The Banking System: Deposit Contraction The Process in Reverse

Deposit Contraction The Process in Reverse The banking system's capacity to create money by making loans is impaired if its reserves are reduced. Suppose misers decide to withdraw $10 million in deposits from banks to stuff back into their mattresses. There will be no change in the money stock at first. The amount of checkable deposits will decline by $10 million, but the amount of currency will increase by the same amount even if the currency stays in mattresses. However, bank reserves will also decline by $10 million as a result of the withdrawal of currency that is not redeposited into the banking system. The $10 million withdrawal from the banking system reduces excess reserves by $8 million. If the banking system is fully loaned up, it will have to obtain more reserves to make up for its loss or will have to reduce the amount of loans it has outstanding or securities it holds. Certain types of loans can be called in. This means the bank tells the borrowers they must repay their loans. As loans are repaid, the banks in the system find that their deposits decline and the required reserves they must hold also decline. Of course, if there are excess reserves in the system, the decline in deposits won't be as drastic. In practice, banks rarely have to "call in" loans when reserves fall. There's a constant turnover of loans as old loans are paid off and new loans are negotiated. The decline in reserves caused by the withdrawal will force the banks in the system to refuse to renew existing loans as their terms expire. The banks will also make fewer new loans than they would have otherwise as existing loans are paid off. Finally, banks typically supply credit in an impersonal way by buying government securities and other notes of indebtedness. Banks can easily and quickly obtain additional reserves to meet their reserve requirements by selling securities they hold. If government securities are sold to the Federal Reserve banks, the banks will be credited with an increase in deposits that serve as reserves at the district Federal Reserve banks. Assuming a required reserve ratio of 0.2, the maximum reduction in the money stock, AM, resulting from an $8 million withdrawal of excess reserves from the banking system will be: The maximum decline in the money stock that results from the $10 million withdrawal from the banking system will therefore be $40 million. Of course, the decline in checkable deposits will be less if the banking system has excess reserves than would be the case when the bank is fully loaned up. Bank Demand for Excess Reserves Why might banks choose to hold excess reserves rather than use them to create checkable deposits for loan customers? Although they give up the opportunity to earn interest income by holding excess reserves, one reason banks do so is to meet expected deposit outflows. They then don't have to call in loans, sell securities, or borrow to meet expected deposit outflows. If they anticipate a heavy net outflow of deposits, banks may retain more excess reserves so they will be prepared to meet that demand. When excess reserves are on hand, they avoid the transaction costs of obtaining the funds in other ways. The savings realized by avoiding these transaction costs often more than offset the foregone interest income on the excess reserves. A bank's opportunity cost of holding each dollar of excess reserves is the interest income it forgoes by not lending that dollar out. Naturally, the higher the interest rate, the lower the quantity of excess reserves demanded. The lower the interest rate, the greater the willingness of banks to hold excess reserves. Remember that banks are motivated to make profits. During a recession, interest rates typically decline and business failures tend to rise. It's both less profitable and riskier for banks to make loans in periods of economic downturn than during periods of recovery when aggregate demand and real GNP are increasing. During a recession, banks are therefore more likely to hold excess reserves because lower interest rates and increased risk of loan defaults make lending money less proftable. Similarly, they're less likely to hold excess reserves in periods of recovery when interest rates increase and the risk of loan default declines. The graph in Box 7 illustrates the downward-sloping bank demand curve for excess reserves and shows how changes in the market rate of interest affect bank holdings of excess reserves. The cyclical fluctuation in bank demand for excess reserves has important implications for the money stock. The more excess reserves that banks hold, the smaller the money stock, because the banks don't create the maximum possible amount of checkable deposits by making loans. For example, if the required reserve ratio is 0.1, each dollar increase in excess reserves held by banks rather than used to make loans or buy securities will prevent the money stock from increasing by $10! During recessions, when banks seek to increase the excess reserves they hold, there will be downward pressure on the money stock. Because, as you'll soon see, the available stock of money influences aggregate demand, the resulting decline in money could further decrease aggregate demand during the recession, thereby causing a further decline in real GNP. By the same token, the eagerness of banks to make loans with their excess reserves during periods of peak economic activity tends to increase the money stock. This puts upward pressure on aggregate demand and can contribute to inflation. The profit-motivated banking system can therefore cause destabilizing swings in aggregate demand that exaggerate the ups and downs of the business cycle. In an attempt to minimize the swings, the Federal Reserve System seeks to manage the total reserves available to the banking system. The role of the Federal Reserve in influencing the money stock in this way is the subject of the following chapter.