Chapter 15 Multiple Deposit Creation and the Money

Chapter 15 Multiple Deposit Creation and the Money Supply Process © 2008 Pearson Education Canada

Players in the Money Supply Process • Central bank (Bank of Canada) • Banks (depository institutions; financial intermediaries) • Depositors (individuals and institutions) • Borrowers (individuals and institutions) © 2008 Pearson Education Canada

Bank of Canada’s Balance Sheet Bank of Canada Assets Liabilities Government securities Currency in circulation Advances to banks Reserves • Monetary Liabilities – Currency in circulation—in the hands of the public – Reserves - bank deposits at Bank of Canada and vault cash • Assets – Government securities - holdings by the Bank of Canada that affect mo – Advances to banks - provide reserves to banks and earn the discount r 3 © 2008 Pearson Education Canada

Bank of Canada’s Balance Sheet (Cont’d) • All LVTS and ACSS participants have accounts at the Bank of Canada (B of C) in which they hold settlement balances • Chartered banks hold desired reserves to manage their short term liquidity requirements and respond to clearing drains and currency drains • Reserves above that desired are known as excess reserves © 2008 Pearson Education Canada

• The definition for the monetary base (MB) is given below. © 2008 Pearson Education Canada

Monetary Base 6 © 2008 Pearson Education Canada

Open Market Purchase from a Banking System Assets Liabilities Securities -$100 Reserves +$100 Bank of Canada Assets Securitie s Liabilities +$100 Reserves +$100 • Net result is that reserves have increased by $100 • No change in currency • Monetary base has risen by $100 7 © 2008 Pearson Education Canada

Open Market Purchase: Summary • 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 (MB) always increases the base by the amount of the purchase © 2008 Pearson Education Canada

. Open Market Sale to Non-Bank Public for Currency Nonbank Public Assets Liabilities Securities +$100 Currency Bank of Canada Assets Securitie s Liabilities -$100 Currency in circulation -$100 • Reduces the monetary base by the amount of the sale • Reserves remain unchanged • The effect of open market operations on the monetary bas 9 © 2008 Pearson Education Canada

Shifts from Deposits into Currency Nonbank Public Assets Banking System Liabilities Chequabl e deposits +$100 Currency -$100 Assets Reserves Liabilities -$100 Cheqeable deposits -$100 Bank of Canada Assets 10 Liabilities Currency in circulation +$100 Reserves -$100 © 2008 Pearson Education Canada

Bank of Canada Advances to Banks. Banking System Assets Reserves Bank of Canada Liabilities +$100 Advances +$100 Assets Advances Liabilities +$100 Reserves +$100 • Monetary liabilities of the Bank of Canada have inc • Monetary base also increases by this amount 11 © 2008 Pearson Education Canada

A Bank Paying Off a Loan from the Bank of Canada Banking System Assets Reserves Bank of Canada Liabilities -$100 Advances -$100 Assets Advances Liabilities -$100 Reserves -$100 • Net effect on monetary base is a reduction • Monetary base changes one-for-one with a change 12 © 2008 Pearson Education Canada

Deposit Creation: The Banking System Bank A Assets Reserve s Bank A Liabilities +$100 Chequable deposits Assets +$100 Reserve s Loans Bank B Assets Reserve s +$10 Chequable deposits +$100 +$90 Bank B Liabilities +$90 Chequable deposits Assets +$90 Reserve s Loans 13 Liabilities +$9 Chequable deposits +$90 +$81 © 2008 Pearson Education Canada

Increase in Assets Increase in Liabilities Reserves Loans Deposits +10 +90 +100 +9 +81 + 90 + 8. 1 +72. 9 + 81 : : : © 2008 Pearson Education Canada

Change in deposits (ie liabilities) equals 100(1 +. 9 +. 81 + 72. 9 + …. . ) = 100(. 90 +. 91 +. 92 +. 93 + …. ) = 100( 1 / (1 -. 9) ) = 100 ( 1 /. 1) note: reserve ratio =. 1 = 100 ( 10 ) = 1, 000 © 2008 Pearson Education Canada

Change in Assets Change in loans equals. 9 ( 1, 000) = 900 Change in reserves. 1 ( 1, 000) = 100 © 2008 Pearson Education Canada

The Formula for Multiple Deposit Creation 17 © 2008 Pearson Education Canada

Critique of the Simple Model • Holding cash stops the process • Banks may not use all of their excess reserves to buy securities or make loans © 2008 Pearson Education Canada