introduction to the money supply process zfundamental property -- money supply expands when banks...
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Introduction to the Money Supply Process
Fundamental Property -- Money supply expands when banks make loans (or more generally, expand loans or buy bonds)
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Deposit Expansion: The Individual Bank
Consider the following example.
(rD = 0.10, rT = 0.05)
Chase
R $20000 D $70000
L $90000 T $80000
Bonds $50000 E $10000
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Computing Required and Excess Reserves
Chase rD = 0.10
R $20000 D $70000 rT = 0.05L $90000 T $80000Bonds $50000 E $10000
RR = rDD + rTT = (0.10)($70000) + (0.05)($80000) = $11000ER = R - RR = $20000 - $11000 = $9000
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Loan of $9000 Step #1 -- Loan is Approved
Chase
R $20000 D $79000
L $99000 T $80000
Bonds $50000 E $10000
Borrower signs loan contract,
receives check from bank.
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Step #2 -- Loan is Spent
ChaseR $11000 D $70000L $99000 T $80000Bonds $50000 E $10000
Seller deposits check in her bank.
HSBCR + $9000 D + $9000
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Bank Loaning and Money Supply Expansion
Consider: M2 = C + D + T + MMMF
M2 = C + D + T + MMMF
Our example: M2 = $0 + $9000 + $0 + $0 = $9000 (Chase’s loan leads to new
deposits for HSBC.)
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Key Concepts: Money Supply Expansion
Key is step #1, Chase expands its deposit commitments without changing its reserves.
Note -- Process is symmetric. Repayment or liquidation of loan leads to decrease in M2 (by the amount of the loan).
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Deposit Expansion: The Banking System
Multiple Expansion -- An initial change in bank reserves prompted by the Federal Reserve leads to an eventual increase in the money supply which is a multiple of that initial change.
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Developing a Formula for Multiple Expansion
Define -- The Monetary Base, or
High Powered Money (H)
H = C + R
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Key Properties: The Monetary Base
The monetary base (H) is unaffected by changes in public asset holdings.
The monetary base (H) is also unaffected by bank loaning.
Important factors that change H: Open Market Operations and Discount Loans (DL).
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Discount Loans and the Monetary Base
Example 1 -- Chase borrows $100 from the Federal Reserve.
Chase
R + $100 DL + $100
H = C + R = $0 + $100 = $100
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Open Market Operations and the Monetary BaseExample 2 -- The Federal Reserve buys a
$100 bond from Chase.
Chase
Bonds - $100
R + $100
H = C + R = $0 + $100 = $100
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The Nonborrowed Base
The Nonborrowed Base (HNON)
HNON = H - DL
Key property -- The nonborrowed base is only affected by open market operations.
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A Formula for Money Supply Determination
Define the following variables.
k = C/D
t = T/D
e = ER/D
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Money Supply Determination: The Formula
M2 = (1 + k + t) (HNON + DL) + MMMF
(k + rD + rTt + e)
The money multiplier (m2)
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Computing the Money Multiplier: An Example
Suppose that:
C = 550 rD = 0.10
D = 600 rT = 0.03
T = 3000
ER = 10.
Compute the money multiplier (m2).
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Computing the Ratios
k = C/D = 550/600 = 0.917
t = T/D = 3000/600 = 5.000
e = ER/D = 10/600 = 0.0167
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Plugging Into The Multiplier Formula
m2 = 1 + k + t
k + rD + rTt + e
m2 = 1 + 0.917 + 5.0
0.917 + 0.10 + (0.03)(5.0) + 0.0167
m2 = 5.84
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Effects of HNON and DL on M2 Determination
Since M2 = (m2)(HNON + DL),
M2 = (m2)( HNON),
M2 = (m2)(DL).
In other words,
HNON M2
DL M2Changes in HNON or DL give banks
reserves, greater ability to loan.
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Effects of Reserve Ratios on M2 DeterminationIncreases in reserve ratios hinder bank
loaning, thereby decreasing the multiplier and M2.
m2 = 1 + k + t
k + rD + rTt + e
rD m2 M2 rT m2 M2
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Effects of k (C/D) and t (T/D) on M2 DeterminationChanges in k and t (public’s desire to
reallocate assets) have different effects on bank loaning, the multiplier, and M2.
m2 = 1 + k + t
k + rD + rTt + e
k m2 M2 t m2 M2
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Effects of e (ER/D) on M2
Changes in e (banks desire to hold more excess reserves) affect the multiplier, which affects M2.
m2 = 1 + k + t
k + rD + rTt + e
e m2 M2
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M2 Determination: Summary
First, the formula again.
M2 = (1 + k + t) (HNON + DL) + MMMF
(k + rD + rTt + e)
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A Summary Table
HNON M2
DL M2 rD M2
rT M2
k M2
t M2
e M2
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The Multiplier -- Trying to Control the Money Supply
M2 = (1 + k + t) (HNON + DL) + MMMF
(k + rD + rTt + e)
Federal Reserve controls HNON, rD, and rT and uses them as policy tools.
But M2 is also determined by public asset holding (k, t, MMMF) and bank behavior (e, DL).
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Can the Federal Reserve Control the Money Supply?
Practical Solution -- The Federal Reserve tries to control money supply growth within a given target range. If actual M2 growth falls within the range, M2 is considered controlled.
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The Multiplier Effect and Controlling M2
Consider formula for M2 determination (apart from MMMF), written as follows (recall that H = HNON + DL).
M2 = (m2)(H)
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M2 Determination in Growth Rates
Since the levels are multiplicative, the growth rates are additive
Growth in M2
(Growth in m2) + (Growth in H)
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Implications for M2 Control
Growth in M2
(Growth in m2) + (Growth in H)
If the multiplier is roughly constant over time (growth in m2 0), then the growth rate of M2 will approximate closely the growth rate of the monetary base.
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Difficulties in M2 Control
Growth in M2
(Growth in m2) + (Growth in H)
But if the multiplier changes over time (growth rate either positive or negative), then the growth rate of M2 will deviate from the growth rate of the monetary base.
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Non-Federal Reserve Changes in M2
Best solution: constant multiplier, zero DL. Unfortunately, not true.
Second best solution: predictable multiplier and DL.
How to predict non-Fed controlled changes in M2? What determines movements in the components (k, t, e, DL, MMMF)?