Money and Banking: Lecture 34

Money and Banking: Lecture 34 provides students with content about: deposit creation in a single bank; deposit expansion in a system of banks; deposit expansion multiplier; deposit expansion with excess reserves and cash withdrawals;... Please refer to the lesson for details!

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Money and

Banking

Lecture 34

Review of the Previous Lecture

Balance Sheet

• Open Market Operation

• Foreign Exchange Intervention

• Discount Loans

• Cash Withdrawals

Deposit Creation in a Single Bank

bank, the bank has excess reserves,

which it will seek to lend

asset on the bank’s balance sheet

Central Bank’s

• Assuming First bank has granted a loan of

$100,000 to Office Builders Incorporated (OBI)

Central Bank’s

• OBI paid off its employees and suppliers

through checks worth $100,000

Central Bank’s

Deposit Expansion in a System of

Banks

spent and as the checks cleared, reserves were transferred to other banks

seek to lend their excess reserves, and

the process continues until all of the funds have ended up in required reserves

• Assume

• Bank hold no excess reserves.

• The reserve requirement ratio is 10%

• Currency holding does not change when

deposits and loans change.

• When a borrower writes a check, none of the

recipients of the funds deposit them back in the bank that initially made the loan.

• Lets say, OBI uses the $100,000 loan to

pay its supplier American Steel Co (ASC), which it deposits in its bank the Second

bank

Deposit Expansion Multiplier

• Assuming

• no excess reserves are held

• there are no changes in the amount of

currency held by the public,

• the change in deposits will be the inverse of

the required deposit reserve ratio (rD) times the change in required reserves, or

∆D = (1/rD) ∆RR

• A decrease in reserves will generate a deposit

contraction in a multiple amount too

D

r 1

• RD=10% (0.10), and ΔRR=$100,000

• ΔD=

• ΔD= $1,000,000

000,

100

$1.1

Deposit Expansion with Excess Reserves and Cash Withdrawals

was derived assuming no excess reserves are held and that there is no change in

currency holdings by the public

• 5% withdraw of cash.

• Excess reserves of 5% of deposits

• Continuing with our previous example, if

American Steel Co (ASC) removes 5% of its new funds in cash, which leaves

$95,000 in the checking account and

$95,000 in the Second bank’s reserve

account

5% of deposits, it would keep reserves of 15% of $95,000 or $14,250 and making a loan of $80,750

• The desire of banks to hold excess

reserves and the desire of account

holders to withdraw cash both reduce the impact of a given change in reserves on the total deposits in the system

to hold, and the more cash that is

withdrawn, the smaller the impact

Money Multiplier

of money (checking account plus currency) is related to the monetary base (reserves in the banking system plus currency held by the

nonbank public)

monetary base, the Quantity of Money, M is

M = m x MB

(This is why the MB is called High Powered Money)

• Consider the following relationships

Money = Currency + Checkable deposits

• The amount of excess reserves a bank holds

depends on the costs and benefits of holding them,

• the cost is the interest foregone

• the benefit is the safety from having the reserves in

case there is an increase in withdrawals

excess reserves will be; the greater the

concern over possible deposit withdrawals, the higher the excess reserves will be

Introducing Excess Reserve Ratio {ER/D}