by mr. lau san-fatch4-deposit creation & ms1 hkce macroeconomics chapter 4: deposit creation and...

By Mr. LAU san-fat CH4-Deposit Creation & MS 1

HKCE Macroeconomics

Chapter 4: Deposit Creation and Money Supply


Assets and Liabilities of a bank

Assets: Anything owned by a bank is an asset. Liquid assets are easily converted into

cash, e.g. cash and short-term loans. Illiquid/Fixed assets cannot be converted

into cash within a short period of time, e.g. estate and office premises.

Liabilities: Anything borrowed from others is

liability.


Assets & Liabilities: Examples

Assets LiabilitiesAmount due from

authorized institutionsCashNegotiable CD heldBonds Investment in

shareholdingsInterest in land &

buildings

Amount due to authorized institutions

Deposits from customers

Negotiable CD outstanding

Amount due to banks abroad


Deposits & Money Supply

Bank deposits are the largest component of money supply.Banks increase money supply by engaging in deposit creation.Money supply will however be contracted if banks engage in deposit withdrawals.


The Fractional Reserve System

A fractional reserve system means that banks are required by law to keep a given fraction of their total deposits (Dd) as required or legal reserves.(Minimum) Required reserves (RR) are the minimum amount of liquid assets (e.g. cash & CDs) that must be kept in banks for withdrawals or emergency purposes.Excess reserves (ER) are the amount in excess of the required reserves.Thus, Dd=RR+ER, RR=Dd-ER, & ER=Dd-RR



The minimum required reserve ratio (RRR) is the the minimum fraction of a bank's total deposits required by law to be kept in the form of cash or other liquid assets. Thus, RRR=RR/Dd.

However, for the prudent/conservative purpose or insufficient loan demand, the actual reserves (AR) kept by a bank may eventually more than the required amount.



The actual reserves ratio (ARR) is found by dividing actual reserves by total deposits. Thus, ARR=AR/Dd.

If the actual reserves is larger than the required reserves, excess reserves were actually kept in the banking system.

Excess reserves actually kept=AR-RR


An ExerciseBelow is a bank's balance sheet with the RRR=20%.

Find: RR=RRRXDd=0.2X100=20 AR=liquid assets kept in the bank=40 ARR=AR/Dd=40/100=0.4 AER(or excess reserves)=AR-RR=40-20=20

Assets($) Liabilities($)CashLoans & Advances

4060

Deposits 100



Cash reserve ratio specifies the minimum fraction of a bank's total deposits that is required by law to be kept in the form of cash.

Liquidity ratio = (short-term liquid assets/short-term liabilities)X100%

In HK, all authorized institutions are required to meet the minimum monthly average liquidity ratio of 25%.


Assumptions behind Deposits Creation

1. Fractional reserve banking system exists.

2. No banks keep excess reserves.3. No cash leakage.4. Sufficient loan demand exists.5. There is only demand deposits.


Deposits Creation: An Illustration

Assumptions: There are 3 banks: Bank A, B & C. An initial amount of $1 000 was

deposited in Bank A. The min. reserve ratio is 0.25.

The Question: What will be the maximum amount of

deposits created out of the initial deposits of $1 000?



Step 1: $1 000 was deposited in Bank A.

Bank A's balance sheetAssets($) Liabilities($)Cash +1000 Deposits +1000



Step 2: Bank A kept 25% of $1 000 as required reserves & loans out the rest.

Bank A's balance sheetAssets($) Liabilities($)CashLoans

250+750

Deposits +1000



Step 3: Suppose the loan of $750 was finally deposited in Bank B.

Bank B's balance sheet

Assets($) Liabilities($)Cash +750 Deposits +750



Step 4: Bank B has to keep 25% of the total deposits as its required reserves and used the rest for loans.

Bank B's balance sheetAssets($) Liabilities($)CashLoans

187.5+562.5

Deposits 750



Step 5: Let Bank C receive $562.5. After keeping 25% of the new deposits, $421.9 will be loaned out.

Bank C's balance sheetAssets($) Liabilities($)CashLoans

+140.6+421.9

Deposits +562.5



Step 6: Total deposits being created by Banks A, B & C=$(1 000+750+562.5)=$2 312.5

Another bank follows the same suit: receiving a certain amount of new deposits, keeping the min. required reserves, & lending the rest.The process goes on until the decreasing deposits becomes zero.Deposits is said to be created in the sense of accounting.


Deposits Creation: Theoretical Process

Step 1: Under the fractional reserves system, a bank will keep a fraction as the required reserves of a new deposits and lend the rest. Step 2: The amount of loans will finally be re-deposited into the same or another bank. That bank will also keep a fraction as the required reserves and loan the rest out.Step 3: The process of receiving new deposits, keeping the required reserves and lending the rest will go on and on, until the decreasing deposits becomes zero.


Banking Multipliers

Maximum banking/money multiplier, k=1/RRRActual banking multiplier=1/ARR


Remarks on Deposits Creation

Maximum deposits being created =initial deposits X (1/RRR)However, if banks keep excess reserves, the maximum deposits being created is lesser as less money is lent out and re-deposited.Thus, the total deposits being actually created =initial deposits X (1/ARR)Total change in deposits in the banking system =deposits created + original total deposits


Remarks on Deposits Creation

Maximum loans/credit being created =excess reserves X (1/RRR)


Limitations of Deposits Creation

Cash leakage will reduce the amount of deposits being created.Banks keep excess reserves will also reduce the deposits being created.Insufficient demand for loans will decrease the amount of deposits being created.Full reserves baking system will, however, prohibit the process multiple creation of deposits from happening. Then the deposits being created is equal to the initial deposits.


Withdrawals/Contraction of Deposits

Step 1: If there is a withdrawal of deposits from a bank, the bank reserves will fall short of the legal requirement.Step 2: The bank will then call back loans or sell assets to get enough reserves.Step 3: To repay the loans or to buy assets, customers will further withdraw deposits from the other banks.Step 4: Withdrawals make bank reserves less than the legal requirement. Banks continue to call back loans. The process goes on and on.


Remarks on Deposits Contraction

Maximum deposits being withdrawn =initial withdrawal X (1/RRR)However, if banks keep excess reserves, the maximum deposits being contracted is less than expected.Thus, the total deposits being withdrawn =initial withdrawal X (1/ARR)Total change in deposits in the banking system = original total deposits - deposits withdrawn


Deposits Creation and Change in Money Supply

If the initial deposits comes from currency in public circulation or cash, the change in deposits will be larger than the change in money supply.Thus, change in M1 =deposits created – fall in cashExample: if the initial deposits=$100, RRR=0.2; then Change in Deposits = $100X(1/0.2)=$500 Change in M1 = $500 - $100 = $400

by mr. lau san-fatch4-deposit creation & ms1 hkce macroeconomics chapter 4: deposit creation and...

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