Bank Reserves and the Money Supply

1
Bank Reserves and the Money Supply
2
Introduction

• Examine the relationship between bank reserves
  and the money supply
• Money supply (M1) is composed mostly of demand
  deposits in commercial banks and other financial
  institutions
• Bank reserves play a crucial role in creating
  demand deposits
• By regulating bank reserves, Federal reserve gets
  leverage to control amount of demand deposits and
  thereby nations money supply

3
Check Clearing and Collection

• Many checks and electronic transfers are
  cleared by local banks exchanging them through
  local clearinghouse associations.
• Clearinghouses net out the value of checks and
  transfers drawn on or received by each depository
  institution in the association.

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The Feds Role in Check Clearing

• The Fed clears a check
• by subtracting the amount of the check from the
  reserve account balance of the bank on which the
  check was written and
• by adding the amount to the reserve account
  balance of the bank that presents the check to
  the Fed for clearing.
• Reserve balances are transferred from one bank to
  another when checks are cleared between them.
  They do not disappear from the banking system.
• Float
• Inter-District Settlement Fund

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Example Barbara is on vacation in Atlanta.
While shopping at Saks Fifth Avenue, she buys a
coat for 500

• She writes a check for the purchase amount on her
  bank in Minneapolis, Norwest Bank.
• Saks receives the check in its processing area.
• It deposits the check at its bank, Wachovia Bank,
  that evening - along with many others.
• The bank first encodes the dollar amount in
  magnetic ink on the bottom right-hand side of the
  check, then batches this check with many others
  it has received that were written on banks
  outside the Atlanta area.

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• It transports the checks to the Atlanta Federal
  Reserve Bank.
• The Atlanta Fed sorts this check and other
  unsorted checks it has received, according to the
  checks destination (the drawee bank-Norwest
  Bank).
• The Atlanta Fed settles accounts, crediting
  Wachovia Banks reserve account according to a
  prearranged availability schedule.
• After settlement, checks drawn on banks in the
  9th District are grouped and sent to the
  Minneapolis Fed.
• The Minneapolis Fed returns Barbaras check to
  Norwest and debits Norwests reserve account
  (called presentment).
• Norwest then debits Barbaras checking account.

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Sequence of events when a check, drawn on
Norwest, is deposited in Wachovia

• Demand deposits in Wachovia increase with a
  corresponding increase in assets
• Check in process of collection
• When the check clears through the Fed check
  clearing system,
• The Fed increases Wachovias deposits in Fed by
  the amount of the check
• There is a corresponding decrease in the deposits
  of Norwest which is made by the Fed
• Demand deposits in Norwest decrease when the
  check clears
• The Federal Reserve neither gains or loses
  deposits, only transfers ownership from one bank
  to another

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Summary

• When a bank receives a check drawn on another
  bank, it gains reserves equal to the amount of
  the check
• The bank on which the check was drawn loses
  reserves of the same amount

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Check Clearing and Collection

• The above sequence of events occur whether the
  banks are members of the Federal Reserve system
  or not
• In this case the banks are in different Federal
  Reserve regions, the two regional banks have a
  clearing account which permits the transfer of
  reserves between regions

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Money Supply

• Monetary Base Currency Reserves
• M1 Currency Travelers Checks Demand
  Deposits
• M2 M1 Savings Deposits Small Time Deposits
  MDA MMMF

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Required Reserves and Depository Institution
Balance Sheets

• Required reserve ratios
• 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
• Legally mandated reserve holdings at depository
  institutions, which are proportional to the
  dollar amounts of transactions accounts.

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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.

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Bank Liquidity

• Why does a bank need liquidity?
• Deposits are convertible on demand into cash.
• Accommodate customers when they come for loans.
• Required reserves
• Not really there to provide liquidity.
• Excess reserves
• Provide liquidity
• Expensive
• Federal funds market banks short of required
  reserves can borrow from those that have excess
  reserves.
• Discount Window banks short of required
  reserves can borrow from the Fed at its discount
  window.

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Required Reserves

• Federal funds market banks short of required
  reserves can borrow from those that have excess
  reserves.
• Discount Window banks short of required
  reserves can borrow from the Fed at its discount
  window.

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Deposit Expansion The Single Bank

• How much a bank safely can loan depends on the
  amount its excess reserves.
• When a bank lends, the borrower receives a
  checking account (demand deposit)
• Both sides of balance rise, increase in demand
  deposits (liability) and increase in loans
  (asset)
• Since demand deposits are part of the money
  supply, when banks create demand deposits through
  lending, there is an increase in the money supply

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Deposit Expansion The Single Bank

• A bank can safely lend up to the amount of its
  excess reserves
• When proceeds of the loan are withdrawn and the
  reserves are reduced by the amount of the check,
  all the excess reserves will be used up.
• If the bank tries to lend more, there will be
  insufficient reserves as soon as the borrower
  withdraws the proceeds from the loan.
• An individual bank can create money (demand
  deposits) only if it has excess reserves.
• As soon as it creates this money, it loses it to
  another bank when the money is spent

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Deposit Expansion The Banking System

• Although the initial bank lost its excess
  reserves, another bank gained these excess
  reserves which permits them to expand their
  lending and increase the money supply
• However, ability of the next bank to extend loans
  is reduced by 10 since some of gain in reserves
  must be held on deposit with Fed.
• Process will continue with each successive bank
  being able to lend only 90 of gained excess
  reserves and 10 placed on deposit with Fed

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How the Banking System Creates Money

• The banking system will have demand deposits that
  are a multiple of the initial injection of excess
  reserves into the system.
• The Fed will have additional required reserves on
  deposit equal to the initial injection of excess
  reserves into the system
• The final state is reached not by shrinking
  reserves, as in the case of a single bank, but by
  expanding deposits

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Deposit Expansion The Banking System

• When one bank loses reserves, another bank gains
  the excess and lends out 90
• As banks lend more and more, demand deposit
  liabilities grow, thereby reducing excess
  reserves
• Whereas a single bank can lend the amount of
  excess reserves, the banking system can create
  demand deposits up to a multiple of original
  change in reserves
• The process of deposit expansion can continue
  until all excess reserves become required
  reserves because of growth of demand deposits

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Demand Deposit Expansion Multiplier

• The demand deposit expansion simple multiplier is
  always the reciprocal of the reserve requirement
  ratio

Where is the simple
multiplier
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The Money Multiplier

• This money multiplier formula calculates the
  maximum possible expansion of M1 because it
  assumes
• everyone deposits their new loans into a checking
  account at a bank.
• banks hold no excess reserves.
• If either of these assumptions are violated, the
  amount of money actually created in the economy
  will be smaller than the formula predicts.
• The money creation process works exactly the same
  in reverse. For example, if someone withdraws
  money from a bank, a bank will be short of its
  required reserves and must reduce loans. M1 will
  decrease by 900,000 in the example above.

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Deposit Contraction

• If a bank starts with deficient reserves,
  potential change in demand deposits is negative
  rather than positive
• Money is destroyed as bank loans are repaid or
  securities sold
• The potential multiple contraction in demand
  deposits (money supply) follows the same
  principles as expansion of demand deposits

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Depository Institution Reserves, the Monetary
Base, and Money

• 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,

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Multiple Expansion Process

• The stages of expansion occur neither
  simultaneously nor in the sequence described
  above.
• Some banks use their reserves incompletely or
  only after a considerable time lag, while others
  expand assets on the basis of expected reserve
  growth.
• The process is continuous and may never reach its
  theoretical limits.
• What happens to the quantity of money will vary,
  depending upon the reactions of the banks and the
  public.

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A number of slippages may occur

• What amount of reserves will be drained into the
  publics currency holdings?
• To what extent will the increase in the reserve
  base remain unused as excess reserves?
• How much will be absorbed by time deposits or
  other liabilities not defined as money but
  against which banks must also hold reserves?

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AppendixThe Complete Money Supply Process

• Actual change in demand deposits will reach the
  maximum amount indicated by the simple multiplier
  if banks lend all excess reserves.
• Any leakages of cash out of the multiple
  expansion cycle will result in a smaller
  expansion of the money supply
• Federal Reserve can control additional excess
  reserves but leakages are outside their control
  and may adversely affect their attempt to expand
  the money supply

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Shifts between Currency and Checking Deposits

• Monetary base (B)total reserves held by banks
  plus currency held by nonbanking public
• When the Federal Reserve injects reserves, it is
  really adding to the monetary base
• Public may elect to hold some of the excess
  reserves as cash instead of demand deposits
• Draining of currency into the hands of the public
  depletes banks excess reserves

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Shifts between Currency and Checking Deposits

• Cash held by the nonbanking public becomes part
  of the money supply, but it reduces the banking
  systems ability to expand demand deposits
• Due to the uncertainty of the publics reaction
  to additional reserves and desire to hold cash,
  the Fed has more control over the monetary base
  than total reserves

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Shifts between Time Deposits and Check Accounts

• The public may desire to hold time deposits
  rather than demand deposits
• Since the required reserves for time deposits is
  smaller than for demand deposits, placing of
  funds in time deposits will increase the banking
  systems ability to expand credit.

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Shifts between Time Deposits and Checking Accounts

• Since time deposits are not part of M1, movement
  of funds into time deposits will reduce the
  expansion of the money supply (M1)
• The reserve multiplier consequences for broader
  money supply definitions are more complicated
  than for M1

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The Role of Interest Rates

• Banks not being able or willing to lend all their
  excess reserves
• Funds may remain idle in the bank
• Since banks will be more inclined to lend or
  purchase securities at higher interest rates,
  this raises the possibility that the money supply
  (multiplier) is a function of interest rate levels

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Implications

• The Federal Reserves ability to control the
  money supply is not precise
• It must deal with leakages of money from the
  demand deposit expansion cycle, factors that are
  generally determined by public preferences

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The Money Multiplier During the Great Depression

• Between 1929 and 1933 bank holdings of excess
  reserves rose from 25 million to over 2
  billion.
• The currency-to-deposits ratio increased from
  approximately 17 percent to 33 percent.

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The Money Multiplier During the Great Depression

• Why do you think these changes occurred?
• If the money multiplier is equal to
• what happened to M1 during this time?
• How could the Fed have improved the situation?