Depository Institutions and Money

T H I R D E D I T I O N
Chapter 13
Why Money and Banking Go Together—
Depository Institutions and Money
Unit III Financial Institutions

© 2006 Thomson Business and Professional Publishing. PowerPoint Presentation by Charlie Cook
All rights reserved. The University of West Alabama
Fundamental Issues
1. How does a change in total depository institution
reserves cause a multiple expansion of the deposit
liabilities of these institutions?
2. What are Federal Reserve open market
operations?
3. What is the money multiplier, and why is it
important?
4. What factors influence the money multiplier?
5. What is the credit multiplier?
6. How will electronic money affect the money supply
process?
© 2006 Thomson Business and Professional Publishing. All rights reserved. 13–2
Reserve Requirements and Deposit
Expansion
• Depository institutions
 Are “special” financial institutions in one key respect: they issue
transactions deposits—demand deposits and negotiable-order-
of-withdrawal (NOW) accounts.
 Recall that transactions deposits are a major part of the money
supply M1, and thus also part of M2 and M3.
 Represent the crucial link between policies to influence the
quantity of money and the actual effects that these policies
have on that quantity.
 Our goal in this chapter is to explain how depository institutions
perform this role.
The Federal Reserve
• Thus far we have not discussed the Federal
Reserve very much: the Fed is our central
bank, and their primary function is to control the
money supply.
• They do this with 3 primary tools:
• 1. Open market operations
• 2. The discount rate
• 3. Reserve ratios.
Assets and liabilities
• Recall the major assets and liabilities of banks:
on the asset side we have loans, securities, and
cash assets: cash assets include both cash in
your vault and cash on deposit at the Federal
Reserve.
• Liabilities include deposits, such as transaction
deposits and savings deposits, etc.
• Why do banks hold cash assets that do not
yield interest to them? In part because they are
required to do so.
Required Reserves and Depository
Institution Balance Sheets
• Required reserve ratios: (rrD)
 Fractions of transactions deposit balances that the
Federal Reserve mandates that depository
institutions maintain either as deposits with Federal
Reserve banks or as vault cash.
• Required reserves: (RR)
 Legally mandated reserve holdings at depository
institutions, which are proportional to the dollar
amounts of transactions accounts.
Required Reserves
• Most rrD’s for transactions deposits are around
10% (.1) This is the figure we will use
throughout the chapter. (Note that reserve
ratios for savings accounts, cd’s, etc, are lower
than this…why?)
Depository Institution Balance Sheets
• Excess reserves:
 Depository institutions’ cash balances at Federal
Reserve banks or in the institutions’ vaults that exceed
the amount that they must hold to meet legal
requirements.
• Total reserves:
 The total balances that depository institutions hold on
deposit with Federal Reserve banks or as vault cash.
• T-Accounts
 A side-by-side listing of the assets and liabilities of a
business such as a depository institution.
Required Reserves
 RR = rrD x D, where D is total transactions
deposits.
 Suppose that D equals 1,000 million, and rrD = .1,
then RR = .1 (1,000 million) = 100 million.
 Any reserves that are not in the required
category become excess reserves, which of
course a bank wants to loan out or buy securities
with.
 Use the books example of a Boston bank. For
simplicity, ignore all other liabilities and equity.
T-Account for the Boston Depository Institution
Assets Liabilities
Total reserves $1,000 million Transactions deposits $1,000 million

Required reserves
($100 million)
Excess reserves
($900 million)
Figure 13–1
T-Account for the Boston Depository Institution
• What does this bank want to do with the 900

million in excess reserves? Why?
• Assume the Boston bank loans out or buys
securities with the 900 million. Their T account
now becomes:
T-Account for the Boston Depository Institution When It Is
Fully Loaned Up
Assets Liabilities
Total reserves $ 100 million Transactions deposits $1,000 million

Required reserves
($100 million)
Excess reserves
($0)
Loans and securities $ 900 million
Total: $1,000 million Total: $1,000 million
Figure 13–2
Bring the Fed into the picture
• Say the Fed purchases 100 million in US
government securities from a securities dealer.
The dealer deposits the money at the Boston
bank.
Boston Depository Institution’s T-Account after New York
Securities Dealer’s Transaction
Assets Liabilities

Required reserves
($110 million)
Excess reserves
($90 million)
Figure 13–3
Deposit expansion
• Boston now has an additional 90 million in

excess reserves to loan out. Assume they do
so, leads to the next T-Account.
Boston Depository Institution’s T-Account after It Once
Again Is Fully Loaned Up
Assets Liabilities

Required reserves
($110 million)
Excess reserves
($0)
Figure 13–4
Deposit expansion
• However, just because the Boston bank is fully

loaned up, this is not the end of the story: the
added 90 million in loans or securities has to go
somewhere!
• Say this 90 million was a purchase of securities
from a dealer in Chicago. The Boston bank
pays for the securities by transferring the
money to the securities dealer’s bank in
Chicago. Lets look at the Chicago bank T-
account:
Chicago Depository Institution’s T-Account Changes after
Second Security Purchase
Assets Liabilities
Total reserves +$90 million Transactions deposits +$90 million

Required reserves
(+$9 million)
Excess reserves
(+$81 million)
Loans and securities
Total: +$90 million Total: +$90 million
Figure 13–5
Deposit expansion
• Of course, the Chicago bank now wants to loan

out the 81 million: say that they loan this to a
company in Milwaukee, who purchases some
equipment from a company in Minneapolis,
where it gets deposited at some bank there.
Chicago Depository Institution’s T-Account Changes after
It Once Again Is Fully Loaned Up
Assets Liabilities
Total reserves +$ 9 million Transactions deposits +$90 million

Required reserves
(+$9 million)
Excess reserves
(+$0)
Loans and securities
Total: +$81 million Total: +$90 million
Figure 13–6
The Ultimate Effects Stemming from the Federal Reserve Bank of
New York’s $100 Million Security Transaction
Increase in Increase in Increase in

Depository Required Loans and Transactions
Institution Reserves Securities Deposits
Boston $ 10.0 million $ 90.0 million $ 100 million

Chicago 9.0 million 81.0 million 90 million
Minneapolis 8.1 million 72.9 million 81 million
All other depository
institutions 72.9 million 656.1 million 729 million
All Depository
Institutions Combined $100.0 million $900.0 million $1,000 million
Table 13–1
Deposit expansion
• Thus a 100 million dollar injection of new money

by the Fed has led to a tenfold increase in
transactions deposits, to 1,000 million. We will
see where this number comes from shortly.
• Note that it took an injection of NEW reserves
from the Fed to set this process in motion: if we
had begun with one securities dealer buying
100 million from another, this would not be the
case: why?
Federal Reserve Open Market Operations
• Open market operations:
 Federal Reserve purchases or sales of securities.
• Open market purchase:
 A Federal Reserve purchase of a security, which
increases total reserves at depository institutions
and thereby raises the size of the monetary base.
• Open market sale:
 A Federal Reserve sale of a security, which
reduces total reserves of depository institutions and
thereby reduces the size of the monetary base.
T-Accounts for a Federal Reserve Open Market Purchase
Open Market Purchase
Federal Reserve Boston Depository Institution
Assets Liabilities Assets Liabilities
Securities Reserve Reserve Transactions

deposits deposits deposits
+$100 million +$100 million +$100 million +$100 million
Figure 13–7
T-Accounts for a Federal Reserve Open Market Sale
Open Market Sale
Federal Reserve Boston Depository Institution
Assets Liabilities Assets Liabilities
Securities Reserve Reserve Transactions

deposits deposits deposits
-$100 million -$100 million -$100 million -$100 million
Figure 13–8
Expanding Total Deposits
: Constant required reserve ratio
: Change in bank deposits
: Change in total reserves

Note that TR = RR + ER, where ER is
excess reserves. But if banks are
fully loaned up, then ER= 0, so TR =
RR, and also ΔTR = ΔRR.
• rrD x ΔD = ΔRR. But since ΔTR = ΔRR, we have
• rrD x ΔD = ΔTR Divide both sides by rrD gives:
• This last equation basically says that if the Fed
changes total reserves TR in the banking
system, then total deposits D will change by a
multiplied factor:
The multiplier factor is the term 1/ rrD.
Expanding Total Deposits (cont’d)
• Deposit expansion multiplier:
 A number that tells how much aggregate transactions
deposits at all depository institutions will change in
response to a change in the total reserves of these
institutions.
Expanding Total Deposits (cont’d)
• In our example earlier, rrD = .1, ΔTR = 100 million, so
Gives us ΔD = 10 x 100 million = 1,000 million,

as in our earlier table.
An open market sale of government securities
by the Fed would have just the opposite effect
on total deposits.
From the deposit expansion multiplier to the
money multiplier
• The deposit expansion multiplier,1/ rrD ignores
the fact that as loans are made, some of the
money will be held as cash: thus the actual
multiplier effect will be smaller than this
formula gives us. Next we develop a
multiplier that takes this into account. (don’t
worry about the proofs!)
Depository Institution Reserves, the
Monetary Base, and Money
• Recall from ch. 1, the monetary base (MB):
 The amount of currency, C, plus the total quantity of
reserves (TR) in the banking system, or money
produced directly by the government,
Depository Institution Reserves, the
Monetary Base, and Money
• As we had earlier, if banks hold no excess reserves, then
TR = RR = rrD x D.
• Assume also that people hold some fraction (c) of their
transactions deposits as currency. Thus we can write C =
c x D.
Similar analysis using M1 instead of the
monetary base
• M1 is a broader monetary aggregate equal to the
sum of currency and transactions deposits.
Multiplier
• This last equation tells us that the quantity of
money M1depends on the monetary base, MB,
and the ratios c and rrD.
• From this we can see the money multiplier:
• mm = c + 1
• c + rrD
• For example, say c = .25 and rrD = .1, then we
have: mm = c + 1
• c + rrD
• = (.25 + 1) / .25 + .1 = 1.25/ .35 or about 3.6
The Money Multiplier
• Money multiplier, mM :
 A number that tells how much the quantity of money
will change in response to a change in the monetary
base.
Federal Reserve Policymaking and the
Money Multiplier
• The Fed cannot control monetary aggregates

such as M1 directly because of the deposit
expansion process. However the Fed can
indirectly affect the monetary aggregates by
changing the amount of reserves in the system.
• Since MB = C + TR, then the Fed can change
MB by either changing C or TR. Mostly the
Fed’s work is done on TR.
Money Multiplier
• Open market actions:
An open market purchase increases the
monetary base and thereby causes a
multiple increase in the quantity of
money.
An open market sale decreases the
monetary base and thereby causes a
multiple reduction in the quantity of
money.
Money Multiplier
• Other actions to change the money supply:
Changes in the discount rate can induce
depository institutions to borrow more or
fewer reserves from the Federal Reserve
banks’ discount windows.
The discount rate is the interest rate
banks have to pay for such borrowing.
Money Multiplier
Thus a lower discount rate will induce
more borrowing, and thus more reserves
enter the banking system, leading to an
expansion of the money supply. A higher
discount rate would do the opposite.
The Fed and the Money Multiplier
Finally, the third thing the Fed could do is
to change the required reserve ratio, rrD.
What happens to the multiplier if rrD is reduced?

What if it is increased?
The Fed and the Money Multiplier
This multiplier is called the M1 multiplier: could have

done the same analysis using M2, would have gotten a
higher value for the multiplier: why?
M1 and M2 Multipliers
SOURCE: Federal Reserve Bank of St.Louis, Federal Reserve Economic Data, various issues. Figure 13–9
Excess reserves and the money multiplier
• Another complication to our formula: we have
assumed that ER = 0, that banks do not hold
any excess reserves. This is not true however.
The holding of excess reserves will also reduce
the multiplier.
• Why would banks hold any excess reserves
even though there is an opportunity cost to
doing so?
Reasons that Depository Institutions Hold
Excess Reserves
• Implicit return:
 Excess reserves cover unexpected deposit
withdrawals, avoiding the costs of calling in loans,
selling securities, or borrowing reserve funds in order
to meet reserve requirements.
• Ready money:
 To have funds on hand to make speedy loans when
good deals arise unexpectedly.
Excess Reserve Holdings of Depository Institutions
SOURCE: Board of Governors of the Federal Reserve System, H.3 (502) Statistical Release. Figure 13–10
Excess reserves and the money multiplier
• Lets assume that banks hold a fraction, e of
their transactions deposits D as excess
reserves. Thus we have:
• ER = e x D.
• Generally e is very small, around 1% (.01)
How Excess Reserves Change The Money Multiplier
How Excess Reserves Change The Money
Multiplier
• Formerly we had mm = c + 1
• c + rrD
• Now our new multiplier is

• c+1
• c + rrD + e
• Since the denominator is now larger, the multiplier

is smaller as expected.
The Credit Multiplier
• The Fed does not just look at M1, M2, etc. It
also at times looks at other financial variables,
one of which is total credit that banks, etc,
extend in making loans and buying securities.
The Feds policies can affect this credit.
A Consolidated T-Account for Depository Institutions
Assets Liabilities
Loans (L ) Transactions deposits (D)

Securities (S)
Required reserves (RR)
Excess reserves (ER)
Figure 13–11
The Credit Multiplier (again, don’t worry
about the proof! )
• Credit multiplier:
 A number that tells
how much total
loans and securities
at depository
institutions will
change in response
to a change in the
monetary base.
• The last equation shows
us the credit multiplier:
If the Fed changes the monetary base, MB, then total

credit TC changes by a multiple as shown.
• Thus the Fed, by affecting MB, can exert
multiplier effects on both the quantity of money,
such as M1, or the total amount of credit.
Which of these they should do is tied to what
the Fed’s goals are, and whether money or
credit affects the economy more.
The Revised Money Multiplier With Digital
Cash
• Finally one last multiplier: what about the

advent of digital cash such as smart cards or
stored value cards? How will this affect the
multiplier?
The Revised Money Multiplier With Digital Cash
The Revised Money Multiplier With Digital Cash
• Comparing the multipliers shows that with the

addition of digital cash, the multiplier gets
larger. Even though at each stage of the
multiplier some money gets held as digital cash,
which means less for banks to loan out, since
this digital cash is now being counted as part of
the M1 money supply, the total effect is larger.
• In the long run, this might not be so clear
however.
Digital Cash and the Money Supply Process
• Direct effect: the money multiplier increases
 Digital cash increases the quantity of money in the
banking system which induces an expansion effect
on the volume of transactions deposits, as well as on
the volume of digital cash.
• Indirect effect: increasing use as a substitute for
currency and checks
 Security (finality and anonymity) versus faster, more
convenient, and lower-cost transactions
Digital Cash and the multiplier
• Recall our earlier multiplier with digital cash:
Recall that c is the fraction of transactions deposits we want

to hold as regular cash. What if digital cash somewhat
replaces regular cash? Then c will fall: since its in both the
numerator and denominator, you can show mathematically
that reducing it will raise the ratio, making for a higher
multiplier.
Features of Alternative Forms of Money
Feature Checks Currency Digital Cash
Security High Low High(?)

Cost Per Transfer High Medium Low
Payment Final,
Face-to-Face No Yes Yes
Payment Final,
Non-Face-to-Face No No Yes
Anonymity No Yes Yes
Acceptability Restricted Wide Uncertain at present
SOURCE: Aleksander Berentsen, “Monetary Policy Implications of Digital Money,” Kyklos 51 (1998): 89–117. Table 13–2
• Online banking and competing nondepository
institutions:
• Has online banking and the ability to make
payments directly from checking accounts
affected the money multiplier process?
• Mostly, the answer is no: just avoid writing
checks, but no fundamental affect on the money
creation process.
• However, there could be one catch in the future.
Online banking
• What if nondepository institutions (in other
words, not banks, etc) find ways to use the
internet to offer transactions deposit? Such
deposits would be acting as money, but would
not be subject to reserve requirements as bank
deposits are. This would lead to a higher
money multiplier. At present this is illegal, but
the Fed is struggling with this present and future
problem.

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T H I R D E D I T I O N

Unit III Financial Institutions

Total reserves $1,000 million Transactions deposits $1,000 million

• What does this bank want to do with the 900

Total reserves $ 100 million Transactions deposits $1,000 million

Total: $1,000 million Total: $1,000 million

Total reserves $ 200 million Transactions deposits $1,100 million

Total: $1,100 million Total: $1,100 million

• Boston now has an additional 90 million in

Total reserves $ 110 million Transactions deposits $1,100 million

Total: $1,100 million Total: $1,100 million

• However, just because the Boston bank is fully

Total reserves +$90 million Transactions deposits +$90 million

Total: +$90 million Total: +$90 million

• Of course, the Chicago bank now wants to loan

Total reserves +$ 9 million Transactions deposits +$90 million

Total: +$81 million Total: +$90 million

Increase in Increase in Increase in

Boston $ 10.0 million $ 90.0 million $ 100 million

• Thus a 100 million dollar injection of new money

Open Market Purchase

Federal Reserve Boston Depository Institution

Assets Liabilities Assets Liabilities

Securities Reserve Reserve Transactions

Open Market Sale

Federal Reserve Boston Depository Institution

Assets Liabilities Assets Liabilities

Securities Reserve Reserve Transactions

: Constant required reserve ratio

: Change in bank deposits

: Change in total reserves

The multiplier factor is the term 1/ rrD.

Gives us ΔD = 10 x 100 million = 1,000 million,

• The Fed cannot control monetary aggregates

What happens to the multiplier if rrD is reduced?

This multiplier is called the M1 multiplier: could have

• Generally e is very small, around 1% (.01)

• Now our new multiplier is

• Since the denominator is now larger, the multiplier

Loans (L ) Transactions deposits (D)

If the Fed changes the monetary base, MB, then total

• Finally one last multiplier: what about the

• Comparing the multipliers shows that with the

Recall that c is the fraction of transactions deposits we want

Security High Low High(?)

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