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HKCE Macroeconomics

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.

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HKCE Macroeconomics

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  1. HKCE Macroeconomics • Chapter 4: Deposit Creation and Money Supply CH4-Deposit Creation & MS

  2. 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. CH4-Deposit Creation & MS

  3. Assets & Liabilities: Examples CH4-Deposit Creation & MS

  4. 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. CH4-Deposit Creation & MS

  5. 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 CH4-Deposit Creation & MS

  6. The Fractional Reserve System • 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. CH4-Deposit Creation & MS

  7. The Fractional Reserve System • 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 CH4-Deposit Creation & MS

  8. An Exercise • Below 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 CH4-Deposit Creation & MS

  9. The Fractional Reserve System • 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%. CH4-Deposit Creation & MS

  10. Assumptions behind Deposits Creation • Fractional reserve banking system exists. • No banks keep excess reserves. • No cash leakage. • Sufficient loan demand exists. • There is only demand deposits. CH4-Deposit Creation & MS

  11. 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? CH4-Deposit Creation & MS

  12. Deposits Creation: An Illustration • Step 1: $1 000 was deposited in Bank A. Bank A's balance sheet CH4-Deposit Creation & MS

  13. Deposits Creation: An Illustration • Step 2: Bank A kept 25% of $1 000 as required reserves & loans out the rest. Bank A's balance sheet CH4-Deposit Creation & MS

  14. Deposits Creation: An Illustration • Step 3: Suppose the loan of $750 was finally deposited in Bank B. Bank B's balance sheet CH4-Deposit Creation & MS

  15. Deposits Creation: An Illustration • 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 sheet CH4-Deposit Creation & MS

  16. Deposits Creation: An Illustration • 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 sheet CH4-Deposit Creation & MS

  17. Deposits Creation: An Illustration • 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. CH4-Deposit Creation & MS

  18. 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. CH4-Deposit Creation & MS

  19. Banking Multipliers • Maximum banking/money multiplier, k=1/RRR • Actual banking multiplier=1/ARR CH4-Deposit Creation & MS

  20. 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 CH4-Deposit Creation & MS

  21. Remarks on Deposits Creation • Maximum loans/credit being created =excess reserves X (1/RRR) CH4-Deposit Creation & MS

  22. 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. CH4-Deposit Creation & MS

  23. 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. CH4-Deposit Creation & MS

  24. 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 CH4-Deposit Creation & MS

  25. 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 cash • Example: • if the initial deposits=$100, RRR=0.2; then • Change in Deposits = $100X(1/0.2)=$500 • Change in M1 = $500 - $100 = $400 CH4-Deposit Creation & MS

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