The economics of money, banking, and financial institutions 2nd ch15

Chapter 15 Multiple Deposit Creation and the Money Supply Process © 2005 Pearson Education Canada Inc Four Players in the Money Supply Process Central bank: the Bank of Canada Banks Depositors Borrowers from banks Bank of Canada Conducts monetary policy Clears checks Regulates banks © 2005 Pearson Education 15-2 The Bank’s Balance Sheet Bank of Canada Assets Liabilities Government securities Currency in circulation Advances to banks Settlement balances Monetary Base, MB = C + R © 2005 Pearson Education 15-3 Control of the Monetary Base MB = C + R Open Market Purchase from bank The Banking System Assets Liabilities The Bank of Canada Assets Liabilities Securities – $100 Reserves + $100 Open Market Purchase from Public Public Assets Liabilities Securities + $100 Reserves + $100 The Bank of Canada Assets Liabilities Securities – $100 Deposits + $100 Banking System Assets Securities + $100 Reserves + $100 Liabilities Reserves + $100 Chequable Deposits + $100 Result: R ↑ $100, MB ↑ $100 © 2005 Pearson Education 15-4 If Person Cashes Cheque Public Assets Liabilities Securities – $100 Currency + $100 The Bank of Canada Assets Liabilities Securities + $100 Currency + $100 Result: R unchanged, MB ↑ $100 Effect on MB certain, on R uncertain The effect of an open market purchase on R depends on whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency The effect of an open market purchase on MB, however, is always the same whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency © 2005 Pearson Education 15-5 Open Market Sale of Bonds MB = C + R Open Market Sale to a bank The Banking System Assets Liabilities The Bank of Canada Assets Liabilities Securities + $100 Reserves - $100 Open Market Sale to the Public Public Assets Liabilities Securities - $100 Reserves - $100 The Bank of Canada Assets Liabilities Securities + $100 Deposits - $100 Banking System Assets Securities - $100 Reserves - $100 Liabilities Reserves - $100 Chequable Deposits - $100 Result: R ↓ $100, MB ↓ $100 © 2005 Pearson Education 15-6 Open Market Purchase in the Foreign Exchange (FX) Market MB = C + R Open Market Purchase of foreign exchange from a bank The Banking System The Bank of Canada Assets Liabilities Assets Liabilities FX – $100 FX + $100 Reserves + $100 Open Market Purchase of foreign exchange from the Public Public The Bank of Canada Assets Liabilities Assets Reserves + $100 FX – $100 Deposits + $100 Banking System Assets Reserves + $100 Liabilities Reserves + $100 Chequable Deposits + $100 FX + $100 Liabilities Result: R ↑ $100, MB ↑ $100 © 2005 Pearson Education 15-7 If Person Cashes Cheque Public Assets The Bank of Canada Liabilities Assets FX – $100 FX + $100 Currency + $100 Liabilities Currency + $100 Result: R unchanged, MB ↑ $100 Effect on MB certain, on R uncertain Again, the effect of an open market purchase on R depends on whether the seller of FX keeps the proceeds from the sale in deposits or in currency The effect of an open market purchase of FX on MB, however, is always the same whether the seller of the FX keeps the proceeds from the sale in deposits or in currency © 2005 Pearson Education 15-8 Open Market Sale in the FX Market MB = C + R Open Market Sale of FX to a bank The Banking System Assets Liabilities The Bank of Canada Assets Liabilities FX + $100 Reserves -$100 Open Market Sale of FX to the Public Public Assets Liabilities FX - $100 Reserves - $100 The Bank of Canada Assets Liabilities FX + $100 Deposits - $100 Banking System Assets FX - $100 Reserves - $100 Liabilities Reserves - $100 Chequable Deposits - $100 Result: R ↓ $100, MB ↓ $100 © 2005 Pearson Education 15-9 Shifts from Deposits into Currency Even if the Bank of Canada does not conduct open market operations, a shift from deposits into currency will affect R However, such a shift will have no effect on MB Shifts From Deposits into Currency: Public Assets Liabilities The Bank of Canada Assets Liabilities Deposits – $100 Currency + $100 $100 Currency + $100 Reserves – Banking System Assets Liabilities Reserves – $100 Deposits – $100 Result: R ↓ $100, MB unchanged © 2005 Pearson Education 15-10 Advances Banking System Assets Liabilities Reserves Advances + $100 + $100 The Bank of Canada Assets Liabilities Advances Reserves + $100 + $100 Result: R ↑ $100, MB ↑ $100 Conclusion: Bank of Canada has better ability to control MB than R © 2005 Pearson Education 15-11 Deposit Creation: Single Bank Consider a $100 open market purchase from First Bank First Bank Liabilities Assets Securities Reserves – $100 + $100 First Bank Liabilities Assets Securities Reserves Loans – $100 + $100 + $100 © 2005 Pearson Education Deposits + $100 15-12 … A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan The final T-account of the First Bank (after the reserves have been withdrawn) is: First Bank Assets Securities Loans Liabilities – $100 + $100 © 2005 Pearson Education 15-13 Deposit Creation: Banking System (r = 10%) Bank A Assets Reserves Liabilities + $100 Assets Reserves Loans Liabilities + $10 + $90 Deposits Bank A + $100 Deposits + $100 Bank B Assets Reserves Liabilities + $90 Assets Reserves Loans Liabilities +$9 + $81 Deposits Bank B + $90 Deposits + $90 © 2005 Pearson Education 15-14 Deposit Creation © 2005 Pearson Education 15-15 Banking System As a Whole Assets Securities Reserves Loans Banking System Liabilities – $100 Deposits + $100 + $1000 © 2005 Pearson Education + $1000 15-16 Same Result when Banks Invest their ER in Securities If the banks choose to invest their ER in securities, the result is the same If Bank A buys securities with $90 cheque Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same Hence, whether a bank chooses to use its ER to make loans or to buy securities, the effect on deposit expansion is the same © 2005 Pearson Education 15-17 Simple Deposit Multiplier Simple Deposit Multiplier ∆D = × ∆R r Deriving the formula R = RR = r × D D= ∆D = r r × R × ∆R © 2005 Pearson Education 15-18 Multiple Deposit Contraction The multiple deposit creation process should also work in reverse When the Bank of Canada withdraws reserves from the banking system , there should be a multiple contraction of deposits In fact, the contraction in deposits will be ∆ D = (1/ r ) × ∆ R Example: If ∆ R = -100 and (1/ r ) = 10 because r =.10, then ∆ D = -1000 © 2005 Pearson Education 15-19 Multiple Deposit Contraction: The Banking System Assets Securities Reserves Loans Banking System Liabilities + $100 Deposits - $100 - $1000 © 2005 Pearson Education - $1000 15-20 Critique of the Simple Model Our simple model seems to indicate that the Bank of Canada has complete control over D It ignores, however, the fact that deposit creation stops if: Proceeds from loan are kept in cash (in this case nothing is deposited in Bank B, and the deposit creation process stops) In this case ∆ D = 100, not 1000 we calculated earlier Banks hold more reserves If Bank A decides to hold on to all $90 of ER, no deposits would be made to Bank B, and this would also stop the deposit creation process Again, in this case ∆ D = 100, not 1000 we calculated earlier © 2005 Pearson Education 15-21 Conclusion The Bank of Canada is not the only player whose behavior influences D and M D and M depend on: the public’s decisions regarding how much C to hold the banks’ decisions regarding the amount of R they wish to hold, and borrowers’ decisions on how much to borrow from banks © 2005 Pearson Education 15-22 ... whether the seller of the bonds keeps the proceeds from the sale in deposits or in currency The effect of an open market purchase on MB, however, is always the same whether the seller of the. .. on whether the seller of FX keeps the proceeds from the sale in deposits or in currency The effect of an open market purchase of FX on MB, however, is always the same whether the seller of the. .. whose behavior influences D and M D and M depend on: the public’s decisions regarding how much C to hold the banks’ decisions regarding the amount of R they wish to hold, and borrowers’ decisions