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Process of Multiple Deposit Creation in a Fractional Reserve Banking System

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Title: Process of Multiple Deposit Creation in a Fractional Reserve Banking System Author: Dolly Last modified by: Dolly Created Date: 9/24/2002 8:55:09 AM – PowerPoint PPT presentation

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Title: Process of Multiple Deposit Creation in a Fractional Reserve Banking System


1
Process of Multiple Deposit Creation in a
Fractional Reserve Banking System
2
Assumptions
  • 1. Fractional reserve system
  • Minimum reserve ratio / legal reserve ratio e.g.
    20 of the total deposits.
  • Banks do not hold excess reserves

3
Assumptions
  1. No cash leakages ( loans made by a bank will
    return to the banking system. )
  1. Adequate qualified borrowers ( enough investment
    opportunities )
  1. One type of deposits

4
Why do banks need to keep minimum reserves?
  • Banks keep minimum reserves because
  1. They are required by the law to do so.
  1. Banks keep minimum reserves to meet the normal
    withdrawal of the depositors.

5
What are minimum reserves?
  • Minimum reserves refer to the minimum amount of
    reserves/reserves required by the law that a bank
    must keep to meet the withdrawal of the
    depositors.
  • The amount depends on the legal reserve ratio and
    the amount of deposits.

6
How to calculate the amount of minimum reserves?
  • Suppose a bank receives a new deposit of 5000
    and the minimum reserve ratio is 25.

The minimum amount of deposits kept by the bank
5000 ( 25 ) 1250
7
What are excess reserves?
  • Excess reserves
  • Actual reserves minimum reserves

New deposit 5000 and minimum reserve ratio
25 Minimum reserves 5000( 25 )
1250 Excess reserves 5000 - 1250 3750
8
A Banks Balance Sheet
  • Liabilities
  • Deposits
  • Assets include
  • Reserves ( in the form of cash or very liquid
    assets ) kept in banks
  • Loans
  • Investment

9
Process of Deposit creation
  • Assumptions Revisited
  1. Minimum reserve ratio, e.g. 20 of deposits
  1. No cash leakage
  1. Adequate investment opportunities/enough
    qualified borrowers
  1. One type of deposits

10
Process of Deposit Creation
  • New deposits 1000
  • Mr.
  • deposits 1000 cash in Bank A.

Minimum reserve ratio 20
11
Bank As Balance Sheet Immediate effect ( New
deposits )
  • Balance Sheet

Liabilities
Assets
Reserves
Deposits
1000
1000
12
Bank A
  • Minimum reserves 1000 ( 20 ) 200
  • Excess reserves 1000 - 200 800
  • Excess reserves are loaned out. 800 loan made to
    a borrower will be deposited to his bank, say
    Bank B.

13
Bank As Balance Sheet after loaning out excess
reserves
Bank As Balance Sheet
Assets
Liabilities
Minimum reserves
Deposits
200
1000
800
Loans
14
Bank B gains a new deposit of 800
15
Bank Bs Balance Sheet Immediate effect ( New
deposits )
Balance Sheet
Assets
Liabilities
Reserves
Deposits
800
800
16
Bank B
  • Minimum reserves 800 ( 20 ) 160
  • Excess reserves 800 - 160 640
  • Excess reserves are loaned out. 640 loan made to
    a borrower will be deposited to his bank, say
    Bank C.

17
Bank Bs Balance Sheet after loaning out excess
reserves
Bank Bs Balance Sheet
Assets
Liabilities
Minimum reserves
Deposits
160
800
640
Loans
18
Bank C gains a new deposit of 640
19
Bank Cs Balance Sheet Immediate effect ( New
Deposits )
Balance Sheet
Assets
Liabilities
Reserves
640
640
Deposits
20
Bank C
  • Minimum reserves 640 ( 20 ) 128
  • Excess reserves 640 - 128 512
  • Excess reserves are loaned out. 512 loan made to
    a borrower will be deposited to his bank, say
    Bank D.

21
Bank Cs Balance Sheet after loaning out excess
reserves
Bank Cs Balance Sheet
Assets
Liabilities
Minimum reserves
128
Deposits
640
Loans
512
22
The process goes on and on ..
23
Summary of the above balance sheets
Minimum reserves
Deposits
Loans
Bank A
1000
200
800
Bank B
640
800
160
Bank C
640
128
512
on and on
24
Maximum Amount of Deposits Created
  • Maximum amount of deposits created
  • 1000 800 640 512
  • 1000 ( 1 0.8 0.82 0.83 0.84 . )
  • 1000 ( 1/1-0.8 )
  • 1000 ( 1/0.2 )

25
Maximum Amount of Deposits Created
  • Maximum amount of deposits created
  • Initial deposits ( 1/minimum reserve ratio )

Maximum Banking Multiplier 1/minimum reserve
ratio
26
Does the supply of money change?
Yes! But Why?
Bank deposits are components of money supply.
When more deposits are created, the money supply
also increases.
But by how much ?
27
Is the increase in money supply the same as the
amount of deposits created?
  • It depends on the source of the initial deposits!

28
If the initial deposit comes from money in
circulation, then
  • the maximum increase in money supply is smaller
    than the maximum increase in total deposits.

29
Initial deposit 1000 ( cash in circulation,
before being deposited in Bank A)
  • The maximum increase in deposits is 5000.
  • The maximum increase in money supply is 5000 -
    1000 4000

30
If the initial deposit does not come from money
in circulation, then
  • the maximum increase in money supply is the same
    as the maximum increase in total deposits.

31
Initial deposit 1000 ( e.g. 1000 brought into
the economy by a ???? ?? from the US )
  • The maximum increase in deposits is 5000.
  • The maximum increase in money supply is also 5000

32
What if ?
33
Limitations to the process of multiple deposit
creation
  1. What if banks keep excess reserves ?

34
Limitations to the process of multiple deposit
creation
  • What if there are cash leakages?

35
Limitations to the process of multiple deposit
creation
  • What if there are not enough qualified borrowers?

36
Process of Multiple Deposit Contraction in a
Fractional Reserve Banking System
  • What happens to the total deposits of the banking
    system if a depositor withdraws money from the
    bank, assuming the banking system is fully loaned
    up?
  • How will the change in bank deposits affect the
    money supply?

37
END
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