Chapter 17. Money Supply ProcessChapter 17. Money Supply ProcessChapter 17. Money Supply ProcessChapter 17. Money Supply Process

• Fed Balance Sheet

• Fed and the Monetary Base

• Deposit Creation

• The money multiplier

• Fed Balance Sheet

• Fed and the Monetary Base

• Deposit Creation

• The money multiplier

The money supply processThe money supply processThe money supply processThe money supply process

• who determines the money supply? the Federal Reserve banks depositors borrowers

• who determines the money supply? the Federal Reserve banks depositors borrowers

The Fed’s balance sheetThe Fed’s balance sheetThe Fed’s balance sheetThe Fed’s balance sheet

Assets• U.S. government bonds

necessary for open market operations

• Gold, SDRs used for international debts

Assets• U.S. government bonds

necessary for open market operations

• Gold, SDRs used for international debts

• other assets foreign bonds, currency physical assets

• cash in collection

• discount loans Fed loans to banks

• other assets foreign bonds, currency physical assets

• cash in collection

• discount loans Fed loans to banks

Fed is self-fundingFed is self-fundingFed is self-fundingFed is self-funding

• open market operations

• discount loans

• both are also key to controlling money supply

• open market operations

• discount loans

• both are also key to controlling money supply

LiabilitiesLiabilitiesLiabilitiesLiabilities

• Federal reserve notes U.S. currency exchangeable for more notes

• Reserves deposits by banks required + excess

• U.S. Treasury deposits

• Federal reserve notes U.S. currency exchangeable for more notes

• Reserves deposits by banks required + excess

• U.S. Treasury deposits

monetary base (MB)monetary base (MB)monetary base (MB)monetary base (MB)

• currency + reserves

• C + R

• also called “high-powered money”

$1 increase in MB will cause

> $1 increase in money supply

• currency + reserves

• C + R

• also called “high-powered money”

$1 increase in MB will cause

> $1 increase in money supply

Controlling MBControlling MBControlling MBControlling MB

• open market operations Fed buys and sells Treasury

securities affect size of monetary base

• use T accounts to track the effect

• open market operations Fed buys and sells Treasury

securities affect size of monetary base

• use T accounts to track the effect

exampleexampleexampleexample

• open market purchase $100 million Fed buys $100 million in Tbonds Fed buys from a bank

• open market purchase $100 million Fed buys $100 million in Tbonds Fed buys from a bank

Securities - $100Reserves $100

Banking SystemAssets Liabilities

increase in bank reserves of $100 million

• if Fed buys Tbonds from public,

& public deposits in account• if Fed buys Tbonds from public,

& public deposits in account

increase in bank reserves of $100 million

reserves $100 checking $100

Banking SystemAssets Liabilities

• discount loans Fed loans to bank Fed credits bank’s reserve account

• discount loans Fed loans to bank Fed credits bank’s reserve account

• reserves increase

• MB increases• reserves increase

• MB increases

Reserves $100 Discount Loans $100

Banking System Assets Liabilities

Deposit creationDeposit creationDeposit creationDeposit creation

• Fed increases reserves by $1,

• deposits increase by > $1 multiple deposit creation

• how?

• Fed increases reserves by $1,

• deposits increase by > $1 multiple deposit creation

• how?

exampleexampleexampleexample

• Fed buys $100 securities from bank bank securities decrease $100 bank reserves increase $100

• Fed buys $100 securities from bank bank securities decrease $100 bank reserves increase $100

Securities - $100Reserves $100

First National BankAssets Liabilities

• $100 increase in reserves are excess reserves, banks lends them out by crediting

checking account

• $100 increase in reserves are excess reserves, banks lends them out by crediting

checking account

Securities - $100 Checking $100Reserves $100Loans $100

First National BankAssets Liabilities

• borrower takes $100 loan and deposits in bank A reserves increase at bank A deposits increase at bank A

• borrower takes $100 loan and deposits in bank A reserves increase at bank A deposits increase at bank A

Reserves $100 Checking $100

Bank AAssets Liabilities

• required reserve ratio = 10%

• bank A must keep $10 free to lend $90

• required reserve ratio = 10%

• bank A must keep $10 free to lend $90

Reserves $10 Checking $100Loans $90

Bank AAssets Liabilities

• borrower at bank A takes $90 loan and deposits in bank B

• borrower at bank A takes $90 loan and deposits in bank B

Reserves $90 Checking $90

Bank BAssets Liabilities

• bank B must keep $9 free to lend $81

• bank B must keep $9 free to lend $81

Reserves $9 Checking $90Loans $81

Assets LiabilitiesBank B

where are we?where are we?where are we?where are we?

• initial $100 open market purchase

• checking deposits so far:

$100 + $90 + $81 = $271

• money has been created

• initial $100 open market purchase

• checking deposits so far:

$100 + $90 + $81 = $271

• money has been created

simple money multipliersimple money multipliersimple money multipliersimple money multiplier

• how much money creation is possible?

• how much money creation is possible?

change indeposits

= change in reserves

x1

reserve req.

• $100 increase in reserves,

$1000 increase in deposits• $100 increase in reserves,

$1000 increase in deposits

change indeposits

= $100 x1

.10= $1000

simple money multipliersimple money multipliersimple money multipliersimple money multiplier

• leaves out 2 possibilities:

(1) borrowers take some of loan as cash

(2) banks hold some excess reserves

• need a more complex multiplier

• leaves out 2 possibilities:

(1) borrowers take some of loan as cash

(2) banks hold some excess reserves

• need a more complex multiplier

a better money multipliera better money multiplier a better money multipliera better money multiplier

• how $1 change in MB will affect MS:

M = m x MB• how $1 change in MB will affect MS:

M = m x MB

rD = required reserve ratio

C/D = ratio of currency to deposits

ER/D = ratio of excess reserves to deposits

m =

rD + ER/D + C/D

1 + C/D

exampleexampleexampleexamplerD = .10 C = $400 billion D = $800 billion

ER = $.8 billion or $800 million

= 2.5

$1 increase in MB, $2.5 increase in M

m =.10 + .001 + .5

1 + .5

Factors affecting mFactors affecting mFactors affecting mFactors affecting m

• changes in rD

• changes in C/D

• changes in ER/D

• changes in rD

• changes in C/D

• changes in ER/D

changes in rchanges in rDDchanges in rchanges in rDD

• higher reserve requirement fewer excess reserves to lend smaller amount of deposit creation

• higher reserve requirement fewer excess reserves to lend smaller amount of deposit creation

higherrD

smallermultiplier

exampleexampleexampleexample

• rD was .10

• suppose it rises to .20

• rD was .10

• suppose it rises to .20

m = 2.14

m =.20 + .001 + .5

1 + .5

changes in C/Dchanges in C/Dchanges in C/Dchanges in C/D

• higher C/D currency does not expand like deposits smaller amount of deposit creation

• higher C/D currency does not expand like deposits smaller amount of deposit creation

higherC/D

smallermultiplier

exampleexampleexampleexample

• original example: C/D = .5

• suppose C/D = .8• original example: C/D = .5

• suppose C/D = .8

m =.10 + .001 + .8

= 2.001 + .8

changes in ER/Dchanges in ER/Dchanges in ER/Dchanges in ER/D

• higher ER/D banks hold more ER, lend less smaller amount of deposit creation

• higher ER/D banks hold more ER, lend less smaller amount of deposit creation

higherER/D

smallermultiplier

exampleexampleexampleexample

• original example: ER/D = .001

• suppose ER/D = .005• original example: ER/D = .001

• suppose ER/D = .005

m =.10 + .005 + .5

= 2.481 + .5

what affects ER/D, C/D?what affects ER/D, C/D?what affects ER/D, C/D?what affects ER/D, C/D?

• as interest rates rise opportunity cost of holding ER and

case rise (money could be earning interest)

• as interest rates rise opportunity cost of holding ER and

case rise (money could be earning interest)

higheri

ER/D, C/Dfall

• expected deposit outflows increase must hold more ER ER/D would rise

• expected deposit outflows increase must hold more ER ER/D would rise

Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33

• big contraction in M1

• big increases in ER/D and C/D depositors withdrew cash banks increase ER due to increase

in deposit outflow

• big contraction in M1

• big increases in ER/D and C/D depositors withdrew cash banks increase ER due to increase

in deposit outflow

• as C/D and ER/D rise, money multiplier declines M1 declines by 25% from 1930-33

• as C/D and ER/D rise, money multiplier declines M1 declines by 25% from 1930-33