14.3 A Simple Model of Multiple Deposit Creation #Notebook

14.3 A Simple Model of Multiple Deposit Creation

The central bank pretty much controls the size of the monetary base and anticipate the fluctuations, although the check clearing process and the government’s banking activities can cause some short-term flutter.

However, money consists of more than just MB. M1 also includes checkable deposits. Each $1 (or €1, etc.) of additional MB creates multiples > 1 of new deposits, a multiple deposit creation.

Suppose the Fed buys $1 million of securities from Citi Bank. 

On the Citi bank's side

Citi bank's asset -1 $1 million securities

                            +1 $1 million reserves

On the Fed's side

The Fed's asset +1 $1 million securities

The Fed's liabilities +1 $milion reserves               

*the Citi Bank suddenly has $1 million in excess reserves.

What will the bank do? Likely what banks do best: make loans. 

So, the Citi bank's balance sheets then become...

Assets: Loans +$1 million  

Liabilities: Deposits +$1 million

Deposits are created in the process of making the loan. So, the bank has effectively increased M1 by $1 million.  

As the deposits flow out of the Citi Bank, its excess reserves decline until Citi Bank has essentially swapped securities for loans:

Citi bank's Assets: Securities −$1 million, Loans +$1 million

The simple deposit multiplier isn’t very accurate. It provides an upper bound to the deposit creation process. Sometimes banks hold excess reserves, and people sometimes prefer to hold cash instead of deposits, thereby stopping the multiple deposit creation process cold. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.