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Money & Banking ­ MGT411
VU
Lesson 34
DEPOSIT CREATION IN A SINGLE BANK
If the central bank buys a security from a bank, the bank has excess reserves, which it will seek
to lend
The loan replaces the securities as an asset on the bank's balance sheet
Table: Change in First Bank's Balance Sheet following Central Bank's purchase of a Treasury
bond
Assets
Liabilities
Reserves
+$100,000
Securities
-$100,000
Assuming First bank has granted a loan of $100,000 to Office Builders Incorporated (OBI)
Table: Change in First Bank's Balance sheet following Central Bank's purchase of a Treasury
bond and Extension of a loan
Assets
Liabilities
Reserves
+$100,000
OBI Checking account
+$100,000
Securities
-$100,000
Loans
+$100,000
OBI paid off its employees and suppliers through checks worth $100,000
Table: Change in First Bank's balance sheet following Central Bank's purchase of a Treasury
Bond, Extension of a loan, and withdrawal by the borrower
Assets
Liabilities
Reserves
$0
Checkable deposits
$0
Securities
-$100,000
Loans
+$100,000
Deposit Expansion in a System of Banks
The loan that the First bank made was spent and as the checks cleared, reserves were transferred
to other banks
The banks that receive the reserves will seek to lend their excess reserves, and the process
continues until all of the funds have ended up in required reserves
Types of Reserves
Actual Reserves (R)
Required Reserves (RR=rDD)
Excess Reserves (ER)
Assume
Bank holds 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.
Let's say, OBI uses the $100,000 loan to pay its supplier American Steel Co (ASC), which it
deposits in its bank the Second bank.
105
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Money & Banking ­ MGT411
VU
Table: Change in Second Bank's Balance sheet following American Steel's Deposit
Assets
Liabilities
Reserves
+$100,000
American Steel's checking
+$100,000
account
Table: Change in Second Bank's Balance sheet following a Deposit and Extension of a loan
Assuming a 10% reserve requirement, banks hold no excess reserves, and there are no changes in
currency holdings.
Assets
liabilities
Reserves
+$10,000
American Steel's Checking
+$100,000
Loan
+$90,000
account
Table: Change in Third Bank's Balance Sheet following a Deposit and Extension of a loan
Assuming a 10% reserve requirement, banks hold no excess reserves, and there are no changes in
currency holdings.
Assets
Liabilities
Reserves
+$9,000
Checking account
+$90,000
Loan
+$81,000
106
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Money & Banking ­ MGT411
VU
Multiple Deposit Creation
Assuming a 10% reserve requirement, banks hold no excess reserves and there are no
changes in currency holdings.
Central Bank
$100,000 Reserves
$100,000 Securities
First Bank
$100,000 Loan
Office Builders lnc.
$100,000 Payment
American Steel Co.
$100,000 Deposit
Second Bank retains $10,000 in reserves
$90,000 Loans
Third Bank retains $90,000 in reserves
$81,000 Loan
Fourth Bank retains $8,100 in reserves
$72,900 Loan
Fifth Bank retains $7,290 in reserves
$65,610 Loan
And so on
And so on
107
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Money & Banking ­ MGT411
VU
Table: Multiple Deposit Expansion following a $100,000 Open Market Purchase Assuming a 10%
reserve requirement
Bank
Increase in Deposits
Increase in Loans
Increase in Reserves
First bank
$0
$100,000
$0
Second bank
$100,000
$90,000
$10,000
Third bank
$90,000
$81,000
$9,000
Fourth bank
$81,000
$72,900
$8,100
Fifth bank
$72,900
$65,610
$7,290
Sixth bank
$65,610
$59,049
$6,561
-
-
-
-
-
-
-
-
-
-
-
-
The Banking System
$1,000,000
$1,000,000
$100,000
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
ĆD = (1/rD) ĆRR
Alternatively
RR = rDD  or ΔRR = rDΔD
So for every dollar increase in reserves, deposits rise by 1/rD
The term (1/rD) represents the simple deposit expansion multiplier.
A decrease in reserves will generate a deposit contraction in a multiple amount too
RD=10% (0.10), and ΔRR=$100,000
1
$ 100 , 000
ΔD=
.1
ΔD= $1,000,000
Deposit Expansion with Excess Reserves and Cash Withdrawals
The simple deposit expansion multiplier was derived assuming no excess reserves are held and
that there is no change in currency holdings by the public.
These assumptions are now relaxed as
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
Bank wishes to hold excessive reserves of 5% of deposits, it would keep reserves of 15% of
$95,000 or $14,250 and making a loan of $80,750
108
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Money & Banking ­ MGT411
VU
Table: Change in Second Bank's Balance sheet following a Deposit and Extension of a Loan
Assuming excess reserves and cash holdings. Note: American Steel also has $5,000 in cash.
Assets
Liabilities
Required reserves
+$9,500
American Steel's checking
+$95,000
Excess reserves
+$4,750
account
Loan
+$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.
The more excess reserves banks desire to hold, and the more cash that is withdrawn, the smaller
the impact.
Money Multiplier
The money multiplier shows how the quantity of money (checking account plus currency) is
related to the monetary base (reserves in the banking system plus currency held by the nonbank
public)
Taking m for money multiplier and MB for 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
M=C+D
Monetary Base = Currency + Reserves
MB = C +R
Reserves = Req. Res. + Exc. Res
R = RR + ER
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
The higher the interest rate, the lower banks' 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}
R = RR + ER
= rDD + {ER/D} D
= (rD + {ER/D}) D
109
Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY