Chapter 17

The Money Supply Process

Players in the Money Supply Process

• Central bank (Federal Reserve)

• Banks (depository institutions)

• Depositors (individuals and institutions)

• Borrowers

Fed’s Balance Sheet (important items)

• Monetary Liabilities– Currency in circulation(in the hands of the public)– Reserves: bank deposits at the Fed

• Assets– Government securities: holdings by the Fed that affect

money supply and earn interest. – Fed now holding MBS.– Discount loans: provide reserves to banks and earn the

discount rate

Federal Reserve System

Assets Liabilities

Government Securities and Mortgage Backed Securities

Currency in circulation

Discount loans Reserves

The Federal Reserve Balance Sheet: June 2003

Assets and Liabilities of the Federal Reserve System, June 30, 2003(millions of dollars)

ASSETS LIABILITIES

Gold $ 11,045 $593,031 Federal Reserve notes (outstanding)

Loans to banks 36,538

U.S. Treasury securities

550,314 20,359 Bank reserves (from depository institutions)

6,219 U.S. Treasury Deposits

All other assets 46,268 24,556 All other liabilities and net worth

Total $644,165 $644,165 Total

Source: Federal Reserve Bulletin, August 2003, Table 1.18.

Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis (Millions of Dollars)

ASSETS LIABILITIES

Gold $ 11,037 $777,769 Federal Reserve notes (outstanding)

Loans to banks 1,342Deposits:

U.S. Treasury securities

779,642 12,771 Bank reserves (from depository institutions)

4,572 U.S. Treasury deposit

All other assets 82,451 79,360 All other liabilities and net worth

Total $ 874,472 $874,472 Total

Source: Board of Governors of the Federal Reserve System.

THE FEDERAL RESERVE BALANCE SHEET: August 2009

ASSETS LIABILITIES

Gold $ 11,037 $872,150 Federal Reserve notes (outstanding)

Loans to banks 339,335Deposits:

U.S. Treasury securities

705,331 724,650 Bank reserves (from depository institutions)

261,487 U.S. Treasury

All other assets 936,031 133,447 All other liabilities and net worth

Total $ 1,991,734 $1,991,734 Total

Source: Board of Governors of the Federal Reserve System.

THE FEDERAL RESERVE BALANCE SHEET: February 2013

ASSETS LIABILITIES

Gold $ 11,037 $1122,000 Federal Reserve notes (outstanding)

Loans to banks 449 Deposits:

U.S. Treasury securities

1730,000 1,795,000 Bank reserves (from depository institutions)

Mortgages 1,083,000 42,000 U.S. Treasury

All other assets 234,000 116,000 All other liabilities and net worth

Total $ 3,075,000 $3,075,000 Total

Source: Board of Governors of the Federal Reserve System.

http://www.federalreserve.gov/releases/h41/Current/

THE FEDERAL RESERVE BALANCE SHEET: February 2013

ASSETS LIABILITIES

Gold $ 11,037 $1,315,000 Federal Reserve notes (outstanding)

Loans to banks 59 Deposits:

U.S. Treasury securities

2,450,000 2,748,000 Bank reserves (from depository institutions)

Mortgages 1,731,000 65,000 U.S. Treasury

All other assets 290,000 353,000 All other liabilities (reverse Repo) and net worth

Total $ 4,481,000 $4,481,000 Total

Source: Board of Governors of the Federal Reserve System.

http://www.federalreserve.gov/releases/h41/Current/

Monetary Base (High Powered Money)

High-powered money

= +

= currency in circulation

= total reserves in the banking system

MB C R

C

R

Note: Vault cash is included in reserves.Recall: M1 = C + DD

The Money Supply Process: Open Market Purchase From a Commercial Bank (Assume a 10% reserve requirement)

• Reserves have increased by $100. • What about excess reserves?• No change in currency• Monetary base (C + R) has increased by $100• Has the money supply changed?

Fed Open Market Purchase from Nonbank Public

• Reserves have increased by $100. • What about excess reserves?• No change in currency• Monetary base (C + R) has increased by $100• Has the money supply changed?

• The person selling the bonds cashes the Fed’s check• Reserves are unchanged• Currency in circulation increases by the amount of the open

market purchase• Monetary base (C+R) increases by the amount of the open

market purchase

Open Market Purchase: Summary

• The effect on reserves in the banking system depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits

• Always increases the monetary base by the amount of the purchase:

MB = C + R

Fed Open Market Sale to non-bank public

• Reduces the monetary base by the amount of the sale

• Reserves remain unchanged• The effect of open market operations on the

monetary base is much more certain than the effect on reserves

Nonbank Public Federal Reserve System

Assets Liabilities Assets Liabilities

Securities +$100 Securities -$100 Currency in circulation

-$100

Currency -$100

Public withdraws $100 from Commercial Bank

+$100

$100

Fed Discount Loan to a Bank

Paying Off a Discount Loan from the Fed

• Net effect is to reduce the monetary base

• Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities

Reserves -$100 Discount loans

-$100 Discount loans

-$100 Reserves -$100

Deposit Creation (Single Bank): Fed Open Market Purchase from First National Bank

Excess reserves increase

Bank loans out the excess reserves

Creates a checking account

Borrower makes purchases

The money supply has increased

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Securities -$100 Securities -$100 Checkable deposits

+$100

Reserves +$100 Reserves +$100

Loans +$100

First National Bank

Assets Liabilities

Securities -$100

Loans +$100

Step 1 Step 2

Step 3

Deposit Creation: The Banking System (10% Reserve Requirement)

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable deposits

+$100 Reserves +$10 Checkable deposits

+$100

Loans +$90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +$90 Checkable deposits

+$90 Reserves +$9 Checkable deposits

+$90

Loans +$81

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

The Formula for the Simple Deposit Multiplier

Assuming banks do not hold excess reserves

Required Reserves ( ) = Total Reserves ( )

= Required Reserve Ratio ( ) times the total amount

of checkable deposits ( )

Substituting

=

Dividing both s

RR R

RR r

D

r D Rides by

1 =

Taking the change in both sides yields

1 =

r

D Rr

D Rr

Critique of the Deposit Multiplier

• Currency removes funds from the banking system and stops the deposit creation process

• Holding excess reserves stops the deposit creation process. Banks may not use all of their excess reserves to buy securities or make loans.

• Depositor decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) affect the money supply and the Fed’s ability to control the money supply.

The M1 Money Multiplier

• M1 =currency + checkable deposits = C + D

• Link the money supply (M1) to the monetary base (MB) and let m be the money multiplier

• Recall: MB = C + R

• This is why the MB is called High Powered Money

M1 = m x MB

Deriving the M1 Money Multiplier

Let’s assume that the desired holdings of currency (C) and excess reserves (ER) grow proportionally with checkable deposits D.

Then,

c = (C/D) = currency ratioe = (ER/D) = excess reserves ratio

Deriving the M1 Money Multiplier: m

M1 = m MB

Reserves: R = RR + ERRequired Reserves: RR = r D R = (r D) + ER

1Mm

MB

Deriving the M1 Money Multiplier

Math Trick: MB = RR + ER + C

MB = (r D) + (ER/D D) + (C/D D)

MB = (r + e + c) D ; Where e=(ER/D) and c =(C/D)

M1 = D + C = D + (C/D D) M1 = (1+ c) D ;

M1 Money Multiplier

m < 1/r

because of currency holding and ER.

m is the increase in the money supply resulting from a $1 increase in MB

1 (1 ) (1 )

( ) ( )

M c xD cm

MB r e c xD r c e

Example

r required reserve ratio = 0.10

C currency in circulation = $400B

D checkable deposits = $800B

ER excess reserves = $0.8B

M money supply (M1) = C D = $1,200B

c $400B

$800B0.5

e $0.8B

$800B0.001

m 10.5

0.10.0010.5 1.5

0.6012.5

This is less than the simple deposit multiplier

Although there is multiple expansion of deposits,

there is no such expansion for currency

Case Study: The Great Depression Bank Panics, 1930 - 1933.

• Bank failures (and no deposit insurance) caused:– Increase in deposit outflows and holding of

currency (depositors)– An increase in the amount of excess reserves

(banks)

Case Study: The Great Depression Bank Panic, 1930 - 1933. Deposits of Failed Commercial Banks

• Bank failures (and no deposit insurance) caused:– Increase in deposit

outflows and holding of currency (depositors)

– An increase in the amount of excess reserves (banks)

Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?

Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933

Case Study: Money Supply 1980 -2005

Determinants of the Money Supply