CHAPTER 14: THE MONEY SUPPLY PROCESS

I. THREE PLAYERS IN THE MONEY SUPPLY PROCESS (Trọng)

The “cast of characters” in the money supply story is as follows:

1. The central bank - the government agency that oversees the banking system and is responsible for the
conduct of monetary policy; in the USA, the FED.

2. Banks (depository institutions) - the financial intermediaries that accept deposits from individuals and
institutions and make loans: commercial banks, mutual saving banks and credit unions.

3. Depositors individuals and institutions that hold deposits in banks.

Of the three players, the central bank – the FED - is the most important. Its conduct of monetary policy
involves actions that affect its balance sheet (holdings of assets and liabilities), to which we turn now.

II. THE FED’S BALANCE SHEET (Trọng)

Liabilities:

1. Currency in circulation: is the amount of currency in the hands of the public.

2. Reserves: Reserves consist of deposits at the Fed plus currency that is physically held by banks (vault
cash). Reserves are assets for the banks but liabilities for the Fed.

Assets:

1. Securities: The primary way in which the Fed provides reserves to the banking system is by purchasing
securities, thereby its holdings of these assets. An increase in government or other securities held by the
Fed leads to an increase in the money supply => affect the money supply and earn interest.

2. Loans to financial institutions: Making loans to banks and other financial institutions. The loans taken
out by these institutions are referred to as borrowed reserves. An increase in loans to financial
institutions can also be the source of an increase in the money supply.

III. CONTROL OF THE MONEYTARY BASE

The monetary base equals currency in circulation (C) plus the total reserves in the banking system (R).
The monetary base MB can be expressed as

MB = C + R

The Fed exercises control over the monetary base through its purchases or sale of government securities
in the open market, called open market operations, and through its extension of loans to banks.

Federal Reverse Open Market Operations (Hạnh)

The primary way in which the Fed can cause changes in the monetary base is through its open market
operations. A purchase of bonds by the Fed is called an open market purchase, and a sale of bonds by
the Fed is called an open market sale. The Fed’s purchases and sales of bonds are always done through
primary dealers.

Open Market Purchase Suppose that the Fed purchases $100 million of bonds from a primary dealer. To
understand the consequences of this transaction, we look at T-accounts.

When the primary dealer sells the $100 million of bonds to the Fed, the Fed adds $100 million to the
dealer’s deposit account at the Fed, so that reserves in the banking system go up by $100 million.

The Fed meanwhile finds that its liabilities have increased by the additional of $100 million of reverses,

along with an increase of $100 million of securities in its assets column.

The net result of this open-market purchase is that reserves have increased by $100 million, the amount
of the open-market purchase. Because bank reserves have increased and there has been no change of
currency in circulation, the monetary base has also risen by $100 million (an open-market purchase
increases the monetary base by an amount equal to the amount of the purchase).

Open Market Sale If the Fed conducts an open market sale of $100 million of bonds to a primary dealer,
the Fed deducts $100 million from the dealer’s deposit account, so the Fed’s reverses (liabilities) fall by
$100 million (monetary base will decline by the same amount).

Shifts from Deposits into Currency (Hạnh)

Even if the Fed does not conduct open market operations, a shift from deposits to currency will affect
the reserves in the banking system.

Let’s suppose that during the Christmas season, the public wants to hold more currency (money) to buy
stuff and so withdraws $100 million in cash. The effect on the T-account of the nonbank public is:
The banking system loses $100 million of deposit and hence $100 million of reserves:

For the Fed, the public’s action means that $100 million of additional currency is circulating in the hands

of the public, while reserves in the banking system have fallen by $100 million.

The net effect on the monetary liabilities of the Fed is a wash (zero); the monetary base is unaffected by
the public’s increased desire for cash. But reserves are affected. Random fluctuations of reserves can
occur as a result of random shifts into currency and out of deposits, and vice versa. The same is not true
for the monetary base, making it a more stable variable and more controllable by the Fed.

Loans to Financial Institutions (Lin Đa)

The monetary base is also affected when the Fed makes a loan to a financial institution. When the Fed
makes a $100 million loan to the First National Bank, the bank is credited with $100 million of reserves
from the proceeds of the loan. The effects on the balance sheet of the banking system and the Fed are
illustrated by the following T-accounts:

The monetary liabilities of the Fed have now increased by $100 million, and the monetary base has
increased by this amount. However, if a bank pays off a loan from the Fed, thereby reducing its
borrowings from the Fed by $100 million, the T-accounts of the banking system and the Bank are as
follows:
The net effect on the monetary liabilities of the Fed, and hence on the monetary base, is a reduction of
$100 million. We see that the monetary base changes one-for-one ratio with the change in the
borrowings from the Fed.

Other Factors That Affect the Monetary Base (Lin Đa)

Two important items that are not controlled by the Bank but affect the monetary base are float and
government deposits at the Fed. When the Fed clears cheques for banks, it often credits the amount of
the cheque to a bank that has deposited it (increases the bank’s reverse) before it debits (decreases the
reserves of) the bank on which the cheque is drawn. The resulting temporary net increase in the total
amount of reverses in the banking system (and hence in the monetary base) occurring from the Fed’s
cheque-clearing process is called float. Also, certain federal government flows (for example, federal
government receipts and disbursements) affect government deposits at the Fed. Net government
receipts lead to a rise in government deposits at the Bank, causing a deposit outflow at the and thus
causing reserves in the banking system and the monetary base to fall. Thus float (affected by random
events such as the weather, which affects how quickly cheques are presented for payment) and
government deposits at the Fed (determined by the federal government s actions) both affect the
monetary base but are not controlled by the Fed at all. Moreover, intervening in the foreign exchange
market also affects the monetary base.

Overview of the Fed’s Ability to Control the Monetary Base (Lin Đa)

Whereas the amount of open market operations (purchases or sales) is completely controlled by the
Fed’s placing orders with dealers in bond markets, the central bank lacks complete control over the
monetary base because it cannot unilaterally determine, and therefore perfectly predict, the amount of
borrowing by banks from the Fed.

Therefore, we might want to split the monetary base into two components: one that the Fed can control
completely and another that is less tightly controlled. The less tightly controlled component is the
amount of the base that is created by advances from the Fed. The remainder of the base (called the
nonborrowed monetary base) is under the Fed’s control because it results primarily from open market
operations. The nonborrowed monetary base is formally defined as the monetary base minus advances
from the Fed, which are referred to as borrowed reserves:

MBn = MB - BR

where MBn = nonborrowed monetary base

BR = borrowed reserves from the Fed

Factors not controlled at all by the Fed undergo substantial shortrun variations and can be important
sources of fluctuations in the monetary base over time periods as short as a week. However, these
fluctuations are quite predictable and so can be offset through open market operations. Although
technical and external factors complicate control of the monetary base, they do not prevent the Fed
from accurately controlling it.

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

With our understanding of how the Fed controls the monetary base and how banks operate, we now
have the tools necessary to explain how deposits are created. When the Fed supplies the banking system
with $1 of additional reserves, deposits increase by a multiple of this amount - a process called multiple
deposit creation.

Deposit Creation: The Single Bank (Quỳnh)

Suppose that the Fed has bought the $100 million bond from the First National Bank, the bank finds that
it has an increase in reserves of $100 million. To analyze what the bank will do with these additional
reserves, assume that the bank does not want to hold more reserves because it earns no interest on
them.

Because the bank has no increase in its checkable deposits, required reserves remain the same, and the
bank finds that its additional $100 million of reserves means that its excess reserves (reserves in excess
of desired reserves) have increased by $100 million.

The bank decides to make a loan equal in amount to the $100 million increase in excess reserves. When
the bank makes the loan, it sets up an account for the borrower and puts the proceeds of the loan into
this account. In this way, the bank alters its balance sheet by increasing its liabilities with $100 million of
checkable deposits and at the same time increasing its assets with the $100 million loan. The results:
The bank has created checkable deposit by its act of lending. Because deposits are part of the money
supply, the bank’s act of lending, in fact, creates money.

The increase in reserves of $100 million has been converted into additional loans at the First National
Bank and deposits to other banks.

Deposit Creation: The Banking System (Quỳnh)

What happens to these deposits at the other banks.

Assume that the $100 million of deposits created by First National Bank’s loan is deposited at Bank A and
that this bank and all other banks hold no excess reserves. Bank A s T-account becomes:

If the required reserve ratio is 10%, Bank A will now find itself with a $10 million increase in required
reserves, leaving it $90 million of excess reserves. Because Bank A does not want to hold on to excess
reserves, it will make loans for the entire amount. Its loans and checkable deposits will then increase by
$90 million.

If the money spent by the borrower to whom Bank A lent the $90 million is deposited in another bank,

such as Bank B, the T-account for Bank B will be:

Bank B keeps 10% of $90 million ($9 million) as required reserves and has 90% of $90 million ($81
million) in excess reserves and so can make loans of this amount. Bank B will make a totaling $81 million
loan to a borrower, who spends the proceeds from the loan. Bank B’s T-account will be:

The $81 million spent by the borrower from Bank B will be deposited in another bank (Bank C).
Consequently, from the initial $100 increase of reserves in the banking system, the total increase of
chequable deposits in the system so far is $271 million (= $100m + $90m + $81m).

Following the same reasoning, if all banks make loans for the full amount of their excess reserves,
further increments in checkable deposits will continue (at Banks C, D, E, and so on). Therefore, the total
increase in deposits from the initial $100 increase in reserves will be $1000 million.

When the bank buys $90 million of securities, it writes a $90 million in checks to the seller of the
securities, who in turn deposits the $90 million at a bank such as Bank B. Bank B’s checkable deposits
rise by $90 million, and the deposit expansion process is the same as before. Whether a bank chooses to
use its excess reserves to make loans or to purchase securities, the effect on deposit expansion is the
same.

In our example, we assume a single bank. However, the banking system as a whole can generate a
multiple expansion of deposits because when a bank loses its excess reserves, these reserves do not
leave the banking system. So as each bank makes a loan and creates deposits, the reserves find their way
to another bank, which uses them to make additional loans and create additional deposits. This process
continues until the initial increase in reserves results in a multiple increase in deposits.

The multiple increase in deposits generated from an increase in the banking system s reserves is called
the simple deposit multiplier. In our example, with a 10% desired reserve ratio, the simple deposit
multiplier is 10. More generally, the simple deposit multiplier equals the reciprocal of the desired reserve
ratio. The formula for the multiple expansion of deposits can be written as:

1
∆ D= ×∆ R
rr
where ∆D = change in total chequable deposits in the banking system
rr = required reserve ratio (0.10 in the example)
∆R = change in reserves for the banking system ($100 in the example)

If Bank A chooses to invest its excess reserves in securities, instead of lending, the result is the same.

For the banking system as a whole, deposit creation (or contraction) will stop only when excess reserves
in the banking system are zero.

Critique of the Simple Model (Tâm)

Our model of multiple deposit creation seems to indicate that the Fed is able to exercise complete
control over the level of checkable deposits by setting the required reserve ratio and the level of
reserves. Currency does not lead to multiple deposit expansion, while deposits do. Thus, if some
proceeds from loans are used to raise the holdings of currency, there is less multiple expansion overall,
and the money supply will not increase by as much as our simple model of multiple deposit creation tells
us.

This is beacause of two simplifying assumptions:

1. Banks do not make loans or buy securities in the full amount of their excess reserves. If banks choose
to hold all or some of their excess reserves, the full expansion of deposits predicted by the simple model
of multiple deposit creation again does not occur (If Bank A decides to hold on to all of its excess
reserves, no deposits would be made in Bank B).

2. Depositors’ decisions regarding how much currency to hold and banks’ decisions regarding the
number of reserves to hold can cause the money supply to change.

FACTORS THAT DETERMINE THE MONEY SUPPLY (Tâm)

The Fed’s open market purchases increase the nonborrowed monetary base, and its open market sales
decrease it. Holding all other variables constant, an increase in MBn arising from an open market
purchase increases the amount of the monetary base and reserves, so that multiple deposit creation
occurs and the money supply increases. Similarly, an open market sale that decreases MBn shrinks the
amount of the monetary base and reserves, thereby causing a multiple contraction of deposits and the
money supply decreases.

→ The money supply is positively related to the nonborrowed monetary base, MB n.

Changes in Borrowed Reverses, BR, from the Fed

An increase in advances from the Fed provides additional borrowed reserves, and thereby increases the
amount of the monetary base and reserves, so that multiple deposit creation occurs, and the money
supply expands. If banks reduce the level of their discount loans, all other variables hold constant, the
monetary base and number of reserves fall, and the money supply would decrease.

→ The money supply is positively related to the level of borrowed reserves, BR, from the Fed

Changes in the Required Reserve Ratio, rr

If the required reserve ratio on checkable deposits increases while all other variables (the monetary
base) stay the same, we have seen that multiple deposit expansion is reduced and hence the money
supply falls. If, on the other hand, the desired reserve ratio falls, multiple deposit expansion is higher,
and the money supply would rise.

→ The money supply is negatively related to the required reserve ratio, rr.

Changes in Excess Reserves

When banks increase their holdings of excess reverses, those reserves are no longer being used to make
loans, causing multiple deposit creation. Resulting in less expansion of the money supply. On the other
hand, banks choose to hold fewer excess reverses, loans and multiple deposits creation increase, and the
money supply rises.

→ The money supply is negatively related to the amount of excess reserves.

Changes in Currency Holdings

Checkable deposits undergo multiple expansions, while currency does not. Hence, when checkable
deposits are converted into currency (other variables held constant), a switch is made from a component
of the money supply that undergoes multiple expansion to one that does not. The overall level of
multiple expansion declines and the money supply falls. On the other hand, if currency holdings fall, a
switch is made into checkable deposits that undergo multiple deposit expansion, so the money supply
rises.

→ The money supply is negatively related to currency holdings.

We now have a model of the money supply process in which all three of the players - the Fed,
depositors, and banks - directly influence the money supply.

The Fed influences the money supply by controlling the first two variables. Depositors influence the
money supply through their decisions about their holdings of currency. Banks influence the money
supply with their decisions about borrowings from the Fed and excess reserves.

THE MONEY MULTIPLIER (Khôi)

The intuition in the section above is sufficient for you to understand how the money supply process
works. We can derive all the above results using a concept called the money multiplier, denoted by m,
which tells us how much the money supply changes for a given change in the monetary base. The
relationship among the money supply M, the money multiplier m, and the monetary base MB is
described by the following equation:

M = m x MB

The money multiplier m tells us what multiple of the monetary base is transformed into the money
supply. The money multiplier is larger than 1, the alternative name for the monetary base, high-powered
money, is logical: a $1 change in the monetary base leads to more than a $1 change in the money supply.

The money multiplier m equation is:

1+c
m=
rr + e+c
It is a function of the currency ratio set by depositors c, the excess reverses ratio set by banks e, and the
required reserve ratio set by the Fed rr.
Intuition Behind the Money Multiplier

To get a feel for what the money multiplier means, let us construct a numerical example with realistic
numbers for the following variables:

rr = required reserve ratio = 0.10

C = currency in circulation = $1,200 billion

D = chequable deposits = $1,600 billion

ER = excess reverves = $2,500 billion

M money supply (M1) = C + D = $2,800 billion

From these numbers we can calculate the value for the currency ratio c and the excess reverses ratio e:

$ 1,200 billion
c= =0.75
$ 1,600 billion
$ 2,500 billion
e= =1.56
$ 1,600 billion
The resulting value of the money multiplier is:

1+ 0.75 1.75
m= = =0.73
0.1+1.56+ 0.75 2.41
The money multiplier of 0.73 tells us that, given the required reserve ratio of 10% on checkable deposit
and the behavior of depositors, as represented by c = 0.75 and banks, as represented by e = 1.56, a $1
increase in the monetary base leads to a $0.73 increase in the money supply (M1).

An important characteristic of the money multiplier is that it is less than the simple deposit multiplier of
10 found earlier in the chapter. There are 2 reasons for this result. First, although deposits undergo
miltiple expansion, currency does not. Second, since e is positive, any increase in the monetary base
and deposits leads to higher excess reserves.

Money Supply Response to Changes in the Factors

Now we can show how the money supply responds to the changes in the factors.

As you can see a rise in MBn or BR raises the money supply M by a multiple amount because the money
multiplier m is greater than one. We can see that a rise in the desired reserve ratio lowers the money
supply by calculating the value of the money multiplier in our numerical example when rr increases from
10% to 15% (leaving all other variables unchanged). The money multiplier then becomes which, as we
would expect, is less than 0.73.

1+ 0.75 1.75
m= = =0.71
0.15+1.56+ 0.75 2.46
Similarly, we can see that a rise in excess reverses lowers the money supply by calculating the money
multiplier when e is raised from 1.56 to 0.30. The money multiplier decreases from 0.73 to 0.45.

1+ 0.75 1.75
m= = =0.45
0.1+3.00+0.75 3.85
We can also analyze when there is a rise in the currency ratio c from 0.75 to 1.50. Instead of falling, the
money multiplier rises from 0.73 to 0.78.

1+ 0.75 1.75
m= = =0.78
0.1+1.56+1.50 3.20