the money supply process

11

The Money Supply Process

Chapter 14

22

Players in the Money Supply Players in the Money Supply ProcessProcess

Central bank (Federal Reserve System)Central bank (Federal Reserve System)

Banks (depository institutions; financial Banks (depository institutions; financial intermediaries)intermediaries)

Depositors (individuals and institutions)Depositors (individuals and institutions)

33

Fed’s Balance SheetFed’s Balance Sheet

Monetary LiabilitiesMonetary Liabilities Currency in circulation: in the hands of the publicCurrency in circulation: in the hands of the public Reserves: bank deposits at the Fed and vault cashReserves: bank deposits at the Fed and vault cash

AssetsAssets Government securities: holdings by the Fed that affect Government securities: holdings by the Fed that affect

money supply and earn interestmoney supply and earn interest Discount loans: provide reserves to banks and earn the Discount loans: provide reserves to banks and earn the

discount ratediscount rate

Federal Reserve SystemFederal Reserve System

AssetsAssets LiabilitiesLiabilities

Government securitiesGovernment securities Currency in circulationCurrency in circulation

Discount loansDiscount loans ReservesReserves

44

Monetary BaseMonetary Base

High-powered money

= +

= currency in circulation

= total reserves in the banking system

MB C R

C

R

55

Open Market Purchase from Open Market Purchase from a Banka Bank

Net result is that reserves have increased by Net result is that reserves have increased by $100$100

No change in currencyNo change in currency Monetary base has risen by $100Monetary base has risen by $100

Banking SystemBanking System Federal Reserve SystemFederal Reserve System

AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities

SecuritiesSecurities -$100-$100 SecuritiesSecurities ++$100$100

ReservesReserves ++$100$100

ReservesReserves ++$100$100

66

Open Market Purchase from Open Market Purchase from Nonbank Public INonbank Public I

Person selling bonds to the Fed deposits the Person selling bonds to the Fed deposits the Fed’s check in the bankFed’s check in the bank

Identical result as the purchase from a bankIdentical result as the purchase from a bank



ReservesReserves +$100+$100 Checkable Checkable depositsdeposits

+$100+$100 SecuritiesSecurities +$100+$100 ReservesReserves +$100+$100

77

Open Market Purchase from Open Market Purchase from Nonbank Public IINonbank Public II

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

open market purchaseopen market purchase Monetary base increases by the amount of the open Monetary base increases by the amount of the open

market purchasemarket purchase

Nonbank PublicNonbank Public Federal Reserve SystemFederal Reserve System


SecuritiesSecurities -$100-$100 SecuritiesSecurities ++$100$100

Currency Currency in in circulationcirculation

++$100$100

CurrencyCurrency ++$100$100

88

Open Market Purchase: Open Market Purchase: SummarySummary

The effect of an open market purchase on The effect of an open market purchase on reserves depends on whether the seller of reserves depends on whether the seller of the bonds keeps the proceeds from the the bonds keeps the proceeds from the sale in currency or in depositssale in currency or in deposits

The effect of an open market purchase on The effect of an open market purchase on the monetary base always increases the the monetary base always increases the monetary base by the amount of the monetary base by the amount of the purchasepurchase

99

Open Market SaleOpen Market Sale

Reduces the monetary base by the amount of the Reduces the monetary base by the amount of the salesale

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

monetary base is much more certain than the monetary base is much more certain than the effect on reserveseffect on reserves

Nonbank PublicNonbank Public Federal Reserve SystemFederal Reserve System


SecuritiesSecurities ++$100$100

SecuritiesSecurities -$100-$100 Currency Currency in in circulationcirculation

-$100-$100

CurrencyCurrency -$100-$100

1010

Shifts from Deposits into Shifts from Deposits into CurrencyCurrency

Net effect

on monetary liabilities

is zero

Reserves are changed

by random fluctuations

Monetary base

is a more stable variable

Nonbank PublicNonbank Public Banking SystemBanking System


Checkable Checkable depositsdeposits

-$100-$100 ReservesReserves -$100-$100 Checkable Checkable depositsdeposits

-$100-$100

CurrencyCurrency ++$100$100

Federal Reserve SystemFederal Reserve System


Currency in Currency in circulationcirculation

+$100+$100

ReservesReserves -$100-$100

1111

Making a Discount Loan to a Making a Discount Loan to a BankBank

Monetary liabilities of the Fed have increased by Monetary liabilities of the Fed have increased by $100$100

Monetary base also increases by this amountMonetary base also increases by this amount



ReservesReserves +$100+$100 Discount Discount loansloans

+$100+$100 Discount Discount loanloan

+$100+$100 ReservesReserves +$100+$100

(borrowing from (borrowing from Fed)Fed)


1212

Paying Off a Discount Loan Paying Off a Discount Loan from the Fedfrom the Fed

Net effect on monetary base is a reductionNet effect on monetary base is a reduction Monetary base changes one-for-one with a Monetary base changes one-for-one with a

change in the borrowings from the Federal change in the borrowings from the Federal Reserve SystemReserve System



ReservesReserves -$100-$100 Discount Discount loansloans

-$100-$100 Discount Discount loansloans

-$100-$100 ReservesReserves -$100-$100



1313

Other Factors Affecting the Other Factors Affecting the Monetary BaseMonetary Base

FloatFloatTreasury deposits at the Federal ReserveTreasury deposits at the Federal Reserve Interventions in the foreign exchange Interventions in the foreign exchange

marketmarket

1414

Open market operations are controlled by the FedOpen market operations are controlled by the Fed

The Fed cannot determine the amount of The Fed cannot determine the amount of borrowing by banks from the Fedborrowing by banks from the Fed

Split the monetary base into two components Split the monetary base into two components

MBMBnn= MB - BR = MB - BR

The money supply is positively related to both the The money supply is positively related to both the non-borrowed monetary base non-borrowed monetary base MBMBnn and and

to the level of borrowed reserves, to the level of borrowed reserves, BR,BR, from from the Fedthe Fed

Fed’s Ability to Control the Fed’s Ability to Control the Monetary BaseMonetary Base

1515

Deposit Creation: Single Deposit Creation: Single BankBank

Excess reserves increase

Bank loans out the excess reserves

Creates a checking account

Borrower makes purchases

The money supply has increased

First National BankFirst National Bank First National BankFirst National Bank


SecuritiesSecurities -$100-$100 SecuritiesSecurities -$100-$100 Checkable Checkable depositsdeposits

+$100+$100

ReservesReserves +$100+$100 ReservesReserves +$100+$100

LoansLoans +$100+$100

First National BankFirst National Bank


SecuritiesSecurities -$100-$100

LoansLoans +$100+$100

1616

Deposit Creation: Deposit Creation: The Banking SystemThe Banking System

Bank ABank A Bank ABank A



+$100+$100 ReservesReserves +$10+$10 Checkable Checkable depositsdeposits

+$100+$100

LoansLoans +$90+$90

Bank BBank B Bank BBank B



+$90+$90 ReservesReserves +$9+$9 Checkable Checkable depositsdeposits

+$90+$90

LoansLoans +$81+$81

1717

Creation of Deposits (10% reserve Creation of Deposits (10% reserve requirement and a $100 increase requirement and a $100 increase

in reserves)in reserves)

1818

The Formula for Multiple The Formula for Multiple Deposit CreationDeposit Creation

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

1919

Critique of the Simple ModelCritique of the Simple Model

Holding cash stops the processHolding cash stops the processCurrency has no multiple deposit expansionCurrency has no multiple deposit expansion

Banks may not use all of their excess Banks may not use all of their excess reserves to buy securities or make loans.reserves to buy securities or make loans.

Depositors’ decisions (how much currency Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of to hold) and bank’s decisions (amount of excess reserves to hold) also cause the excess reserves to hold) also cause the money supply to change. money supply to change.

2020

Money Supply ResponseMoney Supply Response

Player Fed uses the tools (1) Open market purchase (2) Lowering the discount rate Player Fed uses the tools (1) Open market purchase (2) Lowering the discount rate (3) Increasing the required reserve ratio(3) Increasing the required reserve ratio

2121

M m MB

The Money MultiplierThe Money MultiplierDefine money as currency plus checkable Define money as currency plus checkable

deposits: M1deposits: M1M = C + DM = C + D

Link the money supply (Link the money supply (MM) to the monetary ) to the monetary base (base (MBMB) and let ) and let mm be the money be the money multipliermultiplierMB = C + RMB = C + R

M = m(MB)M = m(MB)

2222

Deriving the Deriving the Money Multiplier IMoney Multiplier I

Assume that the desired holdings of currency Assume that the desired holdings of currency CC and excess reserves and excess reserves ERER grow proportionally grow proportionally with checkable deposits with checkable deposits DD. Then,. Then,

cc = { = {C/DC/D} = currency ratio} = currency ratio

ee = { = {ER/DER/D} = excess reserves ratio} = excess reserves ratio

2323

Deriving the Deriving the Money Multiplier IIMoney Multiplier II

The total amount of reserves ( ) equals the sum of

required reserves ( ) and excess reserves ( ).

The total amount of required reserves equals the required

reserve ratio times the amount of

R

RR ER

R = RR + ER

checkable deposits

Subsituting for RR in the first equation

The Fed sets r to less than 1

RR = r × D

R = (r × D) + ER

2424

Deriving the Deriving the Money Multiplier IIIMoney Multiplier III

The monetary base The monetary base MBMB equals currency equals currency (C)(C) plus reserves plus reserves (R)(R)::

MB = C + R = C + (r x D) + ERMB = C + R = C + (r x D) + EREquation reveals the amount of the Equation reveals the amount of the

monetary base needed to support the monetary base needed to support the existing amounts of checkable deposits, existing amounts of checkable deposits, currency and excess reserves.currency and excess reserves.

2525

Deriving the Deriving the Money Multiplier IVMoney Multiplier IV

c = {C / D} C = c D and

e = {ER / D} ER = e D

Substituting in the previous equation

MB (r D) (eD) (c D) (r e c)D

Divide both sides by the term in parentheses

D 1

r e cMB

M D C and C c D

M D (c D) (1 c)D

Substituting again

M 1 c

r e cMB

The money multiplier is then

m 1 c

r e c

2626

Intuition Behind the Intuition Behind the Money MultiplierMoney Multiplier

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

2727

Application: The Great Depression Application: The Great Depression Bank Panics, 1930 - 1933. Bank Panics, 1930 - 1933.

Bank failures (and no deposit insurance) Bank failures (and no deposit insurance) determined:determined: Increase in deposit outflows and holding of Increase in deposit outflows and holding of

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

(banks)(banks)For a relatively constant For a relatively constant MBMB, the money , the money

supply decreased due to the fall of the supply decreased due to the fall of the money multiplier. money multiplier.

2828

Deposits of Failed Commercial Deposits of Failed Commercial Banks, 1929–1933Banks, 1929–1933

Source:Source: Milton Friedman and Anna Jacobson Schwartz, Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the UnitedA Monetary History of the United

States, 1867–1960States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309. (Princeton, NJ: Princeton University Press, 1963), p. 309.

2929

Excess Reserves Ratio and Excess Reserves Ratio and Currency Ratio, 1929–1933Currency Ratio, 1929–1933

Sources:Sources: Federal Reserve Federal Reserve BulletinBulletin; Milton Friedman and Anna Jacobson Schwartz, ; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–A Monetary History of the United States, 1867–19601960 (Princeton, NJ: Princeton University Press, 1963), p. 333. (Princeton, NJ: Princeton University Press, 1963), p. 333.

3131

M1 and the Monetary Base, M1 and the Monetary Base, 1929–19331929–1933

Source:Source: Milton Friedman and Anna Jacobson Schwartz, Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.(Princeton, NJ: Princeton University Press, 1963), p. 333.

3333

MONETARY STATISTICS DURING GREAT DEPRESSIONCurrency Res/Dep Reserves M1

Dec-29 3.85 0.075 3.15 45.9Dec-30 3.79 0.082 3.31 44.1Dec-31 4.59 0.095 3.11 37.3Dec-32 4.82 0.109 3.18 34.0Dec-33 4.85 0.133 3.45 30.8

Why did money supply fell during the Great Depression even though the Fed kept reserves up?

What would M value be in 1932 if reserve ratio did not change?

the money supply process

Documents

open market salereduces

currencymonetary base

bank deposits

reductionmonetary base

summarythe effect

depositsthe effect

fednet effect

federal reserveinterven