Multiple Deposit Expansion

How Banks Work:

Assets	Liabilities & Equity
-Reserves ·         Required reserves (RR)→% required by Fed. To keep on hand to meet demand. ·         Excess reserves (ER)→% reserves over and above the amount needed to satisfy minimum reserve ration set by Fed. -loans to firms, consumers, and other banks (earns interest) Loans to govt=treasury securities -bank property—if bank fails, you could liquidate the building/property	-Demand Deposits ($ put into bank) -timed deposits (CD’s) -loans from: Federal reserve and other banks -Shareholders’ Equity→to set up a bank, you must invest your own $ in it to have a stake in bank’s success/failure

Reserve Requirement:

• Fed requires banks always have some $ readily available to meet consumers' demands for cash
• amount (set by Fed) is Required Reserve Ratio
• required RR is % of demand deposits (checking account balances) must NOT be loaned out
• typically RR ratio=10%

EX 1) Reserve ratio is 5%. You deposit $1000 in bank. How much is bank required to add to its reserves?

0.05x$1000=$50 in reserve ratio

How much $ can bank loan out?

1000 (deposited) - 50 (reserve ratio) = $950 loaned out to next borrower

EX 2) Scenario: 100% Reserve Banking: Now suppose households deposit $1000 @ "Firstbank"

• falls under liabilities (claims of non-owners)
• reserves=$1000 under assets (each side must balance)

**100% reserve banking has no impact on size of $ supply
EX 3) Scenario: Fractional Reserve Banking: Suppose banks hold 20% of deposits in reserve, making loans w/ the rest

-Firstbank will make $800 in loans

Assets	Liabilities
Reserves $200 Loans $800	Deposits $1000

  

-$ supply now=$1800

-depositor still has $1000 in demand deposits (but borrower now holds $800 in currency)

**In a fractional reserve banking system, banks create $.

Required Reserve Ratio:

-% of demand deposits that must be stored as vault cash or kept on reserve as Federal funds in the bank's account w/ Federal Reserve

-Required Reserve Ratio determines the $ multiplier (1/reserve ratio)

• Decreasing the reserve ratio increases rate of $ creation in banking system and is expansionary
• Increasing the reserve ratio decreases rate of $ creation in banking system and is contractionary

-changing required reserve ratio is least used tool of monetary policy and usually held constant @ 10%

Money Multiplier:
-shows us impact of change in demand deposits on loans + eventually the $ supply
-indicates total # of dollars created in banking system by each $1 addition to monetary base (bank reserves + currency in circulation)
-to calculate $ multiplier, divide 1 by required reserve ratio

$ multiplier=1/reserve ratio

EX) if reserve ratio is 25%, multiplier=4

4 Types of Multiple Deposit Expansion Questions:

• Type 1: Calculate initial change in ER aka amount a single bank can loan from initial deposit
• Type 2: Calculate change in loans in banking system
• Type 3: Calculate change in $ supply **sometimes Types 2&3 will have same result if there is no Fed involvement
• Type 4: Calculate change in demand deposits

EX 1) Given a required reserve ratio of 20%, assume Federal Reserve purchases $100 million worth of U.S. Treasury Securities on open market from a primary security dealer. Determine amount that a single bank can lend from this Fed Reserve purchase of bonds.  

the amount of new demand deposits - required reserve=initial change in ER

$100 mill. - (20% x $100 mill.) 

$100 - 20 = $80 mill. in ER

EX 2) Maximum change in loans in banking system.

initial change in ER x $ multiplier=max change in loans

$80 mill. x (1/20%)

$80 mill. x 5 = $400 mill. max in new loans 

EX 3) Maximum change in $ supply.

maximum change in loans + $ amount of Federal Reserve action

$400 mill. + $100 mill.=$500 mill. max change in $ supply

EX 4) Maximum change in demand deposits.

maximum change in loans + $ amount of initial deposit

$400 mill. + $100 mill. = $500 mill. max change in demand deposits