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Multiple deposit creation. Here we demonstrate the principle of multiple deposit creation based on a given excess reserve. Remember that: TR = RR + ER. Thus ER = TR - RR. Initial points: "Banks create money." Banks create money when they credit the checking accounts of loan recipients.

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Multiple deposit creation

Here we demonstratethe principle ofmultiple depositcreation based on a given excess reserve

Remember that:TR = RR + ER. Thus

ER = TR - RR


Initial points:

      • "Banks create money." Banks create money when they credit the checking accounts of loan recipients.
      • By making a loan, a bank is expanding its deposit liabilities--which are money and constitute the bulk of M1.
      • The capacity of banks to make loans and hence to create money depends on their reserve position--that is, do banks have excess reserves available?
      • Federal Reserve open market operations influence the money supply by virtue of the direct and powerful impact these operations have on the reserve position of depository institutions.

Assumptions of the model:

      • The legal reserve ratio is 10% or .10
      • Banks begin and end "fully loaned up."
      • All loans are re-deposited in the banking system.
      • Cash free system, therefore: M = DD, where DD is deposit liabilities of the banking system.

Step 1

Step #1: The FED purchases $100,000 in U.S. government securities from Mrs. Green, paying with a government check. Mrs. Green deposits the government check in Ozark


Ozark National has an excess reserve of $90,000--and no other bank has lost reserves .Therefore, Ozark is positioned to make $90,000 in new loans.


Step #2: Ozark National makes a $90,000 loan to "Travel are We," who plans to use the loan proceeds to purchase new computers for its travel agents.


"Travel are We" writes a $90,000 check to Gateway computers. Gateway deposits the check to its account at Dakota Bank. We assume that the initial statement of Dakota is identical to the initial statement of Ozark National.


Step 3: Dakota now has an $81,000 excess reserve. It makes an $81,000 loan to Sodbusters, Inc. The loan will be used to purchase agricultural machinery.


Step #4 : Sodbusters makes out a check to Case Equipment Company for $81,000. Case deposits the check in their account at Ozark National.


Thus the latest transaction has created a $72,900 excess reserve for Ozark National. This is the basis for further loan expansion.


Point of the story

We stop the story here. But, if Ozark made the loan, an additional $72,900 in DDs would have been created. When the proceeds of the loan were checked away, another $65, 610 in excess reserves would have been created. And so on.


The deposit expansion multiplier

Thus potential loan expansion and money creation as a result of the initial change in excess reserves (ER) is given by:

DD= M = 90,000 + 81,000 + 72,900 + 65,610 + 59,049 + 53,144 + 47,830 + . . . + =$900,000

The process of multiple deposit creation on the basis of a given change in excess reserves is expressed by:

M = DD = 1/rr ER, where 1/rr is the deposit expansion multiplier.


Final notes

  • Note that ER = $100,000 and rr = .10. Thus the money( or deposit expansion) multiplier is 10.
  • The multiplier declines if some loan proceeds are not re-deposited in the banking system.
  • The same holds true if banks do not make loans equal to their holding of excess reserves.