Answer to Question #300247 in Finance for Thom

Question

Give two reasons why a central bank (Fed) does not have complete control over the level of bank deposits and loans. Explain how a change in either factor affects the deposit expansion 

process.

Answer 1

1.     The Fed controls deposit levels by setting interest rates.

2.     People leave money on deposit when rates rise.

When rates are low, people feel free to spend or invest their money elsewhere. The Fed controls the money supply, not deposit levels. The Fed changes interest rates by buying or selling Treasuries based on total money and money velocity. The Fed controls the loan-to-deposit ratio through setting capital ratios. Their central bank reserve requirement only applies to Net Transaction Accounts, which are a subset of total liabilities deposits. To be effective, reserve requirements must apply to all or most bank deposits.

 

That regulator, Basel Capital Controls, is basically related to bank profits, so the Fed has little direct authority over that either, though it does have some indirect effect in terms of obligations to boost them.

The amount of new lending minus the amount of loan repayment and loan write-offs determines the pace of deposit expansion.

 

However, in today's banking system, certain banks not only make loans but also borrow and re-lend. Whether this affects deposit expansion depends on the origin of the loan. The original one-to-one relationship between bank loans and the bank liabilities deposits they created has been destroyed due to loan secularization.