Deposit Money Creation of commercial banks and its Determinants

Deposit Money Creation of commercial banks and its Determinants. Money & Banking

1. Money & Banking Professor Mahmoud Touny Chapter 4 Deposit Money Creation and its Determinants

2. Credit money creation process: Simplified Assumptions: All economic transactions are carried out through the banking system. Thus, the new legal money remains inside the banks and does not leak out of the banking system. The commercial bank is committed only to the mandatory reserve ratio (required reserve ( rd )) determined by the central bank. One of the commercial banks (A) has received a current (demand) deposit of (5) million dollars.

3. This bank will keep the required reserve ratio ( rd ) and lend the rest of the deposit. Assume that ( rd ) is 20%, then Bank (A) will keep 1 million dollars as a required reserve and lend the rest to its customers. RR = rd x Dd = 0.20 x 5,000,000 = $ 1,000,000 Then, the balance sheet of Bank (A) is: Assets (million) Liabilities (million) Required Reserves Loans 1 4 Demand deposit 5 Total 5 Total 5

4. The money that Bank (A) lent to one of its clients (4 million dollars) will be disposed of by this client to pay his obligations. Assuming that there is no cash leakage outside the banking system, the other person will deposit this amount with Bank (B) as a current deposit. Bank (B) will do the same process that Bank (A) did before. Bank (B) will keep 20% x 4,000,000 = $ 800,000 as a required reserve and lend $ 3,200,000 to its customers.

5. This process will be repeated several times and each time the Bank will keep 20% of this deposit as a required reserve and lends the rest which can be illustrated by this simplified table: Assets (million) Liabilities (million) Required Reserves Loans 0.8 3.2 Demand deposit 4 Total 4 Total 4 The balance sheet of Bank (B)

6. Bank Demand Deposits Required Reserves Loans A B C . . . 5 4 3.2 . . . 1 0.8 0.64 . . . 4 3.2 2.56 . . . Total 25 5 20 Deposit Money Creation Process

7. The total demand deposits that commercial banks can collectively create from the original deposit can be calculated by: Dd = (1/ rd ) E E the size of the initial (real) deposit. Dd = (1/0.20) x 5 = $ 25 million The total deposits derived from this process is the difference between the total demand deposits and the original (initial) deposit: Total derived deposits = 25 - 5 = $ 20 million. The required reserves of commercial banks RR are: RR = rd x Dd = 0.20 x 25 = $ 5 million.

8. Simple Money Multiplier: The deposit creation multiplier = (1/ rd ). In the previous example, the simple money multiplier = 1/ rd = 1/0.20 = 5. This means that an initial deposit of 5 million dollars created five times this deposit in the national economy. The total demand deposits are divided into two types: real deposits of (5) million dollars, and derived deposits of (25 - 5 = 20) million dollars. Accordingly, commercial banks can collectively create demand deposits to (20) million dollars to use in its credit activity. Derived Deposits = Real Deposits [(1 ÷ rd ) – 1] Derived Deposits = 5 [(1 ÷ 0.20) – 1] = 5 [5 - 1] = 5 x 4 = $ 20 million.

9. Drawbacks of the simple money multiplier: The simple multiplier assumes that people deposit all their money in banks without any cash leakage outside the banking system, and this matter is not accurate as people usually deposit part of their income in banks, and the other part they keep as liquidity. This liquidity ratio is called the ratio of the currency in circulation (c). c = C/Dd The simple multiplier assumes that banks are lending all the deposits they have after deducting the required reserve ratio. But in fact, the commercial banks usually keep a percentage greater than the required reserve (Excess Reserves) (ER). These constraints limit the ability of commercial banks to create credit.

10. Limitations of the Deposit Creation Process: The first model: The case of current deposits In this form we will discuss the case of only current deposits with no time deposits (the narrow concept of money supply M1) M1 = C + Dd We first will discuss the money multiplier in case of cash leakage outside the banking system without excess reserves and in the next step we will add excess reserves in our analysis.

11. Case (1): Cash leakage The monetary base (MB) refers to the sum of money issued by the central bank which includes the currency in circulation with individuals in addition to the reserves held by commercial banks. MB = C + RR (in case of no excess reserves) The money multiplier ( m1 ) measures the maximum amount of deposit money that commercial banks can create by a given unit of the monetary base. M1 = m1 MB

12. The money multiplier (m1) can be derived through these steps: Assuming that c is the ratio of the currency in circulation to the total demand deposits c = C/Dd The monetary base can be expressed by: MB = C + RR = c Dd + rd Dd MB = (c + rd ) Dd

13. The total demand deposits with can be expressed by: The currency in circulation: Then, M1 money supply is given by: M1 = C + Dd The money multiplier (m1) is represented by:

14. The money multiplier is affected by two main factors, ( rd , c). If there is no cash leakage outside the banking system (c = 0), in this case we arrive at the simple money multiplier (1/ rd ). Case (2): excess reserves If we include the excess reserves in our analysis, we get: TR = RR + ER (Total reserves) e = ER/Dd (The ratio of excess reserves)

15. TR = rd Dd + e Dd The monetary base can be expressed by: MB = C + TR = c Dd + rd Dd + e Dd MB = (c + rd + e) Dd The total demand deposits can be calculated based on the monetary base by:

16. The currency in circulation is calculated based on the monetary base by: Then, the money supply (M1) can be calculated based on the monetary base by: M1 = C + Dd Then, the money multiplier (m1) is given by:

17. Factors Affecting Money Supply (M1): Factors affecting the money supply M1 are the monetary base, the required reserve ratio, excess reserves, and the rate of leakage outside the banking system. 1- The Monetary base (MB): An increase in the monetary base leads to an increase in the ability of commercial banks to expand bank loans provided that this increase in the monetary base is used in the lending process and does not go to increasing excess reserves or to the currency in circulation with individuals.

18. 2- The required reserve ratio ( rd ): A decrease in rd increases the money multiplier and thus the ability of commercial banks to expand granting loans. 3- Ratio of currency in circulation (c): Increasing the ratio of currency in circulation means this money goes out of the money creation process and thus negatively affects the money multiplier and money supply. 4- Excess reserves ratio: Increasing excess reserves ratio negatively affects the money multiplier and thus the ability of commercial banks to grant credit.

19. Example (1): Assuming that rd = 10%, the amount of currency in circulation is $400 billion, the total demand deposits are $800 billion, and the excess reserves are $8 billion. Thus, M1 is calculated as follows: M1 = C + Dd = 400 + 800 = $ 1200 billion The cash leakage ratio is: c = C/Dd = 400/800 = 0.5 This ratio means that individuals tend to keep 50% of their money in cash outside the banking system.

20. The ratio of excess reserves is: e = ER/Dd = 8/800 = 0.01 This means that commercial banks tend to hold 1% of deposits as additional reserves. The money multiplier (m1) is: which means that a $1 increase in the size of the monetary base leads to a $2.46 increase in the money supply (M1).

21. Example (2): Assuming an increase in the rd from 10% to 15%. In this case, the money multiplier is: An increase of rd leads to a decrease of m1 (inverse relationship)

22. Example (3): Assuming that the rd = 10%, but the ratio of the currency in circulation increased to 75%, in this case m1 is: Higher ratio of currency in circulation leads to lower money multiplier (an inverse relationship).

23. Example (4): Assuming that the proportion of excess reserves increased from 1% to 5%. In this case, the m1 is: An increase in the excess reserve ratio leads to a decrease in the money multiplier (an inverse relationship)

24. The second model: The case of time deposits The money supply equation (M2) : M2 = C + Dd + Td + MMF Where: C: Currency in circulation outside the banking system. Dd: Current (demand) deposits. Td: Time and savings deposits. MMF: Mutual funds and money market deposits.

25. Total required reserves consist of: RR = rd Dd + rt Td The monetary base: (in case of no excess reserves) MB = RR + C = rd Dd + rt Td + C The money supply (M2) equation: M2 = C + Dd +Td + MMF

26. The money multiplier for broad money supply (m2) is : m2 = M2/MB

27. In the case of excess reserves, m2 is: Example (5): Assuming that rd = 20%, rt = 10%, C = $100 million, Dd = $400 million, ER = $10 million, Td = $900 million, and MMF = $800 million. Calculate the money multiplier (m2) and the money supply (M2).

28. The solution: M2 = C + Dd + Td + MMF = 100 + 400 + 900 + 800 = $ 2200 million. The money supply multiplier (m2) is: This means that an increase in the monetary base by one dollar leads to an increase in the money supply (M2) by $7.857.

29. Determinants of Money Multiplier (m2) The money multiplier (m2) depends on: • The required reserve ratio for demand deposit ( rd ). • The required reserve ratio for time deposit (rt). • Ratio of currency in circulation (c). • Excess reserve ratio (e). • The ratio of time deposits to demand deposits (Td/Dd) • The ratio of mutual funds to demand deposits (MMF/Dd).

30. Exercises: Assuming that the total demand deposits are 100 Billion dollars, and the required reserve ratio for demand deposits ( rd ) is 20%, the cash leakage ratio (c) is 25%. Calculate money in circulation outside the banking system. Calculate the monetary base MB Calculate the money supply M1 Calculate the total demand deposits, Dd, (using monetary base form) Calculate the volume of currency in circulation, C (using monetary base form)

31. f) Calculate M1 money supply (using monetary base form) g) Calculate the money multiplier m1. h) Assuming that the central bank wants to increase the money supply M1 by 20 billion dollars, what is the required increase in the monetary base to achieve this? i ) Assuming that commercial banks keep additional reserves by 10 billion dollars, what is the impact of this on the money multiplier m1, and what is your explanation for that? j) Assuming that the percentage of the currency in circulation increased to 30%, what is the effect of this on the money multiplier m1 and the money supply M1?

32. Assuming that the size of the monetary base is 42 billion dollars, the volume of currency in circulation is 30 billion dollars, the required reserve ratio for current deposits is 15%, and the volume of demand deposits is 60 billion dollars, the ratio of time deposits to demand deposits is 50%, the required reserve ratio for time deposits (rt) is 10%, and the money mutual funds are $5 billion. Then calculate: The amount of time deposits. Total reserves. The percentage of currency in circulation.

33. d) The narrow money supply M1. e) The broad money supply M2. f) The multiplier of broad money supply m2. g) Assuming that there are additional reserves at the commercial banks e = 0.10, what is the effect of this on the money supply multiplier m2?

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