Federal Reserve Bank of Chicago
Much concern has recently been expressed that both large, procyclical changes in bank assets and ?credit crunches? caused by bank reluctance to expand loans during recessions contribute to economic instability. These effects are difficult to explain using the standard textbook model of deposit expansion in which deposits are constrained only by reserve requirements. However, these effects follow easily if the model is expanded to include a second, capital constraint. Article shows how the simple one-constraint model of monetary policy, which changes the deposits and assets of the banking system by injecting or withdrawing reserves and thereby changes interest rates, is incomplete. In practice, banks are subject to two constraints?capital as well as reserve requirements. Where capital requirements are binding, the model clearly shows that injection of additional reserves by the Fed may not achieve the intended increase in bank deposits and earning assets. The introduction of the capital constraint in the bank deposit expansion model can explain the observed perceived excessive procyclicality in bank balance sheets, characterized by an expansion of bank credit and deposits that is more rapid than the growth of the economy as a whole during expansions and declines in these measures that is more rapid than declines in the macroeconomy during recessions.