645 million. Bank B can use this reserves to make loans, buy securities. ….and so on 13 14 Table 14-1 Maximum Expansion of Deposits Induced Expansion of Deposits in the Banking System 1 Initial Excess reserves x percentage reserve requirement 15 16 Your turn (p.332) Banking system and Money SupplyQ: Suppose the reserve requirement is 20%, you find Money Supply increases when $1million of currency in your grandmother’s attic and deposit into her bank checking account. Bank makes loans Calculate: Bank purchases securities1. The change in reserves in her bank2. The change in required reserves in her bank3. The change in excess reserves in her bank Money Supply decreases when4. The maximum amount by which her bank can expand its Bank calls back loans loans Bank sells securities5. The maximum amount the entire banking system can expand its loans6. The potential expansion in the nation’s deposits7. The potential exansion in M1 17 18 3
  4. 4. Bank Q Reacts and Starts a Multiple Contraction of Deposits Stampede A withdrawal of reserves from the banking system Bank Q can alleviate its reserve deficiency by selling precipitates a multiple contraction of deposits. $6.3 million in securities, by demanding repayment of Suppose customers of Bank Q obtain $7 million in currency $6.3 million worth of loans, or by some combination by drawing down their bank demand deposits. of those two actions. Bank Qs required reserves decline by $0.7 million, Actual reserves fall by the full $7 million. Bank Q’s reserves are deficient by $6.3 million. Bank Q simply shifts its reserve deficiency to another Bank Q initially exhibit excess reserves of negative $6.3 bank, Bank R. million. Bank R becomes deficient in reserves and must liquidate loans or securities, thereby shifting the hot potato to another bank, Bank S. 19 And so on. 20 How The Federal Reserve Gets A The Result and Conclusion Grip On The Money Supply With its unlimited authority to purchase or sell government securities in the open The banking system cannot control its own reserves. market, the Fed can easily swamp any influence of outside forces and thereby control the supply of reserves in the banking system. The public influences reserves by depositing or When the Fed purchases securities (say $900m) in the open market: withdrawing currency from banks. The Federal Reserve System influences reserves by buying and selling securities in the open market and by lending to banks. When the Fed sells securities to individuals, firms, or banks, aggregate reserves are withdrawn from the banking system. Multiple expansion of deposits results when Fed injects excess reserves into banking system. Multiple contraction of deposits result when Fed withdraw reserves from banking system. 21 22 Study QuestionSuppose the reserve requirement is 10%. The Fed buys $1,000 million worth of securities from the dealer.1. What is the initial (direct) change in the reserves (money supply)?2. What is the ultimate effect on the money supply? 23 4

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