Banks role in the money supply

The money supply equals currency

plus
demand (checking account)
deposits:
M = C + D
Since the money supply includes
demand deposits, the banking
system plays an
important role.
slide 1
A few preliminaries

Reserves (R ): the portion of

deposits that banks have not lent.
A banks liabilities include deposits,
assets include reserves and
outstanding loans.
100-percent-reserve banking: a
system in which banks hold all
deposits as reserves.
Fractional-reserve banking:
slide 2
Banks role in the money supply

To understand the role of banks, we

will consider three scenarios:
1. No banks
2. 100-percent reserve banking
(banks hold all deposits as
reserves)
3. Fractional-reserve banking
(banks hold a fraction of deposits
as reserves, use the rest to make
slide 3
 SCENARIO 1:
No banks

With no banks,
D = 0 and M = C =
Rs1000.

slide 4
 SCENARIO 2:
100-percent reserve banking

Initially C = Rs1000, D = Rs 0, M = Rs1,000.

Now suppose households deposit the Rs1,000 at
Firstbank.
After the deposit:
C = Rs0,
FIRSTBANKS D = Rs1,000,
balance sheet M = Rs1,000
Assets Liabilities LESSON:
reserves deposits 100%-reserve
Rs1,000 Rs1,000 banking has no
impact on size of
money supply.

slide 5
 SCENARIO 3:
Fractional-reserve banking

Suppose banks hold 20% of deposits in reserve,

making loans with the rest.
Firstbank will make Rs800 in loans.
The money supply
FIRSTBANKS
now equals
balance sheet Rs1,800:
Assets Liabilities
Depositor has
reserves Rs200 deposits Rs1,000 in
Rs1,000
loans Rs800 demand
deposits.
Borrower holds
Rs800 in
currency. slide 6
SCENARIO 3:
Fractional-reserve banking

Suppose the borrower deposits the Rs800 in

Secondbank.
Initially, Secondbanks balance sheet is:

SECONDBANKS Secondbank will

balance sheet loan 80% of this
Assets Liabilities deposit.

reserves deposits Rs800

Rs800
Rs160
loans Rs640

slide 7
SCENARIO 3:
Fractional-reserve banking

If this Rs640 is eventually deposited in Thirdbank,

then Thirdbank will keep 20% of it in reserve,
and loan the rest out:

THIRDBANKS
balance sheet
Assets Liabilities
reserves deposits Rs640
Rs640
Rs128
l
loans Rs512

slide 8
Finding the total amount of money:

Original deposit = Rs1000

+ Firstbank lending = Rs 800
+ Secondbank lending = Rs 640
+ Thirdbank lending = Rs 512
+ other lending

Total money supply = (1/rr ) Rs1,000

where rr = ratio of reserves to deposits
In our example, rr = 0.2, so M = Rs5,000

slide 9
Money creation in the banking
system

A fractional reserve banking system creates

money, but it doesnt create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.

slide
A model of the money supply

exogenous variables

Monetary base, B = C + R
controlled by the central bank
Reserve-deposit ratio, rr = R/D
depends on regulations & bank
policies
Currency-deposit ratio, cr = C/D
depends on households
preferences
slide
The money multiplier

cr 1
M m B, where m
cr rr
If rr < 1, then m > 1
If monetary base changes by
B,
then M = m B
m is the money multiplier,
the increase in the money
supply resulting from a one-
dollar increase slide
Why the Central Bank cant
precisely control M
cr 1
M m B , where m
cr rr
Households can change cr,
causing m and M to change.
Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves,
then rr, m, and M change.

slide
 Application: The Great Depression
Bank Panics, 1930 - 1933.

Bank failures (and no deposit insurance)

determined:
Increase in deposit outflows and holding of
currency (depositors)
An increase in the amount of excess reserves
(banks)
For a relatively constant MB, the money
supply decreased due to the fall of the
money multiplier.

17-14
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 FIGURE 2 Excess Reserves Ratio
and Currency Ratio, 19291933

Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867
1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

17-15
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 FIGURE 3 M1 and the Monetary
Base, 19291933

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 18671960 (Princeton, NJ:
Princeton University Press, 1963), p. 333.

17-16
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CASE STUDY:
Bank failures in the 1930s

From 1929 to 1933:

over 9,000 banks closed
money supply fell 28%
This drop in the money supply may
have caused the Great Depression,
but certainly contributed to its
severity.

slide
CASE STUDY:
Bank failures in the 1930s
cr 1
M m B, where m
cr rr
Loss of confidence in banks
cr m
Banks became more cautious
rr m

slide
Bank capital, leverage, and capital
requirements
Bank capital: the resources a banks
owners have put into the bank
A more realistic balance sheet:

Liabilities and
Assets
Owners Equity
Rs20 Rs75
Reserves Deposits
0 0
Rs50 Rs20
Loans Debt
0 0
Capital
Rs30
Securities (owners Rs50
0
equity) slide
Bank capital, leverage, and capital
requirements
Leverage: the use of borrowed money to
supplement existing funds for purposes of
investment
Leverage ratio = assets/capital
= (Rs200+500+300)/Rs50 = 20
Liabilities and
Assets
Owners Equity
Rs20 Rs75
Reserves Deposits
0 0
Rs50 Rs20
Loans Debt
0 0
Capital
Rs30
Securities (owners Rs50
0
equity) slide
Bank capital, leverage, and capital
requirements
Being highly leveraged makes banks
vulnerable.
Example: Suppose a recession causes our
banks assets to fall by 5%, to Rs950.
Then, capital = assets liabilities = 950
Liabilities and
950 = 0Assets Owners Equity
Rs20 Rs75
Reserves Deposits
0 0
Rs50 Rs20
Loans Debt
0 0
Capital
Rs30
Securities (owners Rs50
0
equity) slide
The lesson is simple: When financial intermediaries have a lot of
capitalequivalently when their leverage is lowthey can absorb
losses without going bankrupt. But when they have little capital, when
they are highly leveraged, even small losses can lead to bankruptcy.

As the example we just saw also makes clear, leverage also increases
risk: The higher the leverage, the more likely the bank is to go
bankrupt. What happened in the 2000s is that banks decided to get a
higher return and thus to take on more risk as well.
 When the value of their assets fell,
some banks with high leverage went
bust. These obviously stopped
lending.
But also the banks which had enough
capital and survived started
worrying. In order to survive, they
had used almost all their capital and
were now alive but weak.
 First, they tried to raise more capital, but
this was not easy because a crisis is not a
good time to convince people to invest in a
bank.
Second, they reduced the amount of loans
they were holding, which means making
fewer new loans and not renewing those
that could be stopped.
Third, they sold other liquid assets (mostly
stocks) at whatever price they could get
Impact of Crises On India
The initial impact of the crisis was in fact positive as
FII flows accelerated during Sept 07 to Jan 08
This was from the belief that emerging economies
could remain largely unaffected and provide
alternative engines of growth
The argument soon proved unfounded as the global
crisis intensified and spread to the emerging
economies through capital and current account of
the balance of payments.
This resulted in negative net portfolio flows to India
with a knock-on effect on stock market and
exchange rates
 Tools of Monetary Policy
Open market operations
Affect the quantity of reserves and the monetary base
Changes in borrowed reserves
Affect the monetary base
Changes in reserve requirements
Affect the money multiplier
Monetary policy conducted in India mainly through
the liquidity adjustment facility

18-27
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 Open-Market Operations

An expansionary open-market purchase of

a bond for Rs100 increases the base by
Rs100 and the money supply by Rs100
times the multiplier (=Rs165 for a
multiplier = 1.65)
A defensive open-market operation
prevents the money supply from changing
when, for example, the money multiplier
falls
Open-market operations are the most
heavily used of the Central Banks slide
 The LAF helped to develop interest rate as an
instrument of monetary transmission.
Main instruments repo, reverse repo and marginal
standing facility rate.
A repurchase agreement is an operation committing
the seller of the security to repurchase it at a later
date. In the case of repo transactions the central
bank buys securities from dealers under an
agreement for dealers to repurchase them at a
certain date.

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 The central bank uses reverse repurchase
agreement when it conducts open market
sales.
Repo and reverse repos are used to smooth
out temporary fluctuations.
When the central bank permanently wants to
change the level of bank reserves it engages
in outright purchase and sales.

18-30
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 In other words you can always borrow from
the RBI at the repo rate and lend to the RBI
at the reverse repo rate.
A new Marginal Standing Facility (MSF) was
instituted under which scheduled commercial
banks (SCBs) could borrow overnight at their
discretion up to one per cent of their
respective NDTL(net demand and time
liabilities) at 100 basis points above the repo
rate

18-31
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 There is a corridor that is defined with a
fixed width of 200 basis points. The repo
rate was placed in the middle of the corridor,
with the reverse repo rate 100 basis points
below it and the MSF rate 100 basis points
above it.
The weighted average overnight call money
rate was explicitly recognized as the
operating target of monetary policy

18-32
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 Direct Credit controls in India are of three
types
Interest rates on small savings and
provident funds are administratively set.
Banks are to keep 25% of their deposits in
the form of government securities as a
mandatory requirement. This is called SLR
Banks are required to lend to the priority
sectors to the extent of 40% of their loand
made.
18-33
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