Lecture 12: Multiple Deposit Creation & Money Supply Process

4 Players in the Money Supply Process

Central bank
The government agency that oversees the banking system that is responsible for the conduct
of monetary policy. In the United States, it is the Federal Reserve System. In Hong Kong,
the Hong Kong Monetary Authority (HKMA) is playing a similar role.
The Hong Kong Monetary Authority is Hong Kong’s central banking institution. The HKMA
has four main functions: maintaining currency stability within the framework of the Linked
Exchange Rate System; promoting the stability and integrity of the financial system,
including the banking system; helping to maintain Hong Kong’s status as an international
financial centre, including the maintenance and development of Hong Kong’s financial
infrastructure; and managing the Exchange Fund.

Banks (depository institutions)

The financial intermediaries that accept deposits from individuals and institutions and make
loan, e.g. commercial banks, credit unions.

Depositors
Individuals and institutions that hold deposits in banks.

Borrowers from banks

Individuals and institutions that borrow from the depository institutions. Households and
firms would borrow money for consumption or investment. Depository institutions may also
purchase bonds issued by other institutions.

Monetary Base（貨幣基礎）

It is main narrow money measure. It is a part of the monetary liabilities of central bank. The
Monetary Base (MB) is defined, at the minimum, as the sum of the currency in circulation
(banknotes and coins), C, and balance of the banking system held with the central bank (the
reserve balance or the clearing balance), R.

i.e. MB = C + R

In Hong Kong, the Monetary Base comprises Certificates of Indebtedness (for backing the
banknotes issued by the note-issuing banks), government-issued currency in circulation, the
balance of the clearing accounts of banks kept with the HKMA (the Aggregate Balance), and
Exchange Fund Bills and Notes.

MB is an important part of the money supply because increases in it will lead to a multiple
increase in the money supply (everything else being constant). MB is called high-powered
money.
C R

C D

Now C + D is our M1, one definition of money supply.

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Control of the Monetary Base

Open market operations (OMO) are the principal tools of monetary policy to expand or
contract the amount of money in the banking system by buying and selling of government
securities in the open market in order. Purchases inject money into the banking system and
stimulate growth while sales of securities do the opposite.

The central bank can change the MB by open market operations-purchases or sales of
government securities in the open market, and through its extension of discount loans to
banks.

Open Market Purchase from Bank

The Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Securities – $100 Securities + $100 Reserves + $100
Reserves + $100

Open Market Purchase from Public

The Non-bank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities – $100 Securities + $100 Reserves + $100
Deposits + $100

Banking System
Assets Liabilities
Reserves + $100 Checkable + $100
Deposits

Result: R increases $100. MB increases $100.

However, if the central bank purchases the securities from non-bank public but the non-bank
public cashes the Fed’s check, then

The Non-bank Public Federal Reserve System

Assets Liabilities Assets Liabilities
Securities – $100 Securities + $100 Currency + $100
Currency + $100 in circulation

Result: MB increases $100. But R is unchanged.

Discount Loans
Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Reserves + $100 Discount +$100 Discount +$100 Reserves + $100
Loans loans

Result: R increases $100. MB increases $100.

Sometimes, the central bank does not conduct any OMO but there is a shift from deposits to
currency. It will also affect reserves in the banking system but not the monetary base.

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The Non-bank Public Banking System
Assets Liabilities Assets Liabilities
Checkable – $100 Reserves – $100 Checkable – $100
Deposits Deposits
Currency + $100

Federal Reserve System

Assets Liabilities
Currency + $100
in circulation
Reserves – $100

Result: R decreases $100 MB unchanged.

Conclusion

The central bank has better ability to control MB than R.

Multiple Deposit Creation: Simple Model

When the central bank supplies the banking system with $1 of additional reserves, deposits
increase by a multiple of this amount. It is a process called multiple deposit creation.

Suppose $100 open market purchase was conducted with FNB. There will be an increase in
FNB’s reserves.
FNB
Assets Liabilities
Securities - $100
Reserves +$100

Since there is no interest, FNB does not want to hold the excess reserves. FNB can make a
loan equal in amount to the $100 excess reserves by setting up a checking account for the
borrower and putting the proceeds of the loan into this account.

FNB
Assets Liabilities
Securities - $100 Checkable deposits +$100
Reserves +$100
Loans +$100

Checkable Deposits are part of money supply. The bank’s act of lending creates money.
The excess reserves still exist in the FNB’s balance sheet but the borrower can take it out and
deposit them at the other bank. Of course, a single bank cannot loan more than its excess
reserves because the bank will lose these reserves as the deposits created by the loan find
their way to other banks.
FNB
Assets Liabilities
Securities - $100
Loans +$100

Now, let us assume the deposits $100 created by FNB’s loan are deposited at Bank A and all
other banks hold no excess reserves.

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 Bank A
Assets Liabilities
Reserves +$100 Checkable deposits +$100

If the required reserve ratio is 10%, this bank will find itself with $10 increase in required
reserves and leave $90 excess reserves. Bank A will soon convert the excess reserves to
loans for earning profit.
Bank A
Assets Liabilities
Required Reserves +$10 Checkable deposits +$100
Loans +$90

If the money spent by the borrower to whom Bank A lent the $90 is deposited in another
Bank B, then the T-account for Bank B is:
Bank B
Assets Liabilities
Reserves +$90 Checkable deposits +$90

Bank B will do the same thing as A but now its required reserves hold is only $9 and loans
made is $81.
Bank B
Assets Liabilities
Required Reserves +$9 Checkable deposits +$90
Loans +$81

The $81 spent by the borrower from Bank B will be deposited in Bank C. Consequently,
from initial $100 increase of reserves in the banking system, the total increase of checkable
deposits in the system so far is $271=$100 + $90 + $81.

Following the same reasoning, with the fractional reserve system, sufficient demand for
loans, no excess reserves, no cash leakage, the process goes on until the initial deposit is
wholly kept as reserve in the banking system

Creation of Deposits (assuming 10% reserve requirement and $100 increase in reserves)

Increase in Increase in Increase in

Banks
Deposits ($) Loans ($) Reserves ($)
First National Bank 0.00 100.00 0.00
A 100.00 90.00 10.00
B 90.00 81.00 9.00
C 81.00 72.90 8.10
D 72.90 65.61 7.29
E 65.61 59.05 6.56
F 59.05 53.14 5.91
. . . .
. . . .
. . . .
Total for all banks 1000.00 1000.00 100.00

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Formula of multiple expansion of deposits can be written as D = ( 1 / rrr ) x R

where D = change in total checkable deposits in the banking system

rrr = reserve requirement ratio (存款準備金率) / required reserve ratio
(0.10 in our example)
R = change in reserves for the banking system ($100 in our example)

Simple Deposit Multiplier (m) = 1 / rrr

Remarks: Whether bank makes loans or buys securities, we get same deposit expansion if
the seller of securities deposits the money into banking system.

Because of our strong assumptions, critiques of simple model such as proceeds from loan
being kept in cash, bank holding excess reserves could stop the deposit creation.

Modification of the Money Multiplier

MB = C + R = C + ER + RR = C + ER + ( rrr x D )

Multiplying first two items of R.H.S. by D/D, then

MB = D [ C/D + ER/D + rrr ]

Now consider the money supply,

1  (C/D)
M = C + D = D [ 1 + C/D ] =  MB
rrr  (ER/D)  (C/D)

where rrr = required reserve ratio

C = currency in circulation
D = checkable deposits
ER = excess reserves
M = money supply (M1) = C + D

1 + ( C/D )
And m = money multiplier =
rrr + ( ER/D ) + ( C/D )

Definition of deposit would determine the size of M1, M2, or M3…

Money supply and Inflation

Quantity theory of money states that money supply and price level in an economy are in
direct proportion to one another.

M V= P y or %ΔM + %ΔV = %ΔP + %ΔQ

Inflation is caused when the money supply in an economy grows at faster rate than the
economy's ability to produce goods and services.

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Green backed Floating not fixed
History of Hong Kong’s Exchange Rate Systems

1863 - 1935 Silver Standard

12/1935 - 11/1967 Sterling exchange standard at HK$16 = £1.00
11/1967 - 06/1972 Linked to Sterling at HK$14.55 = £1.00
07/1972 - 02/1973 Fixed exchange rate against US$ at HK$5.65 = US$1.00
02/1973 - 11/1974 Fixed exchange rate against US$ at HK$5.085 = US$1.00
11/1974 - 10/1983 HK$ allowed to float (US$1:HK$9.6 on 24/09/1983)
17/10/1983 until present Linked to US$ at HK$7.8 = US$1.00

Fixed exchange rate means a fixed exchange rate that the authorities (government or central
bank) are obliged to maintain as the official exchange rate, by intervention if necessary for
stability. A set price will be usually determined against a major world currency.

Linked exchange rate is also fixed but the authorities are not obliged to intervene, as there is
‘arbitrage and competition’ mechanism to ensure the convergence of the market rate with the
official rate. In other words, the government set the linked exchange rate unilaterally.

Under the present ‘linked’ rate system, the value of the Hong Kong dollar (HK$) is
determined by the value of the US dollar (US$) to which it is linked. A linked rate doesn’t
mean a fixed rate. Under the present system, the value of the HK$ will not be fixed unless the
US$ maintains a fixed value against other currencies.

Note-issuing in Hong Kong

Under the linked exchange rate system, the note-issuing mechanism is a system with the US$
chosen as the standard of value for the HK$. It means the value of one HK$ against any
particular currency is determined by the purchasing power of US$ 0.128 over that currency.
Thus, the system is a ‘US$ standard’. Legal Tender Notes Issue Ordinance《法定貨幣紙幣發行
條例》 is a statute to regulate the issue of banknotes and currency notes. Under the Ordinance,
the banknotes issued by Bank of China (Hong Kong) Limited, Standard Chartered Bank
(Hong Kong) Limited and The Hongkong and Shanghai Banking Corporation Limited and
the HK$10 currency notes issued by the Financial Secretary pursuant thereto since 2002 are
legal tender notes within Hong Kong.

When the 3 Note-issuing banks (NIBs) issue banknotes, they are required to submit US
dollars (at HK$7.80=US$1) to the HKMA for the account of the Exchange Fund in return for
Certificates of Indebtedness (which are required by law as backing for the banknotes issued).
Then they can be authorized to issue HK$ up to the amount as stipulated by the Certificate of
Indebtedness. The HK$ banknotes are therefore fully backed by US$ held by the Exchange
Fund. In the case of coins, which are issued by the HKMA, transactions between the HKMA
and the agent bank responsible for storing and distributing the coins to the public are settled
against US$ at the rate of HK$7.80 to US$ 1.

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Linked Exchange Rate System

The linked exchange rate system is a Currency Board System. It is a monetary system that
complies with the monetary rule requiring that any change in the monetary base should be
matched by a corresponding change in foreign reserves in a specified foreign currency at a
fixed exchange rate. It ensures that the monetary base: Certificates of Indebtedness (as
backing for banknotes) and coins issued; the sum of balances of banks’ clearing accounts
(Aggregate Balance) maintained with the HKMA for the purpose of clearing and settling
transactions between the banks themselves, and also between the banks and the HKMA; and
the outstanding amount of Exchange Fund Bills and Notes, is fully backed by foreign
reserves.

When the HKMA buys US dollars from the licensed banks for the account of the Exchange
Fund within the Convertibility Zone (HK$7.75 to HK$7.85 for one US dollar) or at the
strong-side Convertibility Undertaking (7.75), the Hong Kong-dollar equivalent of the
transactions is "created" and credited to the clearing accounts of the licensed banks. This
leads to a corresponding increase in the Aggregate Balance. This process is commonly
referred to as the HKMA injecting money into the interbank market.

Under such arrangements, there are essentially two foreign exchange markets.

The government linked the exchange rate between US$ and HK$ at US$1 = HK$7.8 in the
official or closed market on the average. Foreign exchange is basically transacted between
the Exchange Fund and all licensed banks at the exchange rate of HK$ 7.80 per US$. At such
rate, US$ and HK$ can also be traded between Exchange Fund and the note-issuing banks.

In the open market, the exchange rate is allowed to float. Foreign exchange is freely
transacted between banks and the non-bank public at freely flexible rates. The public and
also the note-issuing banks can buy and sell the foreign currency at the market rate. The
exchange rate is freely determined by the demand and supply in the market.

e e
S

e = 7.8

0 Quantity of US$ 0 Quantity of US$

Official Market Open Market

The Exchange Fund’s primary objective, as laid down in the Exchange Fund Ordinance, is to
affect, either directly or indirectly, the exchange value of the currency of Hong Kong. The
Fund may also be used to maintain the stability and integrity of Hong Kong’s monetary and
financial systems to help maintain Hong Kong as an international financial centre. The
Exchange Fund, under the control of the Financial Secretary. It may be invested in any
securities and any other appropriate assets.

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The Linked Rate and Interest Rate Adjustment Mechanism

Under the currency board system, Hong Kong dollar exchange rate stability, in fact, is
maintained through an interest rate adjustment mechanism.

Under the linked rate system, the US$/HK$ exchange rate is more or less fixed. There will be
no exchange risk when Hong Kong people invest in the U.S. Thus, interest rates in Hong
Kong should equal those in the U.S. Any interest differentials are risk premium and can
only be explained by the risks involved in different investment opportunities of the two
countries.

Capital inflow occurs when investors Capital outflow occurs if investors switch
switch from foreign currencies into HK from HK dollars into foreign currencies.
dollars.
 
Market participants (Banks) buy HK Market participants sell HK dollars to
dollars from the HKMA. the HKMA.
 
As demand for HK$ increases, there is As demand for HK$ falls, there is
upward pressure on the HK$ exchange downward pressure on the HK$
rate. exchange rate.
 
Currency Board sells HK$ to the banks in Currency Board purchases HK$ from
return for US$. the banks in return for US$.
 
When the Board credits the clearing When the HKMA debits the clearing
accounts of the banks with HK$, the accounts of the banks with HK$, the
aggregate balance of the banking system in aggregate balance of the banking system
the monetary base expands. in the monetary base contracts.
 
The HK dollar interest rates fall The HK dollar interest rates rise
automatically with the expansion of the automatically with the contraction of the
monetary base. The Monetary Base monetary base. It is creating the monetary
expands and so discouraging continued conditions conducive to capital inflows.
inflows.
 
Banks reduce their holdings of HK$ Banks increase their holdings of HK$
because the rate of return on HK$ falls. because the rate of return on HK$
increases.
 
HK dollar exchange rate is stable again.

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Policy Trilemma

Exchange Rate Stability

Free Capital Mobility Independent Monetary Policy

Seigniorage

The term “seigniorage” refers to the revenue or income that a government raises from issuing
coinage and paper currency. It is usually ensured by a monopoly. This revenue is often used
by governments to finance a portion of their expenditures without having to collect taxes.

Literally the face value of the money minus the cost of physically making it is the profit.
Full-bodied, commodity money such as a silver/gold coin contains metallic value roughly
equal to its face value. In contrast, subsidiary coins & paper money cost much less to
produce than their face value. The excess of the face value over the cost of coinage or
printing paper money is called seigniorage. This income usually accrues to a government;
and in early times, accrued to the seigneur (ruler) who issued the money.

A typical central bank certainly earns seigniorage on its IOUs or fiat currency in circulation
as well as interest on its holdings of marketable securities. It also earns seigniorage on the
legal reserve balances that commercial banks hold with it.

A more important source of seigniorage for a typical central bank is inflation. It needs no
elaboration that a central bank can create inflation at its discretion by increasing the monetary
base and hence money supply. As such, term seigniorage is sometimes known as the
“inflation tax” or “money tax”.

A Currency Board earns no seigniorage from inflation. A genuine, rules-based CB cannot

create inflation, as it has to equate any base money expansion with an equivalent change in
forex reserves, which are ultimately dictated by BOP conditions and the public demand.

The existence of cryptocurrencies such as “Ether”, “Bitcoin”, (if successful) is a challenge to

the traditional seigniorage of the central bank (government).