The Banking System: Multiple Expansion of The Money Stock

Multiple Expansion of The Money Stock The truly amazing fact is that the entire banking system can create checkable deposits by an amount equal to a multiple of existing reserves available to all banks. To see how this process works, we need to trace the progress of newly created checkable deposits resulting from loans as they filter their way down through many banks. Suppose the deposits that the Denver bank received during its first week of operation increases total reserves for the banking system by $10 million. This would be the case if the $10 million in new deposits was of currency from the mattresses of local misers! The $10 million in deposits would then increase excess reserves in the banking system by $8 million. In the previous section we saw how this $10 million in deposits supported $8 million of newly created checkable deposits as the Denver bank loaned out its excess reserves. To see how these initial deposits can support still more loans and more money creation, assume that all of the $8 million of new checkable deposits created by the Denver bank is deposited in the Detroit bank. The table in Box 4 shows the changes in assets and liabilities of the Detroit bank. The $8 million increases the Detroit bank's liabilities by $8 million. As the deposited checks clear, the Detroit bank's reserves also increase by $8 million as $8 million in deposits at the Federal Reserve bank is transferred from the Denver bank's account to the Detroit bank's account. Remember that the deposits the banks hold at their district Federal Reserve banks constitute the bulk of their reserves. The Detroit bank must hold 20 percent of its new reserves as required reserves against its $8 million in new deposits. This amounts to $1.6 million. The remaining $6.4 million is excess reserves that can be loaned out. The initial $10 million in deposits at the Denver bank that already has supported $8 million in loans can now be used to support an additional $6.4 million in loans. As the Detroit bank makes these loans, it will create checkable deposits equal to $6.4 million for its clients, assuming it loans out all its excess reserves. The total expansion in the money stock as a result of the initial $10 million increase in bank reserves is now 58 million plus $6.4 million, which equals $14.4 million. The process of expansion doesn't stop here! As the checkable deposits created by the Detroit bank are spent by the people who obtain the loans, they will be deposited in other banks, increasing the reserves of still more banks and allowing sand moving additional money creation. For example, suppose all of the $6.4 million is deposited in a New York bank. After the checks clear, the New York bank will find that both its deposits and its total reserves have increased by $6.4 million. This bank must keep 20 percent of these funds, which is $1.28 million in required reserves, and can loan out amounts up to the excess reserves of $5.12 million as newly created checkable deposits. The initial change in the New York bank's balance sheet is shown in Box 5. Assuming the New York bank loans out all its excess reserves, the money stock will increase by an additional $5.12 million. The Money Creation Process By now you can probably see how the process works. At each stage, as a result of new loans made by banks, the initial $10 million injection of reserves allows more money creation. However, at each stage the loans that can be made become smaller and smaller, because only 80 percent of the deposits created from new loans end up as excess reserves that can be used to make more loans. The increase in checkable deposits becomes smaller and smaller as the funds work their way through the banking system. Eventually the new loans that can be made approach zero. The table in Box 6 shows how newly created checkable deposits at each stage decline, assuming that all excess reserves created at each stage of redeposit of loan proceeds are used to make new loans. It's also assumed, in the process of deposit and redeposit of checks among banks, that no reserves leak out of the banking system. For example, at each stage some of the people presenting checks to the banks may not deposit the full amount in their checking accounts. Instead they may ask the bank to give them a portion of the funds in currency. If the currency is held by customers instead of being deposited in banks, the growth of excess reserves at each stage will be less and the amount of new checkable deposits that can be created will also be less. The sum of additional deposits eventually reaches a limit as the additional excess reserves for the banking system that result from redeposit of funds eventually approach zero. The table in Box 6 shows how additional checkable deposits fall to $4.10 million when the checks drawn on the New York bank's $5.12 million of deposits are deposited in a Chicago bank. The table also shows how the maximum amount of checkable deposits that can be created becomes smaller as the Chicago bank makes loans and as the funds are then deposited in a St. Louis bank. The last column traces out the process for a number of other stages and shows how the maximum sum of new checkable deposits that can be created approaches $40 million when banks find it profitable to loan out all the excess reserves they acquire at each stage of the process.