Chapter 18. Bank Reserves and the Money Supply. Learning Objectives. Introduction

Chapter 18 Bank Reserves and the Money Supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Understand the mec...
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Chapter 18 Bank Reserves and the Money Supply

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Learning Objectives • Understand the mechanics of check clearing and its impact on the balance sheets of commercial banks and the Federal Reserve • Explain how banks create deposits by making loans • Define the role of the banking system in deposit creation and destruction

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Introduction • Examine the relationship between bank reserves and the money supply • Money supply (M1) is composed mostly of demand deposits in commercial banks and other financial institutions • Bank reserves play a crucial role in creating demand deposits • By regulating bank reserves, Federal reserve gets leverage to control amount of demand deposits and thereby nation’s money supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Check Clearing and Collection • Focus on the relationship between reserves and demand deposits • Demand deposit is an asset for the depositor, but a liability of a bank because it is obligated to pay it on demand • Federal Reserve has little direct contact with the public, mainly deal with the government and financial institutions Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Check Clearing and Collection (Cont.) • Federal Reserve is primary collection vehicle for checks • Check clearing is accomplished by adding or subtracting reserves held on deposit by the bank at its regional Federal Reserve bank

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Check Clearing and Collection (Cont.) • Sequence of events when a check, drawn on the other bank (B), is deposited in our bank (A) – Demand deposits in Bank A increase with a corresponding increase in assets (check in process of collection) – When the check clears through the Fed check clearing system, the Fed increases Bank A’s “deposits in Fed” by the amount of the check – There is a corresponding decrease in the deposits of Bank B which is made by the Fed

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Check Clearing and Collection (Cont.) • Sequence of events (Cont.) – Demand deposits in Bank B decrease when the check clears – Therefore, the Federal Reserve neither gains or loses deposits, only transfers ownership from one bank to another – Summary • When a bank receives a check drawn on another bank, it gains reserves equal to the amount of the check • The bank on which the check was drawn loses reserves of the same amount

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Check Clearing and Collection (Cont.) • The above sequence of events occur whether the banks are members of the Federal Reserve system or not • If the banks are in different Federal Reserve regions, the two regional banks have a clearing account which permits the transfer of reserves between regions

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Check Clearing and Collection (Cont.) • The balance sheet of Bank A (as shown in the text) reflects the following changes: – Demand deposits have increased by $2,000,000 – Deposits in Fed (reserves) have increased by $2,000,000 – Bank A’s total reserves now equal $3,000,000 ($100,000 cash, plus $2,900,000 deposit in Fed) – Since the bank is required to hold 10% of demand deposits as required reserves, Bank A’s excess reserves now total $2,800,000 ($3,000,000 - $200,000)

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Deposit Expansion: The Single Bank • How much a bank safely can loan depends on: – Amount of excess reserves – What happens when a loan is made

• When a bank lends, the borrower receives a checking account (demand deposit) – Both sides of balance rise, increase in “demand deposits” (liability) and increase in “loans” (asset) – Since demand deposits are part of the money supply, when banks create demand deposits through lending, there is an increase in the money supply

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Deposit Expansion: The Single Bank (Cont.) • A bank can safely lend up to the amount of its excess reserves – When proceeds of the loan are withdrawn and the reserves are reduced by the amount of the check, all the excess reserves will be used up. – If the bank tries to lend more, there will be insufficient reserves as soon as the borrower withdraws the proceeds from the loan.

• If the bank purchases government securities equal to the amount of excess reserves, it loses excess reserves when its check clears Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Deposit Expansion: The Single Bank (Cont.) • Conclusion of the section – A single bank can safely lend (or purchase securities) up to an amount equal to its excess reserves – An individual bank can create money (demand deposits) only if it has excess reserves. – As soon as it creates this money, it loses it to another bank when the money is spent

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Deposit Expansion: The Banking System • Although the initial bank lost its excess reserves, another bank gained these excess reserves which permits them to expand their lending and increase the money supply • However, ability of the next bank to extend loans is reduced by 10% since some of gain in reserves must be held on deposit with Fed • Process will continue with each successive bank being able to lend only 90% of gained excess reserves and 10% placed on deposit with Fed Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Deposit Expansion: The Banking System (Cont.) • Banking system creating money – The banking system will have demand deposits that are a multiple of the initial injection of excess reserves into the system. – The Fed will have additional required reserves on deposit equal to the initial injection of excess reserves into the system – The final state is reached not by shrinking reserves, as in the case of a single bank, but by expanding deposits

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Deposit Expansion: The Banking System (Cont.) • Banking system creating money (Cont.) – When one bank loses reserves, another bank gains the excess and lends out 90% – As banks lend more and more, demand deposit liabilities grow, thereby reducing excess reserves – Whereas a single bank can lend the amount of excess reserves, banking system can create demand deposits up to a multiple of original change in reserves – The process of deposit expansion can continue until all excess reserves become require reserves because of growth of demand deposits Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Deposit Expansion: The Banking System (Cont.) • The demand deposit expansion simple multiplier is always the reciprocal of the reserve requirement ratio Δ Demand Deposits = Δ Excess Re serves x

Where:

1 Re serve Ratio

1 Re serve Ratio

is the simple multiplier

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Deposit Contraction • If a bank starts with deficient reserves, potential change in demand deposits is negative rather than positive • Money is destroyed as bank loans are repaid or securities sold • The potential multiple contraction in demand deposits (money supply) follows the same principles as expansion of demand deposits Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Deposit Contraction (Cont.) • Downward multiple change in demand deposits could conceivably take place in one single bank, but more likely would be a result of action by entire banking system trying to acquire reserves to make up for the deficiency

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Deposit Contraction (Cont.) • Very important asymmetry in the creation or contraction of reserves/money supply – When banks have deficient reserves, they must reduce their demand deposits which reduces the money supply – When banks have excess reserves, they may lend more and increase the money supply. – Usually assume banks will want to lend out all their excess reserves and expand demand deposits to the maximum because they earn interest on the loans.

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Appendix THE COMPLETE MONEY SUPPLY PROCESS

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Appendix—The Complete Money Supply Process • Actual change in demand deposits will reach the maximum amount indicated by the simple multiplier if banks lend all excess reserves. • Any leakages of cash out of the multiple expansion cycle will result in a smaller expansion of the money supply • Federal Reserve can control additional excess reserves but leakages are outside their control and may adversely affect their attempt to expand the money supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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Appendix—The Complete Money Supply Process (Cont.) • Shifts between Currency and Checking Deposits – Monetary base (B)—total reserves held by banks plus currency held by nonbanking public – When the Federal Reserve injects reserves, it is really adding to the monetary base – Public may elect to hold some of the excess reserves as cash instead of demand deposits – Figure 18A.1 shows this ratio varies over time – Draining of currency into the hands of the public depletes bank’s excess reserves

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FIGURE 18A.1 The currency ratio (c/dd) has varied considerably over time.

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Appendix—The Complete Money Supply Process (Cont.) • Shifts between Currency and Checking Deposits (Cont.) – Although cash held by the nonbanking public becomes part of the money supply, it reduces the banking system’s ability to expand demand deposits – Due to the uncertainty of the public’s reaction to additional reserves and desire to hold cash, the Fed has more control over the monetary base than total reserves

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Appendix—The Complete Money Supply Process (Cont.) • Shifts between time deposits and checking accounts – The public may desire to hold time deposits rather than demand deposits – Since the required reserves for time deposits is smaller than for demand deposits, placing of funds in time deposits will increase the banking system’s ability to expand credit.

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Appendix—The Complete Money Supply Process (Cont.) • Shifts between time deposits and checking accounts (Cont.) – However, since time deposits are not part of M1, movement of funds into time deposits will reduce the expansion of the money supply (M1) – This suggests that the reserve multiplier consequences for broader money supply definitions are more complicated than for M1

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Appendix—The Complete Money Supply Process (Cont.) • The role of interest rates – Banks not being able or willing to lend all their excess reserves – These funds may remain idle in the bank – Since banks will be more inclined to lend or purchase securities at higher interest rates, this raises the possibility that the money supply (multiplier) is a function of interest rate levels – Figure 18A.2—excess reserves as a percentage of demand deposits tends to be high when interest rates are low

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FIGURE 18A.2 Excess reserves as a percent of checking deposits tend to be high when the level of the three-month Treasury bill is low, and vice versa.

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Appendix—The Complete Money Supply Process (Cont.) • Implication of the three complications – The Federal Reserve’s ability to control the money supply is not precise – It must deal with leakages of money from the demand deposit expansion cycle, factors that are generally determined by public preferences

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