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Functions of Banks Savings Investment (deposits) (loans) Banks channel savings into investment 1 Affecting Money Supply Investment (loans) Savings (deposits) Money supply = Cp (currency in public circulation) + Deposits •save cash into bank account: Cp drops but deposit rises •make loans to investors: reserves drop but Cp rises 2 Deposit / Credit Creation Adam Cp = $1000 deposit = $1000 Bank reserve = $1000 Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve $1000 Deposit $1000 Required reserve = $250 Excess reserve = $750 3 Ms = Cp + Dep = $1750 Bank loan RR = $250 = $750 ER = $750 Bobby Cp = $750 Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve $250 Loan $750 Deposit $1000 4 Ms = 0 + $1750 = $1750 Bobby Cp = $750 deposit = $750 Bank reserve + $750 Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve Loan $1000 Deposit $1750 $750 Required reserve = $437.5 Excess reserve = $562.5 5 Ms = $562.5 + $1750 = $2312.5 Bank loan RR = $437.5 = $562.5 ER = $562.5 Cindy Cp = $562.5 Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve Loan $437.5 Deposit $1750 $1312.5 6 Process of deposit creation 1. Initial deposit is saved into a bank under fractional reserve system. 2. The bank lends out all excess reserve. 3. The public does not have cash leakage, i.e., all cash will be re-deposited. 4. Banks lend out all excess reserve again and the above process goes on and on. 5. Multiple deposit creation will happen. 7 Ms = 0 + $4000 = $4000 Zeith Cp = $0.00.. deposit = $0.00.. Bank reserve + $0.00.. Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve $1000 Loan $3000 Deposit $4000 Required reserve = $1000 Excess reserve = $0 8 Ms = 0 + $4000 = $4000 Bank loan RR = $1000 = $0 ER = $0 The public Cp = $0 Balance Sheet of the Banking System (required reserve ratio = 25%) Reserve $1000 Loan $3000 Deposit $4000 Further deposit / credit creation is impossible when excess reserve = 0, or required reserve = actual reserve. 9 Formula of deposit creation Maximum amount of deposit = Initial deposit 1 Required Reserve Ratio Banking multiplier 10 Process of deposit contraction 1. Initial withdrawal of deposit from a bank under fractional reserve system. 2. The bank lacks of actual reserve and then calls back loans. 3. Since the public does not hold any cash on hand, they have to withdraw deposit. 4. Banks lacks of actual reserve again and the above process goes on and on. 5. Multiple deposit contraction will happen. 11