11.3 Money Creation by the Banking System

Question 1

What does money supply include?

Answer 1

Money supply includes both currency and deposits at commercial banks

Question 2

What are the three assumptions we will make in this section in order to focus on the essential aspects how how commercial bankes create money.

Answer 2

• Suppose that banks have only one kind of asset—loans—and they have only one kind of deposit.
• No excess reserves. We assume that all banks choose to lend out any reserves in excess of their target reserves, which we assume are a fixed ratio of total deposits. loans.
• No cash drain from the banking system. We also assume that the public holds a fixed absolute amount of the currency in circulation, whatever the level of their bank deposits.

Later on we will assume that the amount of currency held by the public grows as total bank deposits grow. This is called a cash drain.

Question 3

TD balence sheet

Answer 3

Question 4

What is a “new” deposit?

Answer 4

By “new,” we mean a deposit of cash that is new to the commercial banking system. There are three examples:

-An individual might immigrate to Canada and bring cash. When that cash is deposited into a commercial bank, it constitutes a new deposit to the Canadian banking system.

• An individual who finds some long-forgotten cash stashed under their bed or in a closet has now decided to deposit it into an account at a commercial bank.

-If the Bank of Canada were to purchase a government security from an individual or from a firm, it would purchase that asset with a cheque drawn on the Bank of Canada. When the individual or firm deposits the cheque with a commercial bank, it would be a new deposit to the commercial banking system.

Question 5

What is an important point to keep in mind regarding the process of money creation by commercial banks?

Answer 5

The important point to keep in mind here is that the source of the new deposit is irrelevant to the process of money creation by the commercial banks.

Question 6

Why is the purchase of securities from individuals or firms resulting in new deposits?

Answer 6

Suppose the Bank of Canada enters the open market and buys $100 worth of Government of Canada bonds from John Smith. The Bank issues a cheque to Smith, who then deposits the $100 cheque into his account at TD. This $100 is a wholly new deposit for the commercial bank

Question 7

Why would a bank choose to loan out its excess resrves as oposed to holding it in reserves?

Answer 7

TD now chooses to lend the $80 in excess reserves that it is holding because it will earn more interest on a new loan than it will earn on its reserves.

Question 8

What happens when the bank loans out its access reserves?

Answer 8

As it lends the $80, it increases its loan portfolio by $80 but reduces its reserves by the same amount. Table 11-5 shows TD’s balance sheet after this new loan is made. Notice that TD has restored its reserve ratio to 20 percent, its target reserve ratio.

Question 9

What is the result on other banks from a loan givin to an individual?

Answer 9

As a result, other banks have received new deposits of $80 stemming from the loans made by TD; persons receiving payment from those who borrowed the $80 from TD will have deposited those payments in their own banks.

Question 10

What do we call banks that receive deposits from the proceeds of an initial banks loan?

Answer 10

The banks that receive deposits from the proceeds of TD’s loan are called second-round banks, third-round banks, and so on.

Question 11

What is the dominio effect of new deposits resulting from a long from an intial bank?

Answer 11

In this case, the second-round banks receive new deposits of $80, and when the cheques clear, they have new reserves of $80.

Because they desire to hold only $16 in additional reserves to support the new deposits, they have $64 of excess reserves.

They now increase their loans by $64.

After this money has been spent by the borrowers and has been deposited in other, third-round banks, the balance sheets of the second-round banks will have changed, as in Table 11-6.

Question 12

The Sequence of Loans and Deposits After a Single New Deposit of $100

Answer 12

Question 13

When can the banking system as a whole create deposit money?

Answer 13

The banking system as a whole can create deposit money whenever it receives new deposits.

Question 14

With no cash drain to the public, how much will the banking system as a whole eventually increase deposits?

Answer 14

With no cash drain to the public, the banking system as a whole eventually increases deposits by 1/v

Question 15

If v is the target reserve ration, how much will a new deposit to the banking system increase the total amount of deposits?

Answer 15

If v is the target reserve ratio, a new deposit to the banking system will increase the total amount of deposits in the system by

1/v

times the new deposit.

Question 16

How much can a banking system with a target reserve ration of v change its deposits?

Answer 16

With no cash drain from the banking system, a banking system with a target reserve ratio of v can change its deposits by 1/v times any change in reserves.

Question 17

Formula for a change in deposits

Answer 17

Question 18

What happens when there is a withdrawl of funds?

Answer 18

The “multiple expansion of deposits” that we have just described applies in reverse to a withdrawal of funds.

Deposits of the banking system will fall by 1/v times the amount withdrawn from the banking system creating a “multiple contraction of deposits.”

Question 19

What happens if banks choose to not lend their excess reserves?

Answer 19

If banks choose to not lend their excess reserves, the multiple expansion that we discussed will not occur.

Question 20

What are risky situations where a bank may not be willing to loan out their excess reserves?

Answer 20

It is one thing to be offered a good rate of interest on a loan, but if the borrower defaults on the payment of interest and principal, the bank will be the loser.

Similarly, if the bank expects interest rates to rise in the future, it may hold off making loans now so that it will have reserves available to make more profitable loans after the interest rate has risen.

Question 21

Does deposit creation happen automatically?

Answer 21

Deposit creation does not happen automatically; it depends on the decisions of bankers. If commercial banks choose not to lend their excess reserves, there will not be a multiple expansion of deposits.

Question 22

What are some things that influences commercial banks addition to money supply?

Answer 22

Money supply is partly determined by the commercial banks—in response, for example, to changes in national income, interest rates, and expectations of future business conditions.

Question 23

How do we alter our assumption about people holding a fixed number of dollars?

Answer 23

instead of holding a fixed number of dollars, people decide to hold an amount of cash equal to a fixed fraction of their bank deposits.

Question 24

How does cash effect the amount of money in the banking system?

Answer 24

For example, people may choose to hold an average of 10 percent of the value of their bank deposits in the form of currency in their wallets. In this case, an extra $100 that now gets injected into the banking system as a new cash deposit will not all stay in the banking system. As the amount of deposits multiplies, 10 percent of those deposits will be added to the cash held by the public.

In such a situation, any multiple expansion of bank deposits will be accompanied by what is called a cash drain to the public. This cash drain will reduce the multiple expansion of bank deposits in exactly the same way that taxes and imports reduced the value of the simple multiplier

Question 25

If c is the ratio of cash to deposits that people want to maintain, the final change in deposits will be given by

Answer 25

Question 26

When the cash drain gets larger, what is affected?

Answer 26

The larger is the cash drain from the banking system, the smaller will be the total expansion of deposits created by a new cash deposit.

Question 27

What is a more realistic percentage for reserves and cash drains in Canada?

Answer 27

Canadian commercial banks hold reserves equal to roughly 3 percent of their deposit liabilities. A realistic value for the cash-deposit ratio in Canada is roughly 5 percent—indicating that firms and households hold cash outside the banks equal to 5 percent of the value of their bank deposits.