Money creation.docx

How the banking system is used to create money. Suppose that all banks have zero excess reserves. Suppose that Bank A has the following balance sheet: Bank A Now suppose that Bank A sells a security to the Fed for $1000. Bank A’s balance sheet now has $1000 more reserves. Bank A In this balance sheet let R = total reserves; RR = required reserves, and ER = excess reserves. The reserve ration is 0.10. Bank A has $8000 in loans (to keep the picture fairly simple we will ignore securities and most of the other item on the balance sheet. All deposits will be demand deposits. Pay particular attention to the increases in reserves and deposits on the balance sheets. Demand deposits are part of M1. If demand deposits increase by $1.00 then M1 increases by $1.00 as well. Now suppose that Bank A lends out the $1000 to a business person who spends it at the local computer store. This person deposits the proceeds in the stores demand deposit in Bank B. Bank B’s deposits will increase by $1000 so M1 just increased by $1000. Likewise Banks B’s reserves increase by $1000. Of this reserve increase $100 will be in required reserves and $900 will be in excess reserves. Bank A After the loan Bank A is left with zero excess reserves. We will only record changes to Bank B’s balance sheet as they affect reserves and deposits. Bank B Bank B now lends $900 and the proceeds wind up in a deposit in Bank C. Bank B The total increase in M1 at Bank B is $1000 and the total increase in reserves at Bank B is $100. Bank C Bank C will increase its deposits by $900 and its required reserves by $90. It can now loan $810 out of excess reserves. If it does so the balance sheet will be Bank C Bank C increases deposits by $900 and reserves by $90. M1 increases by $900. Suppose the proceeds end up as a deposit in Bank D. Bank D Now Bank D lends out all of its’ excess reserves Bank D The proceeds wind up in Bank E. Bank E. Bank E lends all of its excess reserves Bank E Assets Liabilities + Net Worth R +72.90 +729 Deposits RR +72.90     ER 0     Loans +656.10     The increase in deposits thus far has been $1000+900+810+729 (this is also the increase in M1). The increase in reserves in $100+90+81+72.90. Note that the increase in deposits is 10 times the increase in reserves. Recall that where R = total reserves, RR = required reserves, and ER = excess reserves. If the banking system is willing to drive excess reserves to zero, then and because required reserves are a fraction of deposits where = total demand deposits and is the reserve ratio. So the change in demand deposits will be related to the change is reserves by where is called the simple deposit multiplier. The simple deposit multiplier determines the maximum amount of deposits that can be created with a change in reserves. Recall that the initial increase in reserves was $1000 so So the initial increase of $1000 could create as much as $10000 additional demand deposits. Again this represents the maximum amount of new deposits. Because demand deposits are part of M1, this also represents the maximum increase in the nations money supply brought about by a $1000 increase in reserves. How small could the increase be? Suppose Bank A did not make the initial loan. In that case no additional deposits or money would be created. So the amount of new deposits and new money created will be somewhere between zero and $10000. This may give some indication of how difficult the Fed can find it to be to control the money supply. But the key to Fed money supply creation is the control of reserves. If the Fed wants to change the money supply it does so by changing reserves. Money supply contraction Money supply contraction is a bit more difficult to explain. Actually money supply contraction is pretty rare. 0000Figure 1. Money supply growth rates Figure 1 shows growth rates for M1, M2 and M3 since 1960. Most of the time the growth rate has been positive. Generally the Fed has reduced the rate of growth of the money supply rather than actually decreasing it. Rates of growth are harder to understand than absolute values. Consider a bank with inadequate excess reserves. This bank may try to build up excess reserves by calling in loans. When the loan is repaid with a demand deposit that reduces M1. If the bank does not issue a new loan, then M1 stays reduced. If the Fed sell a bond to a bank, this will reduce a banks excess reserves and starts the process by which the bank builds up its excess reserves. If the Fed sell a bond to a member of the public who pays with a demand deposit that reduces deposits but increases currency. These offset one another. But the demand deposit reduction also decreases excess reserves which starts off the process described above. Assets Liabilities + Net Worth R +1000 -1000 Deposits RR -100     ER +1100     Loans -1000 +1000 Net worth When a depositor pays off a loan, deposits fall in the banking system and this will reduce the money supply if the bank does not re—lend the money taken in when the loan is repaid. The Fed’s balance sheet and the monetary base The monetary base is a convenient way of viewing how the Fed might control reserves. First consider the Fed’s balance sheet: The Fed’s balance sheet (end of 1999) Assets Securities: These are mostly government securities that the Fed has purchased. Usually these are Treasury securities. Discount loans: Loans the Fed has made to banks. Gold and SDRs. SDRs are special drawing rights that have been issued by the International Monetary Fund. They have generally replaced gold as a means of settling international transactions. Coin. Coins are issued by the Treasury. The Fed holds some. Cash item in the process of collection. Check that have not yet cleared the bank of the check writer. The Fed takes the checks in and these are an asset until the proceeds have been collected. Other Federal Reserve Assets: The Fed’s physical assets (computers, buildings, etc) pus holding of foreign currency and government bonds. Liabilities. Federal Reserve notes outstanding: These are the bills in your wallet. They have printed “Federal Reserve note” on them. This is cash in the hands of the nonbank public. Reserves: These are mostly deposits that member banks have made with the Fed. The member make deposits with the Fed just like we make deposits with our banks. The member banks must have deposits as least as large are required reserves with the Fed. The reserves also consists of vault cash—that is cash in the hands of banks. Treasury deposits: The Fed serves as the Treasury’s bank. The Treasury writes checks on the Fed. Foreign and other deposits: Deposits made by foreign governments, foreign central banks, and international agencies such as the U.N. and by U.S. government agencies such as the FDIC. Deferred—availability cash items. Remember the cash items in the process of collection? The Fed does not immediately credit the receiving bank. Other Federal Reserve liabilities and capital accounts. The member banks are required to buy shares in the Fed. This is the capital. Monetary Base The monetary base (MB) consists of the Fed’s monetary liabilities (Federal Reserve notes + Reserves in the banking system) plus the Treasury’s monetary liabilities (Treasury notes + coins). The monetary base is also called high power money. MB = (Federal Reserve notes + Treasury liabilities – coins owned by Fed) + reserves MB = C + R Where C is currency in the hands of the nonblank public, that is Federal reserve notes, Treasury currency and coins in the hands of the non bank public (Note that the coins in the expression above are coins that the Fed owns, not coins in the hands of the nonblank public). Another way of looking at this is that the money base is equal to vault cash, deposits at the Fed, and currency in circulation. Note that vault cash is part of a banks reserves. We can do a little accounting Assets = Liabilities = Federal Reserve notes + reserves + [U.S. Treasury deposits + Foreign and other deposits + Deferred availability cash items + other Federal Reserve liabilities and capital]. Or Federal Reserve notes + reserves = (Assets) – [U.S. Treasury deposits - Foreign and other deposits - Deferred availability cash items - other Federal Reserve liabilities and capital]. Now put in the items that make up assets. Federal Reserve notes + reserves = (Securities + discount loans + gold and SDRs + coins +cash items in the process of collection + other Federal Reserves assets) - [U.S. Treasury deposits - Foreign and other deposits - Deferred availability cash items - other Federal Reserve liabilities and capital]. Now some arranging Float = cash items in the process of collection – deferred availability cash items Move coins to the left hand side Add Treasury currency to both sides MB = Federal Reserve notes +Treasury currency – coins + reserves MB = Securities + discount loans + gold and SDRs +Float + other Federal Reserves assets + Treasury currency - U.S. Treasury deposits - Foreign and other deposits - other Federal Reserve liabilities and capital. Now we can determine things that will increase or decrease MB Factor Change in Factor Change in MB Securities Discount loans Gold and SDRs Float Other Federal Reserve assets Treasury currency Treasury deposits with Fed Foreign and other deposits Other Fed liabilities and capital Controlling the monetary base versus controlling reserves Open market operations Suppose that the Fed buys a $1000 security from a bank. The banks balance sheet before the sale of the security The banks balance sheet after the sale The bank deposits the reserves with the Fed. The change in the Fed’s balance sheet Assets Liabilities Securities +1000 +1000 Reserves MB = C + R and reserves have increased by $1000 so MB increases by $1000 as well. Suppose that the security had been owned by a member of the nonblank public (us). If we deposit the Fed’s check in our bank Change in our bank’s balance sheet Change in the Fed’s balance sheet \s In this case R increases and so does the monetary base MB=C+R. Suppose rather than deposit the proceeds with our bank we take out $1000 in cash. The banks reserves are unchanged. It gets $1000 from the Fed which is an increase in reserves but loses $1000 in vault cash (a decrease in reserves). The Fed gets the security, but now has an additional $1000 liability in the form of currency in circulation (the bank will likely ask the Fed to replenish the vault cash).. We get $1000 in cash. So C increases and MB = C+R increases but R does not change. The Fed’s balance sheet is Changes in the Fed’s balance sheet. The Fed was able to increase the monetary base by $1000 in both cases. Reserves increased by $1000 only in the case where the individual deposits the Fed’s check with his bank. The public decides to hold more currency Suppose that a person decides to take out $1000 in cash from his checking account The banks balance sheet The Fed’s balance sheet Assets Liabilities     -1000 Reserves     +1000 Currency in circulation From MB = C+R we see that C has increased by $1000 while R has decreased by $1000. So MB remains unchanged while there has been a decrease in reserves. NOTE: the decrease in reserves will tend to reduce the money supply however. Class I Discount loans Suppose that a bank wishes to build up its reserve position by borrowing from the Fed. If the Fed agrees it will give the bank a discount loan. 102870027432000The bank’s balance sheet 102870033528000The Fed’s balance sheet MB = C+R and both MB and R increase by $1000