Multiple Deposit Creation &

Money Supply Process

Kanjaraj Tangtatswas

Note: Chapter 15 – in the textbook 1

Players in the Money Supply
Process

• Banks (depository institutions; financial

intermediaries)
• Depositors (individuals and institutions)
• Borrowers (individuals and institutions)
• Central bank

2
Central Bank’s Balance Sheet
Central Bank

Assets Liabilities
* majority in a
Government securities Currency in circulation
+
others investment Monetary
Loans to financial Reserves Base
→ commercial banks deposit
institutions @ central bank

• Assets
Government securities—holdings by central bank that affect
money supply and earn interest
Loans to financial institutions

• Monetary Liabilities
Currency in circulation—in the hands of the public
Reserves—bank deposits at central bank and vault cash
3
Control of the Monetary Base

High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
The Money Supply Model

• Link the money supply (M) to the

monetary base (MB) and let m be the
money multiplier

M = m x MB

• Define money as currency plus

checkable deposits: M1

5
Deposit Creation – Single Bank
=
open market operation → buy bond from the market !

• Central bank conducts $100 open market purchase

www.
with First National Bank.
• Bank makes loan equal to an amount of excess
reserve $100. ↳ convert reserve to loans / lend out
so, can gain more 1+1
p money multiply
• The bank creates deposit by lending. www

• The borrower takes out $100 loan.

Assets Liabilities
Securities -$100 Checkable Deposit
checkable Deposit $700

Borrow out
$100
Reserve $100
Loans $700

Loans $100
6
Deposit Creation – Banking System
• Assume that the loan that is created by First National
Bank is deposited in Bank A.
• Required reserve ratio is 10%.
• Use excess reserves to make loan.
• The loan is deposited in Bank B.

Bank A Bank B
REAR $70
Req reqRR
$$90
9 Deposit $$9090
-

Deposit $9 Deposit
Req EXCR
Reserves
R $100
$10 Deposit $100
$100
Reserves
-

1109ns )
$90 EXCR
-

$87
-

ExcReserves
Loans
R $ $700
90 Exc
loanR $81
$90

7
Creation of Deposits
(assuming 10% reserve requirement and a $100
increase in reserves)

multiply by 70 time

8
The Formula for Multiple Deposit
Creation

• Assume banks do not hold excess reserves.

Required Reserves (RR) = Total Reserves (R) -------- (1)
RR = Required reserve ratio (r) x Deposit (D) -------- (2)

R=rxD
Divide both sides by r
D = 1/r x R

9
Critique of the Simple Model

• Holding cash stops the process - Currency has no

multiple deposit expansion
• Banks may not use all of their excess reserves to buy
securities or make loans

Depositors’ decisions (how much currency to hold) and

bank’s decisions (amount of excess reserves to hold)
also cause the money supply to change

10
Determinants of the Money
Supply

11
Factors That Determine the Money Supply

M = m x MB
• Changes in money multiplier (m)
Changes in the required reserve ratio (r)
Changes in currency holding (c)
Changes in excess reserve (e)
• Changes in monetary base (MB)
Nonborrowed monetary base MBn
Borrowed monetary base (borrowed reserve or BR)

12
Deriving Money Multiplier

Reserves = Req Reserves + Excess Reserves

R = RR + ER --------- (1)
RR = r x D --------- (2)

Substitute (2) in (1)

R = (r x D) + ER --------- (3)

“r” is set to be less than 1.

13
Deriving Money Multiplier

Monetary base (MB)

MB = R + C ------- (4)

Substitute equation (3) in (4)

MB = (r x D) + ER + C

14
Deriving Money Multiplier Formula

• Let “C” be the desired level of currency

Let “c” be currency ratio

c = C/D

• Assume that excess reserve (ER) grows

proportionally with deposit
Let “e” be excess reserves ratio

e = ER/D

15
Deriving Money Multiplier Formula

MB = (r x D) + ER + C
• ER = e x D
• C=cxD
MB = (r x D) + (e x D) + (c x D)
MB = (r + e + c) x D
D= 1 x MB
r+e+c
16
Deriving Money Multiplier Formula

Money Supply (M) = D + C

C=cxD
M = D + (c x D)
M = (1 + c) x D
M= 1+c x MB
r + e +c

m= 1+c
r+e+c
17
Money Multiplier – Example

• r = required reserve ratio = 0.1

• C = currency in circulation = $400B
• D = checkable deposits = $800B
• ER = excess reserve = $0.8B
• M = money supply (M1)= C + D = $1,200B

18
Money Multiplier – Example

• c = C/D = $400B/ $800B = 0.5

• e = ER/D = $0.8B/ $800B = 0.001

• m = (1 + c)/ (r + c +e)

= (1+0.5)/ (0.1 + 0.5 + 0.001)

= 1.5/0.601 = 2.5

19
Money Multiplier – Example

m = 2.5

Given the required reserves ratio, the behavior

of depositors (as represented by “c”),
and banks (as represented by “e”),
a $1 increase in the monetary base leads to a
$2.50 increase in the money supply (M1).

Money multiplier is less than

the simple deposit multiplier.

20
Factors that Determine
the Money Multiplier

1. Changes in the required reserve ratio r

The money multiplier and the money
supply are negatively related to r

2. Changes in the currency ratio c

The money multiplier and the money
supply are negatively related to c

21
Factors that Determine
the Money Multiplier

3. Changes in the excess reserves ratio e

The money multiplier and the money
supply are negatively related to the excess
reserves ratio e

The excess reserves ratio e is positively

related to expected deposit outflows
The excess reserves ratio e is negatively
related to the market interest rate

22
Excess Reserves Ratio and Currency Ratio,
1929–1933

Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960
(Princeton, NJ: Princeton University Press, 1963), p. 333.
M1 and the Monetary Base, 1929–1933

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960
(Princeton, NJ: Princeton University Press, 1963), p. 333.
Quantitative Easing and the Money Supply,
2007–2017
• When the global financial crisis began in the fall of 2007, the Fed
initiated lending programs and large-scale asset-purchase
programs in an attempt to bolster the economy.
 M1 and the Monetary Base, 2007–2017

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

 Excess Reserves Ratio and Currency Ratio,
2007–2017

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Shifts from Deposits into
Currency
Nonbank Public Banking System

Assets Liabilities Assets Liabilities

Checkable Checkable
deposits -$100 Reserves -$100 deposits -$100
Currency +$100

Central Bank Reserves are

changed by
Assets
Assets Liabilities
Liabilities • April decides to withdraw
random
Currency in +$100
$100 from fluctuations
a bank account
circulation
and keep the money at
Monetary
home.
Reserves -$100 base.

Net effect on monetary

liabilities is zero.
28
Central Bank’s influence on
monetary base and money supply

• Open market operations

• Lending to financial institutions

29
Open Market Purchase from a Bank

Banking System Federal

Central
Reserve
Bank
System
Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Reserves +$100
Reserves +$100

• Central bank buys $100 securities from banking

system.

30
 Open Market Purchase from
Nonbank Public
Banking System Federal
Central
Reserve
Bank
System
Assets
Assets Liabilities
Liabilities Assets
Assets Liabilities
Liabilities
Reserves +$100 Checkable +$100 Securities +$100 Reserves +$100
deposits

• Central bank buys $100

securities from nonbank public.
• Person selling bonds to central
bank deposits the check in the Nonbank Public
bank.
• Identical result as the purchase Assets Liabilities
from a bank
Securities -$100

Checkable
deposits +$100
31
Open Market Purchase from
Nonbank Public
Banking
Banking System
System Central
Federal Bank
Reserve System
Assets Liabilities Assets Liabilities

Securities +$100 Currency +$100

• Central bank buys $100

securities from nonbank
public.
• The person selling the bonds Nonbank Public
cashes the check.
Assets Liabilities

Securities -$100

Cash +$100

32
Open Market Purchase

• The effect of an open market purchase

on reserves depends on whether the
seller of the bonds keeps the proceeds
from the sale in currency or in deposits
• The effect of an open market purchase
on the monetary base always increases
the base by the amount of the purchase

33
Open Market Sales to a Bank

Banking System Federal

Central
Reserve
Bank
System
Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Reserves -$100
Reserves -$100

• Central bank sells $100 securities to banking

system.

34
Open Market Sales to
Nonbank Public
Banking System Central
Federal Bank
Reserve System
Assets
Assets Liabilities
Liabilities Assets
Assets Liabilities
Liabilities
Reserves -$100 Checkable -$100 Securities -$100 Reserves -$100
deposits

• Central bank sells $100

securities to nonbank
public.
Nonbank Public
• Person buying bonds
paying via a deposit Assets Liabilities
account.
Securities +$100

Checkable
deposits -$100
35
Open Market Sales to
Nonbank Public
Banking
BankingSystem
System Central
Federal Bank
Reserve System
Assets Liabilities
Liabilities Assets
Assets Liabilities
Liabilities
Securities -$100 Currency -$100

• Central bank sells $100

securities to nonbank public.
• The person uses cash to buy
the bonds. Nonbank Public

Assets Liabilities

Securities +$100

Currency -$100

36
Bank borrowing from central bank

Banking
Banking System
System Central Bank
Central Bank
Assets Liabilities Assets Liabilities
Liabilities
Reserves +$100 Discount +$100 Discount +$100 Reserves +$100
loans loan
(borrowing from (borrowing from
Fed) Fed)

• Central bank makes a discount loan to a bank.

37
Paying Off Loan from the Central
Bank
Banking System
Banking System Central Bank
Central Bank
Assets
Assets Liabilities
Liabilities Assets
Assets Liabilities
Liabilities
Reserves -$100 Discount -$100 Discount -$100 Reserves -$100
loans loans
(borrowing from (borrowing from
Fed) Fed)

• A bank pays off a discount loan.

• Net effect on monetary base is a reduction.

38
Central Bank’s Ability to Control
the Monetary Base
• Open market operations are controlled by central
bank.
• Central bank cannot determine how much and when
banks will borrow from them.
• Split the monetary base into two components:
MBn= MB - BR
• The money supply is positively related to both the
non-borrowed monetary base MBn and
to the level of borrowed reserves, BR, from
the central bank.
Explaining Movements in the Money
Supply

• Over long periods, the primary

determinant of movements in the money
supply is the non-borrowed monetary base,
which is controlled by central bank’s open
market operations.

40
Money Supply Response

Change Money
in Supply
Player Variable Variable Response Reason
Central Bank Nonborrowed More MB for deposit
monetary base, MBn creation
Central Bank Required reserve Less multiple deposit
ratio, rr expansion
Banks Borrowed reserves, More MB for deposit
BR creation
Banks Excess reserves Less loans and deposit
creation
Depositors Currency holdings Less multiple deposit
expansion