Chapter 7

Depository Institutions and the Money Supply Process

What is the Chapter about?

You must have had a general idea as to how movements in the money supply affect interest rates and the overall health of the economy. It is however important to understand how the money supply is determined. Who controls it? What causes it to change? Bank deposits are largest component of money supply. How these deposits are created is the first step in understanding the money supply process.
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Four Players in the Money Supply Process

1. The Central Bank: SBP which is responsible for the conduct of monetary policy. 2. Banks / Depository Institutions: financial intermediaries that accepts deposits and make loans. 3. Depositors: individuals/institutions that hold deposits in banks. 4. Borrowers from the banks: Individuals/institutions that borrow from banks.
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Introduction
Commercial Banks and Thrift institutions accepts Transaction deposits or Demand Deposits which means that they will hold your fund and pay them out as you order them to do so. Institutions are required to hold certain percentage of these deposits as reserve and not 100%. There exists a relationship between the level of reserves and the total amount of deposits and the level of money and credit in the economy.
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 The key points to remember are:

1. When someone deposits a check in one bank that is written on another bank, the two banks involved are individually affected but the overall amount of deposits in the banking system does not change. 2. When someone deposits a check that is written on the Fed in a depository institution, a multiple expansion in the level of deposits results.
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RESERVES & DEPOSITS

Types of reserves are : 1. Required Reserves (which includes vault cash and reserve account with Fed) 2. Excess Reserves. Banks as profit making institutions will try to make their excess reserves zero by making loans to customers because they are not earning anything on the excess reserves.
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How a Single Bank reacts to increase in Reserves

Assumptions that we need to make are: Required reserve ratio= 10% Excess reserves have to be zero at any point in time Ready demand for lending Loans are the only assets; deposits only liabilities Public withdraws no cash when a loan is made
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How a Single Bank reacts to increase in Reserves

What happens here is that the Quantity of money and credit is unaffected by the transfer of funds from one depository institution to another. This is because while the total assets and liabilities in bank 1 are increasing they are decreasing in Bank 2. No new reserves are created when checks written on one depository institution are deposited in another, one depository institution gets an increase in reserves that is offset by the others loss in reserves.
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FEDS Affect on Total Reserves

The Fed can change the quantity of money in the economy through OMOs. When the Fed is buying security in the open market, it: expands the total reserves quantity of deposits increases excess deposits for banks increase these excess reserves enable banks to lend more to business Hence money stock increases.

FEDS Affect on Total Reserves

The concept works exactly in the opposite way incase the Fed sells Tbills to depository institutions causing the money stock to fall. Sample Open market Transaction (Using T accounts pg 332-333 of handout)

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To Summarize!!!
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. If the proceeds are kept in currency the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves increase by the amount of the open market purchase. The Monetary Base also increases.
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To Summarize!!!
Open market Sale: the effect of an open market sale of securities by Fed reduces the monetary base.

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Prices of Government Securities

No one is forced to deal with the Fed. Fed sells or purchases government securities in the open market. It adjusts the price it offers or asks until it can buy or sell what it wants. For example, if Fed wants to sell a security for US100,000 and no one wants to buy, the Fed can lower the selling price (thereby increasing the yield) Because, the Feds duty is to operate for social benefit not private gains, the Fed can purchase as many securities as it wishes because unlike the depository institutions, it can pay for them by writing a check on itself and thereby achieve objectives of monetary policy.
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Deposit Expansion By the Banking System

Pg 334-335 from handout T accounts.

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Money Expansion Multiplier

The change in the total reserves in the banking system equals the required reserve ratio times the change in the transaction deposits. (Equation 14-1) The relationship between changes in total reserves and changes in transaction deposits from public is defined by the deposit expansion multiplier. Deposit expansion multiplier is the number by which change is reserves is multiplied to calculate the change in the total deposits in the banking system. In the simple model of multiple deposit creation in which banks do not hold on to excess reserves and the public holds no currency, the multiple increase in deposits equals the reciprocal of the required reserve ratio.
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Complete Money & Credit Multiplier

In real world, the following above made assumptions do not hold: Banks hold no excess reserves (Banks do hold some excess reserves) Public makes no withdrawal (they make currency withdrawals from the banking system) Considering Currency leakages and positive excess reserve holding, the real world money multiplier is less than the maximum money multiplier. (This is derived through various formulas on pg 343-344)
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Money & Credit Multiplier

Money Multiplier is defined as a number by which the monetary base is multiplied to obtain the total quantity of money in the economy.

Bank deposit expansion also implies bank credit expansion. Consequently, there is a multiplier relationship between total bank credit and the monetary base. Monetary base (MB) is the amount of government supplied money (i.e. cash in circulation) plus the total banks reserves.
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Monetary Base
The Monetary Base is basically a sum of currency in circulation, coins, currency and the reserves of the banks. The MB is an important part of money supply because increases in it will lead to a multiple increases in money supply. This is why it is also called as high powered money. The Fed exercises control over the monetary base through the sale/purchase of government securities i.e. through OMOs.
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Testing Question
1. If the Fed sells $2 million of bonds to Mr. ABC, an investor, who pays for the bonds with a briefcase filled with currency, what happens to reserves and the monetary base?

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Answer
Reserves are unchanged but the monetary base falls by $2 million. As per the T accounts, Investor: Currency decrease 2m Securities increase 2m

Fed :

Securities Currency

decrease 2m liability 2m
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Testing Question
2. If the Fed lend five banks an additional total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base?

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Answer
Reserves increase by $50 m but the monetary base increases by $100 m.
What will the T accounts of banks and Fed depict?

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Testing Question
3. If a bank decides that it wants to hold $1 million of excess reserves, what effect will this have on checkable deposits in the banking system?

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Answer
The $1 million holdings of excess reserves means that the bank has to reduce its holdings of loans or securities, thus starting the multiple contraction process. Assuming the required reserve ratio is 10%, checkable deposits must decline by $10 million.
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