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
Banking SystemBanking System Federal Reserve SystemFederal Reserve System
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
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
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
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
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
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
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
Checkable Checkable depositsdeposits
-$100-$100 ReservesReserves -$100-$100 Checkable Checkable depositsdeposits
-$100-$100
CurrencyCurrency ++$100$100
Federal Reserve SystemFederal Reserve System
AssetsAssets LiabilitiesLiabilities
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
Banking SystemBanking System Federal Reserve SystemFederal Reserve System
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
ReservesReserves +$100+$100 Discount Discount loansloans
+$100+$100 Discount Discount loanloan
+$100+$100 ReservesReserves +$100+$100
(borrowing from (borrowing from Fed)Fed)
(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
Banking SystemBanking System Federal Reserve SystemFederal Reserve System
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
ReservesReserves -$100-$100 Discount Discount loansloans
-$100-$100 Discount Discount loansloans
-$100-$100 ReservesReserves -$100-$100
(borrowing from (borrowing from Fed)Fed)
(borrowing from (borrowing from Fed)Fed)
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
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
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
AssetsAssets LiabilitiesLiabilities
SecuritiesSecurities -$100-$100
LoansLoans +$100+$100
1616
Deposit Creation: Deposit Creation: The Banking SystemThe Banking System
Bank ABank A Bank ABank A
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
ReservesReserves +$100+$100 Checkable Checkable depositsdeposits
+$100+$100 ReservesReserves +$10+$10 Checkable Checkable depositsdeposits
+$100+$100
LoansLoans +$90+$90
Bank BBank B Bank BBank B
AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities
ReservesReserves +$90+$90 Checkable Checkable depositsdeposits
+$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?