Chapter 14The Federal Reserve’s Balance Sheet and the Money Supply Process

 Brief Chapter Summary and Learning Objectives

14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 412–419)Explain the relationship between the Fed’s balance sheet and the monetary base. There is a close connection between the monetary base and the Fed’s balance sheet, which lists

the Fed’s assets and liabilities. The monetary base is the sum of the Fed’s two major liabilities, currency in circulation and bank

reserves. The most direct method the Fed uses to change the monetary base is open market operations,

which involve buying or selling securities, generally U.S. Treasury securities. Though less commonly used, the Fed can also increase or decrease reserves by making discount

loans to commercial banks. Although open market operations and discount loans both change the monetary base, the Fed has

greater control over open market operations than over discount loans.

14.2 The Simple Deposit Multiplier (pages 420–424)Derive the equation for the simple deposit multiplier and understand what it means. An increase in bank reserves results in rounds of bank loans and creation of checkable deposits

and an increase in the money supply that is a multiple of the initial increase in reserves. The simple deposit multiplier relates the initial change in reserves to the change in the money

supply and equals the inverse of the required reserve ratio.

14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 424–433)Explain how the behavior of banks and the nonbank public affect the money multiplier. Increases in currency holdings or excess reserves reduce the multiple deposit creation process. The money multiplier is the ratio of the money supply to the monetary base. It is shown that the money multiplier equals 1 plus the currency-to-deposit ratio divided by the sum

of the currency-to-deposit ratio, the excess reserves-to-deposit ratio, and the required reserve ratio. During the financial crisis of 2007–2009, the excess reserves-to-deposit ratio soared, causing the

money multiplier to decline by about 50%.

14A The Money Supply Process for M2 (page 441) Describe the money supply process for M2

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 Key Terms and Concepts

Bank reserves Bank deposits with the Fed plus vault cash.

Currency-to-deposit ratio (C/D) The ratio of currency held by the nonbank public, C, to checkable deposits, D.

Currency in circulation Paper money and coins held by the nonbank public.

Discount loan A loan made by the Federal Reserve, typically to a commercial bank.

Discount rate The interest rate the Federal Reserve charges on discount loans.

Excess reserves Reserves that banks hold over and above those the Fed requires them to hold.

Monetary base (or high-powered money) The sum of bank reserves and currency in circulation.

Multiple deposit creation Part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits and an increase in the money supply that is a multiple of the initial increase in reserves.

Open market operations The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

Open market purchase The Federal Reserve’s purchase of securities, usually U.S. Treasury securities.

Open market sale The Fed’s sale of securities, usually Treasury securities.

Required reserve ratio The percentage of checkable deposits that the Fed specifies that banks must hold as reserves.

Required reserves Reserves that the Fed compels banks to hold.

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

Vault cash Currency held by banks.

 Chapter Outline

George Soros, “Gold Bug”

During 2009 and 2010, sales of gold for investment soared. Billionaire George Soros held more than $600 million in gold bullion and shares of stock in gold mining companies. Investors saw gold as a way to hedge against the risk of inflation.

14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 412–419)

Learning Objective: Explain the relationship between the Fed’s balance sheet and the monetary base.A. The Federal Reserve’s Balance Sheet

There is a close connection between the monetary base and the Fed’s balance sheet, which lists the Fed’s assets and liabilities. The Fed’s primary assets include government securities and discount loans, while its primary liabilities are currency in circulation and reserves.

B. The Monetary BaseThe monetary base is the sum of the Fed’s two major liabilities, currency in circulation and bank reserves. Currency in circulation equals currency outstanding minus vault cash. Bank reserves equals commercial bank deposits at the Fed plus vault cash. Reserves include required reserves and excess reserves.

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C. How the Fed Changes the Monetary BaseThe most direct method the Fed uses to change the monetary base is open market operations, which involve buying or selling securities, generally U.S. Treasury securities. In an open market purchase, the Fed buys Treasury securities and increases the monetary base by the amount of the purchase. Similarly, the Fed can reduce the monetary base through an open market sale of Treasury securities. The effect of the Fed’s actions on the balance sheets of the banking system as a whole, the nonbank public, and the Fed can be illustrated using T-accounts. Though less commonly used, the Fed can also increase or decrease reserves by making discount loans to commercial banks. This change in bank reserves changes the monetary base

D. Comparing Open Market Operations and Discount LoansAlthough open market operations and discount loans both change the monetary base, the Fed has greater control over open market operations than over discount loans. Economists think of the monetary base as having two components: (1) the nonborrowed monetary base, Bnon (which the Fed controls), and (2) borrowed reserves, BR, which is another name for discount loans.

14.2 The Simple Deposit Multiplier (pages 420–424)

Learning Objective: Derive the equation for the simple deposit multiplier and understand what it means.A. Multiple Deposit Expansion

An open market purchase increases the excess reserves of the banking system. Normally, banks use the excess reserves to make loans, which are redeposited into the banking system after being used to purchase an item. The bank that receives the new deposit holds some of it in the form of required reserves and loans the rest. This process continues in rounds of loans and bank deposits, resulting in an increase in the money supply that is a multiple of the initial increase in reserves.

B. Calculating the Simple Deposit MultiplierThe simple deposit multiplier relates the initial change in reserves to the change in the money supply and equals the inverse of the required reserve ratio.

14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 424–433)

Learning Objective: Explain how the behavior of banks and the nonbank public affect the money multiplier.

The simple deposit multiplier assumed banks hold no excess reserves and the nonbank public did not change its currency holdings.

A. The Effect of Increases in Currency Holdings and Increases in Excess ReservesSince funds deposited in banks are subject to the multiple deposit creation process, while funds held as currency are not, an increase in currency holdings reduces the multiple deposit creation. In a similar way, if banks hold more excess reserves relative to deposits, the multiple deposit creation is reduced.

B. Deriving a Realistic Money MultiplierA realistic money multiplier links the monetary base to the money supply. The money multiplier is the ratio of the money supply to the monetary base. It is shown that the money multiplier is 1 plus currency-deposit ratio divided by the sum of the currency-to-deposit ratio, excess reserves-to-deposit ratio, and required reserve ratio. Since the money supply equals the money multiplier times the monetary base, the money supply can increase due to either an increase in the money multiplier or an increase in the monetary base. Increases in the currency-to-deposit ratio, excess

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reserves-to-deposit ratio, or required reserve ratio reduce the money multiplier and this reduces the money supply (assuming no change in the monetary base).

C. The Money Supply, Money Multiplier, and the Monetary Base during the 2007–2009 Financial CrisisDuring the financial crisis of 2007–2009, the currency-to-deposit ratio declined slightly, but the excess reserves-to-deposit ratio soared, leading to a 50% decline in the money multiplier. Reasons for the dramatic increase in the excess reserves-to-deposit ratio include (1) the desire on the part of banks for increased liquidity as banks sought to increase their capital due to heavy losses on mortgage-backed-securities, (2) tighter lending standards due to uncertainty about the credit worthiness of borrowers, and (3) the introduction of interest on reserves. In 2010, banks’ enormous holdings of excess reserves left investors, policymakers, and economists concerned about the implications for future inflation.

14A The Money Supply Process for M2 (page 441)

Learning Objective: Describe the money supply process for M2.

Many analysts and policymakers pay more attention to M2 than M1. M2 includes everything in M1 plus nontransaction accounts such as small savings and time deposit accounts and money market deposit accounts. We can derive an expression for the M2 multiplier similar to the expression we derived for the M1 multiplier. The result is:

M2 multiplier [1 (C/D) (N/D) (MM/D)]/[(C/D) + rrD + (ER/D)]

Increases in the required reserve ratio and the currency-to-deposit ratio reduce the extent of deposit expansion, thereby reducing the multiplier. However, an increase in the nonbank public’s preference for nontransaction or money market–type accounts relative to checkable deposits increases the multiplier.

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 Solutions to the End-of-Chapter Questions and Problems

Answers to Thinking Critically Questions

1. The Federal Reserve bought mortgage-backed securities when their prices were very high and interest rates were low. In a growing economy, the demand for loans increases and interest rates rise. The Fed would have to accept lower and lower prices to sell its mortgage-backed securities to other investors. Selling the securities at a loss would reduce the Federal Reserve's profits. The Federal Reserve transfers some of the profits it earns on the securities it holds to the U. S. Treasury, so lower profits for the Fed would mean lower profits transferred to the Treasury.

2. Selling mortgage-backed securities during an economic recovery would reverse the benefits of the original program. It could cause interest rates to rise and reduce economic growth. A "fire sale" could also damage the banking industry by driving down the value of other mortgage securities that banks hold in large quantities.

14.1 The Reserve’s Balance Sheet and the Monetary Base

Learning Objective: Explain the relationship between the Fed’s balance sheet and the monetary base.

Review Questions

1.1 The monetary base is the sum of bank reserves and currency in circulation. The money supply equals the monetary base multiplied by the money multiplier.

1.2 Currency in circulation Currency outstanding – Vault cash. Currency in circulation is part of the monetary base.

1.3 Required reserves are reserves that the Fed compels banks to hold. Excess reserves are reserves, beyond those that are required by the Fed. Excess reserves are reserves the banks elect to hold. The required reserve ratio is the percentage of checkable deposits that the Fed specifies that banks must hold as reserves.

1.4 Open market operations are the Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. An open market purchase increases the monetary base.

1.5Bank of America

Assets Liabilities

Securities $1 million

Reserves $1 million

Federal ReserveAssets Liabilities

Securities $1 million Reserves $1 million

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1.6 The nonborrowed monetary base is the part of the monetary base that is not borrowed via the Fed’s discount lending facility. The monetary base equals the nonborrowered monetary base plus borrowed reserves.

Problems and Applications

1.7 a. The size of the Fed’s balance sheet refers to the total value of Federal Reserve assets.b. There is a strong connection between the two. When the Fed expands its balance sheet, the Fed

is buying securities and other assets in exchange for reserves. Banks receive (excess) reserves in exchange for the securities the Federal Reserve purchases.

1.8 The size of the balance sheet would stay the same, since the mortgaged-backed securities will simply be replaced with U.S. Treasury securities. The Federal Reserve would most likely do this if the economy were weak.

1.9 a.Banking system

Assets Liabilities

Reserves $2 billion Borrowings (Discount Loans) $2 billion

Federal ReserveAssets Liabilities

Discount Loans $2 billion Reserves $2 billion

b.Banking system

Assets Liabilities

Securities $2 million

Reserves $2 million

Federal Reserve

Assets Liabilities

Securities $2 million Reserves $2 million

1.10 The renovation will increase the monetary base by $10 million. The Fed will write a check, the renovation company will deposit the check in its bank and the bank will send the check to the Fed, which increases the bank’s reserves.

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14.2 The Simple Deposit Multiplier

Learning Objective: Derive the equation for the simple deposit multiplier and understand what it means.

Review Questions

2.1PNC Bank

Assets Liabilities

Securities $1 million

Loans $1million

Securities are sold for cash (excess reserves), which are immediately lent out (loans).

2.2 Multiple deposit creation is the part of the money supply process in which an increase in the bank reserves results in subsequent rounds of bank loans and the creation of checkable deposits, resulting in an increase in the money supply that is a multiple of the initial increase in reserves.

2.3 The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. Simple deposit multiplier 1/rrD 1/.15 6.66%

Problems and Applications

2.4 The $100,000 loan to Jill’s Jerseys with the accompanying checking account increases Bank of America’s assets and liabilities by $100,000.

Bank of America

Assets Liabilities

Loans $100,000 Checkable Deposits Q + $100,000

The $100,000 check spent by Jill’s Jerseys and deposited in PNC decreases Bank of America’s reserves by $100,000 and Jill’s Jerseys checking account by $100,000.

Bank of AmericaAssets Liabilities

Reserves $100,000 Checkable Deposits $100,000

Loans $100,000

The total change in Bank of America’s assets equals zero with an additional $100,000 in loans and a loss of $100,000 of reserves. The total change in liabilities equals zero with the $100,000 checking account being spent.

2.5 The bank can lend out 90% of the $10,000, or $9,000

2.6 a.JP Morgan Chase Bank: open market sale to FedAssets Liabilities

Securities $100 millionReserves $100 million

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Federal Reserve: open market purchase from JP Morgan Chase BankAssets Liabilities

Securities $100 million Reserves $100 million

b.JP Morgan: Granted $100 million loan but before the borrower has spent the

proceeds of the loan.Assets Liabilities

Securities $ 100 million Checkable Deposits $ 100 million

$ 100 million

Loans $ 100million

c.JP Morgan after loan proceeds have been spent

Assets Liabilities

Securities $ 100 million Checkable Deposits $ 0Loans $ 100 millionReserves $ 0

Wells Fargo after receiving new deposit of $100 millionAssets Liabilities

Reserves: $100 million Checkable Deposits $ 100 million

2.7 a. Required reserves 0.03(30) 0.12(150) 18.9. Excess reserves 0.b. Assets: Reserves 23.9, Securities 26.1; everything else is the same. Total reserves are now

23.9; Required reserves still equal 18.9, so excess reserves equal 5.

Assets Liabilities

Reserves $23.9 Checkable deposits $180.0

Loans 150.0 Net worth 20.0

Securities 26.1

Total $200.0 Total $200.0

c. Assets: Loans 155; Liabilities: Checkable deposits 185; everything else is the same, as in part (b), other than total assets and total liabilities rise to $205. Required reserves rise to 19.5, so with reserves of $23.9, excess reserves equal $4.4.

Assets Liabilities

Reserves $23.9 Checkable deposits $185.0

Loans 155.0 Net worth 20.0

Securities 26.1

Total $205.0 Total $205.0

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d Assets: Reserves 18.9; Liabilities: Checkable deposits 180; everything else the same as in part (c), other than total assets and total liabilities fall to $200. Required reserves equal $18.9, so excess reserves equal 0.

Assets LiabilitiesReserves $18.9 Checkable deposits $180.0Loans 155.0 Net worth 20.0Securities 26.1Total $200.0 Total $200.0

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2.8 a. People asked the goldsmiths to store gold for them in return for a receipt to prove the gold was there. Today, we ask banks to store our paychecks and portions of our savings in return for checking and savings accounts. The goldsmiths become more like modern banks when 1) the goldsmith’s receipts, instead of the gold itself, began to be used as the medium of exchange, and 2) the goldsmiths began to make loans on their holdings of gold.

b. Multiple deposits would only work if other institutions accepted the gold receipts as deposits.

14.3 Banks, the Nonbank Public, and the Money Multiplier

Learning Objective: Explain how the behavior of banks and the nonbank public affect the money multiplier.

Review Questions

3.1 The simple deposit multiplier differs from the money multiplier in three ways: 1) The money multiplier provides a link between the monetary base and the money supply; 2) it includes the effects of the money supply process on changes in the public’s desire to hold currency relative to checkable deposits; and 3) the money multiplier includes the effects of changes in banks’ desire to hold excess reserves to deposits.

3.2 a. The higher the C/D ratio, the lower the money multiplier.b. The larger the ER/D ratio, the smaller the money multiplier.c. The higher the rrD , the lower the money multiplier.

3.3 The currency-to-deposit ratio (C/D) fell, and the excess reserves-to-deposit ratio (ER/D) rose dramatically during the financial crisis. The increase in ER/D was significantly larger than the decrease in C/D, causing the value of the money multiplier to decline.

Problems and Applications

3.4 If the required reserve ratio equaled zero, the simple deposit multiplier would equal infinity, implying that multiple deposit expansion would go on forever. However, the realistic money multiplier, which includes currency and excess reserve holdings, would not equal infinity even if the required reserve ratio equaled zero, so multiple deposit expansion would not go on forever.

3.5 Interest rates are what people could be earning instead of holding gold, hence the next best opportunity. Low interest rates are likely to increase the price of gold

3.6 The M1 monetary multiplier (m) would equal 1: m [(C/D) 1] / [(C/D) rrD (ER/D)] (1 1) / (1 1 0) 1.

3.7 Currency-to-deposit ratio (C/D) $100/$800 .125; total reserves to deposits equals $200/$800 .25; the monetary base equals $100 $200 $300; for the M1 money multiplier, m, the excess reserves-to-deposit ratio equals $40 / $800 = .05 and the required reserve ratio, rrD, equals $160 / $800 .20, so m (.125 1) / (.125 .2 .05) 1.125 / 0.375 3; M1 $900.

3.8 a. Currency-to-deposit ratio = $850 / $700 = 1.214; total reserves-to-deposit ratio $700 / $700 1; the monetary base $850 $700 $1,550; the M1 money multiplier (1.214 1) / (1.214 1 0) 1, assuming the $700 billion of bank reserves are all required ; and M1 $850 billion $700 billion $1,550 billion.

b. (1.214 1) / (1.214 2 0) 0.69

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3.9

 C/D R/D

Monetary Base

Money Multiplier

M1 Money Supply

1930 $3,681/21,612 0.17

3,227/21,612 0.15 69083.7

25,293

1931 3,995/19,888 0.20 3,307/19,888 0.166 7302 3.3 23,883

1932 4,959/15,490 0.32 2,829/15,490 0.183 7788 2.6 20,449

Currency and reserves increased relative to deposits, because depositors were liquidating accounts in response to the crisis.

3.10 a. Banks were holding reserves to guard against bank runs.b. Meltzer is referring to the money multiplier process.c. Because the excess reserves would not be loaned, the Fed overestimated the money multiplier.d. Increasing the required reserve ratio lowered the money multiplier and reinforced monetary

contraction. Meltzer says the Fed didn’t understand that banks planned to hold their excess reserves for safety.

3.11 a. The value is as intrinsic as the value that people assign to it. Because of its long history as a hedge against inflation, many people believe gold has intrinsic value. Buiter is arguing that gold only has the value that people assign it. In this sense, gold is similar to fiat money.

b. If people believe the price of gold should be higher, then they will buy it and push the price higher.

c. We could look at the inflation-adjusted value of gold over time, or the value of gold compared to some other stable asset to determine if prices are historically high.

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Data Exercises

D14.1 The peak was 1981 when the federal funds rate exceeded 20%. The lower point is the current rate between 0 to 0.25%.

D14.2 a. The trend was moderately upward and stable.b. The monetary base skyrocketed to record heights.c. The recession of 2002 and the recent financial crisis have the most volatility.

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