Learning Objectives

• List and describe the

Preview
A
“three players” that s we saw in Chapter 5 and will see in later chapters on monetary theory, move-
influence the money ments in the money supply affect interest rates and inflation and thus affect us
supply. all. Because of its far-reaching effects on economic activity, it is important to
• Classify the factors understand how the money supply is determined. Who controls it? What causes it to
affecting the Federal change? How might control of it be improved? In this chapter, we start to answer these
Reserve’s assets and questions by providing a detailed description of the money supply process, the mecha-
liabilities. nism that determines the level of the money supply.
• Identify the factors Because deposits at banks are by far the largest component of the money supply,
that affect the mon- learning how these deposits are created is the first step in understanding the money
etary base and discuss supply process. This chapter provides an overview of how the banking system creates
their effects on the deposits and describes the basic principles of the money supply, concepts that will
Federal Reserve’s bal- form the foundation for the material presented in later chapters.
ance sheet.
• Explain and illustrate
the deposit creation THREE PLAYERS IN THE MONEY
process through
T-accounts. SUPPLY PROCESS
• List the factors that The “cast of characters” in the money supply story is as follows:
affect the money
supply. 1. The central bank—the government agency that oversees the banking system and is
• Summarize how the responsible for the conduct of monetary policy; in the United States, the Federal
“three players” can Reserve System
influence the money 2. Banks (depository institutions)—the financial intermediaries that accept deposits
supply. from individuals and institutions and make loans: commercial banks, savings and
• Calculate and inter- loan associations, mutual savings banks, and credit unions
pret changes in the 3. Depositors—individuals and institutions that hold deposits in banks
money multiplier. Of the three players, the central bank—the Federal Reserve System—is the most
important. The Fed’s conduct of monetary policy involves actions that affect its balance
sheet (holdings of assets and liabilities), to which we turn now.

THE FED’S BALANCE SHEET

The operation of the Fed and its monetary policy involve actions that affect its balance
sheet, or its holdings of assets and liabilities. Here we discuss a simplified balance sheet
388
 CHAPTER 15 The Money Supply Process 389

that includes just four items that are essential to our understanding of the money sup-
ply process.1

Federal Reserve System

Assets Liabilities
Securities Currency in circulation
Loans to financial Reserves
institutions

Liabilities
The two liabilities on the balance sheet, currency in circulation and reserves, are often
referred to as the monetary liabilities of the Fed. They are an important part of the money
supply story, because increases in either or both will lead to an increase in the money sup-
ply (everything else held constant). The sum of the Fed’s monetary liabilities (currency in
circulation and reserves) and the U.S. Treasury’s monetary liabilities (Treasury currency
in circulation, primarily coins) is called the monetary base (also called high-powered
money). When discussing the monetary base, we will focus only on the monetary liabili-
ties of the Fed, because those of the Treasury account for less than 10% of the base.2
1. Currency in circulation. The Fed issues currency (those green-and-gray pieces of paper
in your wallet that say “Federal Reserve Note” at the top). Currency in circulation is
the amount of currency in the hands of the public. Currency held by depository insti-
tutions is also a liability of the Fed, but is counted as part of the reserves.
Federal Reserve notes are IOUs from the Fed to the bearer and are also liabili-
ties, but unlike most liabilities, they promise to pay back the bearer solely with
Federal Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if
you bring a $100 bill to the Federal Reserve and demand payment, you will receive
two $50s, five $20s, ten $10s, one hundred $1 bills, or some other combination of
bills that adds to $100.
People are more willing to accept IOUs from the Fed than from you or me
because Federal Reserve notes are a recognized medium of exchange; that is, they
are accepted as a means of payment and so function as money. Unfortunately, nei-
ther you nor I can convince people that our IOUs are worth anything more than
the paper they are written on.3
1
A detailed discussion of the Fed’s balance sheet and the factors that affect the monetary base can be found in Appen-
dix 1 to this chapter, which you can find at www.pearson.com/mylab/economics.
2
It is also safe to ignore the Treasury’s monetary liabilities when discussing the monetary base because legal restric-
tions prevent the Treasury from actively supplying its monetary liabilities to the economy.
3
The currency item on our balance sheet refers only to currency in circulation—that is, the amount in the hands
of the public. Currency that has been printed by the U.S. Bureau of Engraving and Printing is not automatically
a liability of the Fed. For example, consider the importance of having $1 million of your own IOUs printed. You
give out $100 worth to other people and keep the other $999,900 in your pocket. The $999,900 of IOUs does not
make you richer or poorer and does not affect your indebtedness. You care only about the $100 of liabilities from
the $100 of circulated IOUs. The same reasoning applies to the Fed in regard to its Federal Reserve notes.
For similar reasons, the currency component of the money supply, no matter how it is defined, includes only
currency in circulation. It does not include any additional currency that is not yet in the hands of the public. The
fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and thus
cannot affect anyone’s behavior. Therefore, it makes sense not to include it in the money supply.
390 PART 4 Central Banking and the Conduct of Monetary Policy

2. Reserves. All banks have an account at the Fed in which they hold deposits.
Reserves consist of deposits at the Fed plus currency that is physically held by
banks (called vault cash because it is stored in bank vaults). Reserves are assets for
the banks but liabilities for the Fed, because the banks can demand payment on
them at any time and the Fed is required to satisfy its obligation by paying Federal
Reserve notes. As you will see, an increase in reserves leads to an increase in the
level of deposits and hence in the money supply.
Total reserves can be divided into two categories: reserves that the Fed requires
banks to hold (required reserves) and any additional reserves the banks choose to
hold (excess reserves). For example, the Fed might require that for every dollar of
deposits at a depository institution, a certain fraction (say, 10 cents) must be held as
reserves. This fraction (10%) is called the required reserve ratio.

Assets
The two assets on the Fed’s balance sheet are important for two reasons. First, changes
in the asset items lead to changes in reserves and the monetary base, and consequently
to changes in the money supply. Second, because these assets (government securities
and Fed loans) earn higher interest rates than the liabilities (currency in circulation,
which pays no interest, and reserves), the Fed makes billions of dollars every year—its
assets earn income, and its liabilities cost practically nothing. Although it returns most
of its earnings to the federal government, the Fed does spend some of it on “worthy
causes,” such as supporting economic research.
1. Securities. This category of assets covers the Fed’s holdings of securities issued by the
U.S. Treasury and, in unusual circumstances (as will be discussed in Chapter 16),
other securities. As we will see, the primary way in which the Fed provides reserves
to the banking system is by purchasing securities, thereby increasing its holdings of
these assets. An increase in government or other securities held by the Fed leads to
an increase in the money supply.
2. Loans to financial institutions. The second way in which the Fed can provide reserves
to the banking system is by making loans to banks and other financial institutions.
The loans taken out by these institutions are referred to as discount loans, or alter-
natively as borrowings from the Fed or as borrowed reserves. These loans appear as a
liability on financial institutions’ balance sheets. An increase in loans to financial
institutions can also be the source of an increase in the money supply. During nor-
mal times, the Fed makes loans only to banking institutions, and the interest rate
charged to banks for these loans is called the discount rate. (As we will discuss in
Chapter 16, however, during the recent financial crisis, the Fed made loans to other
financial institutions.)

CONTROL OF THE MONETARY BASE

The monetary base equals currency in circulation C plus the total reserves in banking
system R.4 The monetary base MB can be expressed as
MB = C + R
4
Here, currency in circulation includes both Federal Reserve currency (Federal Reserve notes) and Treasury cur-
rency (primarily coins).
 CHAPTER 15 The Money Supply Process 391

The Federal Reserve exercises control over the monetary base through its purchases
or sales of securities in the open market, called open market operations, and through
its extension of discount loans to banks.

Federal Reserve Open Market Operations

The primary way in which the Fed causes 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. Federal
Reserve purchases and sales of bonds are always done through primary dealers, gov-
ernment securities dealers who operate out of private banking institutions.

Open Market Purchase Suppose the Fed purchases $100 million of bonds
from a primary dealer. To understand the consequences of this transaction, we look at
T-accounts, which list only the changes that occur in balance sheet items, starting from
the initial balance sheet position.
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 banking system’s T-account after this transaction is

Banking System
Assets Liabilities
Securities –$100 m
Reserves +$100 m

The effects on the Fed’s balance sheet are shown next. The balance sheet shows
an increase of $100 million of securities in its assets column, along with an increase of
$100 million of reserves in its liabilities column:

Federal Reserve System

Assets Liabilities
Securities +$100 m Reserves +$100 m

As you can see, the Fed’s open market purchase of $100 million causes an expan-
sion of reserves in the banking system by an equal amount. Another way of seeing this
is to recognize that open market purchases of bonds expand reserves because the cen-
tral bank pays for the bonds with reserves. Because the monetary base equals currency
plus reserves, an open market purchase increases the monetary base by an amount
equal to the amount of the purchase.

Open Market Sale Similar reasoning indicates that if the Fed conducts an open
market sale of $100 million of bonds to a primary dealer, the Fed deducts $100 million
392 PART 4 Central Banking and the Conduct of Monetary Policy

from the dealer’s deposit account, so the Fed’s reserves (liabilities) fall by $100 million
(and the monetary base falls by the same amount). The T-account is now

Federal Reserve System

Assets Liabilities
Securities –$100 m Reserves –$100 m

Shifts from Deposits into Currency

Even when the Fed does not conduct open market operations, a shift from deposits to
currency will affect the reserves in the banking system. However, such a shift will have
no effect on the monetary base. This tells us that the Fed has more control over the
monetary base than over reserves.
Let’s suppose that during the Christmas season, the public wants to hold more cur-
rency to buy gifts and so withdraws $100 million in cash. The effect on the T-account
of the nonbank public is

Nonbank Public
Assets Liabilities
Checkable deposits –$100 m
Currency +$100 m

The banking system loses $100 million of deposits and hence $100 million of reserves:

Banking System
Assets Liabilities
Reserves –$100 m Checkable deposits –$100 m

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 Fed’s T-account is

Federal Reserve System

Assets Liabilities
Currency in circulation +$100 m
Reserves –$100 m
 CHAPTER 15 The Money Supply Process 393

The net effect on the monetary liabilities of the Fed is a wash; 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

In this chapter so far, we have seen how changes in the monetary base occur as a result
of open market operations. However, 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 pro-
ceeds of the loan. The effects on the balance sheets of the banking system and the Fed
are illustrated by the following T-accounts:

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves +$100 m Loans +$100 m Loans +$100 m Reserves +$100 m
(borrowings (borrowings
from the Fed) from the Fed)

The monetary liabilities of the Fed have now increased by $100 million, and the
monetary base, too, 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 Fed are as follows:

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves –$100 m Loans –$100 m Loans –$100 m Reserves –$100 m
(borrowings (borrowings
from the Fed) from the Fed)

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 in a one-
to-one ratio with the change in the borrowings from the Fed.

Other Factors That Affect the Monetary Base

So far in this chapter, it seems as though the Fed has complete control of the monetary
base through its open market operations and loans to financial institutions. However,
the world is a little bit more complicated for the Fed. Two important items that affect
the monetary base, but are not controlled by the Fed, are float and Treasury deposits at
394 PART 4 Central Banking and the Conduct of Monetary Policy

the Fed. When the Fed clears checks for banks, it often credits the amount of the check
to a bank that has deposited it (increases the bank’s reserves) before it debits (decreases
the reserves of) the bank on which the check is drawn. The resulting temporary net
increase in the total amount of reserves in the banking system (and hence in the mon-
etary base) caused by the Fed’s check-clearing process is called float. When the U.S.
Treasury moves deposits from commercial banks to its account at the Fed, leading to an
increase in Treasury deposits at the Fed, it causes a deposit outflow at these banks such
as that shown in Chapter 9, and thus causes reserves in the banking system and the
monetary base to decrease. Thus float (affected by random events such as the weather,
which influences how quickly checks are presented for payment) and Treasury deposits
at the Fed (determined by the U.S. Treasury’s actions) both affect the monetary base
but are not controlled by the Fed at all. Decisions by the U.S. Treasury to have the Fed
intervene in the foreign exchange market also affect the monetary base.

Overview of the Fed’s Ability to Control the Monetary Base

Our discussion above indicates that two primary features determine the monetary base:
open market operations and lending to financial institutions. Whereas the amount of
open market purchases or sales is completely controlled by the Fed’s placing orders
with dealers in bond markets, the central bank cannot unilaterally determine, and
therefore cannot perfectly predict, the amount of borrowings from the Fed. The Federal
Reserve sets the discount rate (interest rate on loans to banks), and then banks make
decisions about whether to borrow. The amount of lending, though influenced by the
Fed’s setting of the discount rate, is not completely controlled by the Fed; banks’ deci-
sions play a role, too.
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 loans 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.5 The non-
borrowed monetary base is formally defined as the monetary base minus borrowings
from the Fed, which are referred to as borrowed reserves:
MBn = MB - BR

where MBn = nonborrowed monetary base

MB = monetary base
BR = borrowed reserves from the Fed
Factors not controlled at all by the Fed (for example, float and Treasury deposits
with the Fed) undergo substantial short-run variations and can be important sources of
fluctuations in the monetary base over time periods as short as a week. However, these
fluctuations are usually predictable and so can be offset through open market operations.
Although float and Treasury deposits with the Fed undergo substantial short-run
fluctuations, which complicate control of the monetary base, they do not prevent the
Fed from accurately controlling it.

5
Actually, other items on the Fed’s balance sheet (discussed in Appendix 1 to Chapter 15 located at www.pearson
.com/mylab/economics) affect the magnitude of the nonborrowed monetary base. Because their effects on the non-
borrowed base relative to open market operations are both small and predictable, these other items do not present
the Fed with difficulties in controlling the nonborrowed base.
 CHAPTER 15 The Money Supply Process 395

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

With our understanding of how the Federal Reserve controls the monetary base and
how banks operate (Chapter 9), 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

Suppose the $100 million open market purchase described earlier was conducted with
the First National Bank. After the Fed has bought the $100 million in bonds 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 excess reserves because it earns little interest on them. We begin
the analysis with the following T-account:

First National Bank

Assets Liabilities
Securities –$100 m
Reserves +$100 m

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 have risen by $100 million. Let’s say the bank decides to make a
loan equal in amount to the $100 million rise in excess reserves. When the bank makes
the loan, it sets up a checking 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 resulting T-account looks like this:

First National Bank

Assets Liabilities
Securities –$100 m Checkable deposits +$100 m
Reserves +$100 m
Loans +$100 m

The bank has created checkable deposits by its act of lending. Because checkable
deposits are part of the money supply, the bank’s act of lending has, in fact, created
money.
In its current balance sheet position, the First National Bank still has excess
reserves and so might want to make additional loans. However, these reserves will not
stay at the bank for very long. The borrowers took out loans not to leave $100 million
396 PART 4 Central Banking and the Conduct of Monetary Policy

sitting idle in a checking account at the First National Bank but to purchase goods
and services from other individuals and corporations. When the borrowers make these
purchases by writing checks, the checks will be deposited at other banks, and the $100
million of reserves will leave the First National Bank. As a result, a bank cannot safely
make a loan for an amount greater than the excess reserves that it has before it
makes the loan.
The final T-account of the First National Bank is

First National Bank

Assets Liabilities
Securities –$100 m
Loans +$100 m

The increase in reserves of $100 million has been converted into additional loans
of $100 million at the First National Bank, plus an additional $100 million of deposits
that have made their way to other banks. (All the checks written on accounts at the
First National Bank are deposited in banks rather than converted into cash, because we
are assuming that the public does not want to hold any additional currency.) Now let’s
see what happens to these deposits at the other banks.

Deposit Creation: The Banking System

To simplify the analysis, let’s 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

Bank A
Assets Liabilities
Reserves +$100 m Checkable deposits +$100 m

If the required reserve ratio is 10%, this bank will now find itself with a $10 million
increase in required reserves, leaving it $90 million of excess reserves. Because Bank A
(like the First National Bank) 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, but when the borrowers spend the $90 million of checkable deposits, they
and the reserves at Bank A will fall back down by this same amount. The net result is
that Bank A’s T-account will look like this:

Bank A
Assets Liabilities
Reserves +$10 m Checkable deposits +$100 m
Loans +$90 m
 CHAPTER 15 The Money Supply Process 397

If the money spent by the borrowers 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
Assets Liabilities
Reserves +$90 m Checkable deposits +$90 m

The checkable deposits in the banking system have risen by another $90 million,
for a total increase of $190 million ($100 million at Bank A plus $90 million at Bank
B). In fact, the distinction between Bank A and Bank B is not necessary to obtain the
same result on the overall expansion of deposits. If the borrowers from Bank A write
checks to someone who deposits them at Bank A, the same change in deposits occurs.
The T-accounts for Bank B would just apply to Bank A, and its checkable deposits
would increase by the total amount of $190 million.
Bank B will want to modify its balance sheet further. It must keep 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 loans totaling
$81 million to borrowers, who spend the proceeds from the loans. Bank B’s T-account
will be

Bank B
Assets Liabilities
Reserves +$ 9 m Checkable deposits +$90 m
Loans +$81 m

The $81 million spent by the borrowers from Bank B will be deposited in another
bank (Bank C). Consequently, from the initial $100 million increase of reserves in
the banking system, the total increase of checkable deposits in the system so far is
$271 million ( = $100 m + $90 m + $81 m).
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), as depicted in Table 1. Therefore, the total increase in deposits from
the initial $100 increase in reserves will be $1,000 million: The increase is tenfold, the
reciprocal of the 10% (0.10) reserve requirement.
If the banks choose to invest their excess reserves in securities, the result is the
same. If Bank A had taken its excess reserves and purchased securities instead of mak-
ing loans, its T-account would have looked like this:

Bank A
Assets Liabilities
Reserves +$10 m Checkable deposits +$100 m
Securities +$90 m
398 PART 4 Central Banking and the Conduct of Monetary Policy

TABLE 1 Creation of Deposits (assuming 10% reserve requirement

and a $100 million increase in reserves)

Increase in Increase in Increase in

Bank Deposits ($) Loans ($) Reserves ($)
First National 0.00 100.00 m 0.00
A 100.00 m 90.00 m 10.00 m
B 90.00 m 81.00 m 9.00 m
C 81.00 m 72.90 m 8.10 m
D 72.90 m 65.61 m 7.29 m
E 65.61 m 59.05 m 6.56 m
F 59.05 m 53.14 m 5.91 m
. . . .
. . . .
. . . .
. . . .
Total for all banks 1,000.00 m 1,000.00 m 100.00 m

When the bank buys $90 million of securities, it writes $90 million in checks to
the sellers of the securities, who in turn deposit the $90 million at a bank such as Bank
B. Bank B’s checkable deposits increase by $90 million, and the deposit expansion pro-
cess 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.
You can now see the difference in deposit creation for a single bank versus the
banking system as a whole. Because a single bank can create deposits equal only to the
amount of its excess reserves, it cannot by itself generate multiple deposit expansion. A
single bank cannot make loans greater in amount than its excess reserves, because the
bank will lose these reserves as the deposits created by the loan find their way to other
banks. 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, even though they are lost to the individual bank. 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. As you have seen,
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 sys-
tem’s reserves is called the simple deposit multiplier.6 In our example, with a 10%
required reserve ratio, the simple deposit multiplier is 10. More generally, the sim-
ple deposit multiplier equals the reciprocal of the required reserve ratio, expressed as

6
This multiplier should not be confused with the Keynesian multiplier, which is derived through a similar step-
by-step analysis. That multiplier relates an increase in income to an increase in investment, whereas the simple
deposit multiplier relates an increase in deposits to an increase in reserves.
 CHAPTER 15 The Money Supply Process 399

a fraction (for example, 10 = 1/0.10). So the formula for the multiple expansion of
deposits can be written as follows:
1
∆D = * ∆R (1)
rr

where ∆D = change in total checkable deposits in the banking system

rr = required reserve ratio (0.10 in the example)
∆R = change in reserves for the banking system ($100 million in the
example)

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creation of deposits can be derived directly using alge-
bra. We obtain the same result for the relationship between a change in deposits and a
change in reserves.
Our assumption that banks do not hold on to any excess reserves means that the
total amount of required reserves in the banking system RR will equal the total reserves
in the banking system R:
RR = R
The total amount of required reserves equals the required reserve ratio rr times the total
amount of checkable deposits D:
RR = rr * D
Substituting rr * D for RR in the first equation,
rr * D = R
and dividing both sides of the preceding equation by rr gives
1
D = * R
rr
Taking the change in both sides of this equation and using delta to indicate a change
gives
1
∆D = * ∆R
rr
which is the same formula for deposit creation given in Equation 1.7

7
A formal derivation of this formula follows. Using the reasoning in the text, the change in checkable deposits is
$100 ( = ∆R * 1) plus $90 3 = ∆R * (1 - rr)4 plus $81 3 = ∆R * (1 - rr)2 4 and so on, which can be rewritten as

∆D = ∆R * 31 + (1 - rr) + (1 - rr)2 + (1 - rr)3 + g 4

Using the formula for the sum of an infinite series found in footnote 3 of Chapter 4, this equation can be rewritten as

1 1
∆D = ∆R * = * ∆R
1 - (1 - rr) rr
400 PART 4 Central Banking and the Conduct of Monetary Policy

This derivation provides us with another way of looking at the multiple creation of
deposits, because it forces us to examine the banking system as a whole rather than one
bank at a time. For the banking system as a whole, deposit creation (or contraction)
will stop only when excess reserves in the banking system are zero; that is, the banking
system will be in equilibrium when the total amount of required reserves equals the
total amount of reserves, as seen in the equation RR = R. When rr * D is substituted
for RR, the resulting equation rr * D = R tells us how high checkable deposits must
be for required reserves to equal total reserves. Accordingly, a given level of reserves
in the banking system determines the level of checkable deposits when the banking
system is in equilibrium (when ER = 0); put another way, the given level of reserves
supports a given level of checkable deposits.
In our example, the required reserve ratio is 10%. If reserves increase by $100 mil-
lion, checkable deposits must rise by $1,000 million for total required reserves also to
increase by $100 million. If the increase in checkable deposits is less than this—say,
$900 million—then the increase in required reserves of $90 million remains below
the $100 million increase in reserves, so excess reserves still exist somewhere in the
banking system. The banks holding the excess reserves will now make additional loans,
thereby creating new deposits; this process will continue until all reserves in the system
are used up, which occurs when checkable deposits rise by $1,000 million.
We can also see this by looking at the resulting T-account of the banking system as
a whole (including the First National Bank):

Banking System
Assets Liabilities
Securities –$ 100 m Checkable deposits +$1,000 m
Reserves +$ 100 m
Loans +$1,000 m

The procedure of eliminating excess reserves by loaning them out continues until
the banking system (First National Bank and Banks A, B, C, D, and so on) has made
$1,000 million of loans and created $1,000 million of deposits. In this way, $100 mil-
lion of reserves supports $1,000 million (ten times the quantity) of deposits.

Critique of the Simple Model

Our model of multiple deposit creation seems to indicate that the Federal Reserve is
able to exercise complete control over the level of checkable deposits by setting the
required reserve ratio and the level of reserves. The actual creation of deposits is much
less mechanical than the simple model indicates. If proceeds from Bank A’s $90 million
loan are not deposited but are kept in currency, nothing is deposited in Bank B and the
deposit creation process ceases. The total increase in the money supply is now the $90
million increase in currency plus the initial $100 million of deposits created by First
 CHAPTER 15 The Money Supply Process 401

National Bank’s loans, which were deposited at Bank A, for a total of only $190 mil-
lion—considerably less than the $1,000 million we calculated using the simple model
above. In other words, currency does not lead to multiple deposit expansion, whereas
deposits do. Thus, if some proceeds from loans are not deposited in banks but instead
are used to raise the holdings of currency, less multiple expansion occurs overall, and
the money supply does not increase by the amount predicted by our simple model of
multiple deposit creation.
Another situation ignored in our model is one in which banks do not make
loans or buy securities in the full amount of their excess reserves. If Bank A decides
to hold on to all $90 million of its excess reserves, no deposits will be made in Bank
B, and this will stop the deposit creation process. The total increase in deposits will
be only $100 million, not the $1,000 million increase in our example. Hence, if
banks choose to hold on to 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.
Our examples indicate that the Fed is not the only player whose behavior influ-
ences the level of deposits and therefore the money supply. Depositors’ decisions
regarding how much currency to hold and banks’ decisions regarding the amount of
excess reserves to hold also can cause the money supply to change.

FACTORS THAT DETERMINE THE MONEY SUPPLY

Our critique of the simple model shows how we can expand on it to discuss all the fac-
tors that affect the money supply. Let’s look at changes in each factor in turn, holding
all other factors constant.

Changes in the Nonborrowed Monetary Base, MBn

As shown earlier in the chapter, the Fed’s open market purchases increase the non-
borrowed monetary base, and its open market sales decrease it. Holding all other
variables constant, an increase in MBn arising from an open market purchase raises
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 reduces
MBn shrinks the amount of the monetary base and reserves, thereby causing a mul-
tiple contraction of deposits and a decrease in the money supply. We have the fol-
lowing result: The money supply is positively related to the nonborrowed monetary
base MBn.

Changes in Borrowed Reserves, BR, from the Fed

An increase in loans from the Fed provides additional borrowed reserves and thereby
increases the amount of the monetary base and reserves so that multiple deposit cre-
ation occurs and the money supply expands. If banks reduce the level of their discount
loans, all other variables held constant, the monetary base and amount of reserves fall,
and the money supply decreases. The result is this: The money supply is positively
related to the level of borrowed reserves, BR, from the Fed.
402 PART 4 Central Banking and the Conduct of Monetary Policy

Changes in the Required Reserve Ratio, rr

If the required reserve ratio on checkable deposits increases while all other variables,
such as 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 required reserve
ratio falls, multiple deposit expansion is higher and the money supply rises.
We now have the following result: The money supply is negatively related to the
required reserve ratio rr. In the past, the Fed sometimes used reserve requirements
to affect the size of the money supply. In recent years, however, reserve requirements
have become a less important factor in the determination of the money multiplier and
the money supply, as we shall see in the next chapter.

Changes in Excess Reserves

When banks increase their holdings of excess reserves, those reserves are no longer
being used to make loans, causing multiple deposit creation to stop dead in its tracks,
resulting in less expansion of the money supply. If, on the other hand, banks choose to
hold fewer excess reserves, loans and multiple deposit creation increase, and the money
supply rises. The money supply is negatively related to the amount of excess reserves.
Recall from Chapter 9 that the primary benefit to a bank of holding excess reserves
is that they provide insurance against losses due to deposit outflows; that is, they enable
the bank experiencing deposit outflows to escape the costs of calling in loans, selling
securities, borrowing from the Fed or other corporations, or bank failure. If banks fear
that deposit outflows are likely to increase (that is, if expected deposit outflows increase),
they will seek more insurance against this possibility, and excess reserves will rise.

Changes in Currency Holdings

As shown before, checkable deposits undergo multiple expansion, whereas currency
does not. Hence, when checkable deposits are converted into currency, as long as the
amount of excess reserves are 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 mul-
tiple deposit expansion, so the money supply rises. This analysis suggests the following
result: Holding excess reserves constant, the money supply is negatively related to
currency holdings.

OVERVIEW OF THE MONEY SUPPLY PROCESS

We now have a model of the money supply process in which all three of the players—
the Federal Reserve System, depositors, and banks—directly influence the money supply.
As a study aid, Summary Table 1 charts the money supply responses to the five factors
discussed above and gives a brief synopsis of the reasoning behind them.
The variables are grouped by the player who is the primary influence behind the
variable. The Federal Reserve, for example, influences the money supply by controlling
the first two variables. Depositors influence the money supply through their decisions
about holdings of currency, while banks influence the money supply with their deci-
sions about borrowings from the Fed and excess reserves.
 CHAPTER 15 The Money Supply Process 403

SUMMARY TABLE 1
Money Supply Response
Change in Money Supply
Player Variable Variable Response Reason
Federal Reserve Nonborrowed monetary ↑ ↑ More MB for deposit
System base, MBn creation
Required reserve ratio, rr ↑ ↓ Less multiple deposit
expansion
Banks Borrowed reserves, BR ↑ ↑ More MB for deposit
creation
Excess reserves ↑ ↓ Less loans and deposit
creation
Depositors Currency holdings ↑ ↓ Less multiple deposit
expansion
Note: Only increases (↑) in the variables are shown. The effects of decreases on the money supply would be the opposite of those
indicated in the “Money Supply Response” column.

THE MONEY MULTIPLIER

The intuition inherent in the preceding section is sufficient for you to understand
how the money supply process works. For those of you who are more mathemati-
cally inclined, we can derive all of 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 between the money supply M, the
money multiplier, and the monetary base is described by the following equation:
M = m * MB (2)
The money multiplier m tells us what multiple of the monetary base is transformed
into the money supply. Because the money multiplier is typically larger than 1, the
alternative name for the monetary base, high-powered money, is logical: A $1 change in
the monetary base typically leads to more than a $1 change in the money supply.

Deriving the Money Multiplier

Let’s assume that the desired holdings of currency C and excess reserves ER grow pro-
portionally with checkable deposits D; in other words, we assume that the ratios of
these items to checkable deposits are constants in equilibrium, as the braces in the fol-
lowing expressions indicate:

c = 5C>D6 = currency ratio

e = 5ER>D6 = excess reserves ratio
404 PART 4 Central Banking and the Conduct of Monetary Policy

We will now derive a formula that describes how the currency ratio desired by deposi-
tors, the excess reserves ratio desired by banks, and the required reserve ratio set by the
Fed affect the multiplier m. We begin the derivation of the model of the money supply
with the following equation:
R = RR + ER
which states that the total amount of reserves in the banking system R equals the sum
of required reserves RR and excess reserves ER. (Note that this equation corresponds to
the equilibrium condition RR = R given earlier in the chapter, where excess reserves
were assumed to be zero.)
The total amount of required reserves equals the required reserve ratio rr times the
amount of checkable deposits D:
RR = rr * D
Substituting rr * D for RR in the first equation yields an equation that links reserves in
the banking system to the amount of checkable deposits and excess reserves they can
support:
R = (rr * D) + ER
A key point here is that the Fed sets the required reserve ratio rr to less than 1. Thus
$1 of reserves can support more than $1 of deposits, and the multiple expansion of
deposits can occur.
Let’s see how this works in practice. If excess reserves are held at zero (ER = 0),
the required reserve ratio is set at rr = 0.10, and the level of checkable deposits in the
banking system is $1,600 billion, then the amount of reserves needed to support these
deposits is $160 billion ( = 0.10 * $1,600 billion). The $160 billion of reserves can
support ten times this amount in checkable deposits because multiple deposit creation
will occur.
Because the monetary base MB equals currency C plus reserves R, we can gener-
ate an equation that links the amount of the monetary base to the levels of checkable
deposits and currency by adding currency to both sides of the preceding equation:
MB = R + C = (rr * D) + ER + C
Notice that this equation reveals the amount of the monetary base needed to support
the existing amounts of checkable deposits, currency, and excess reserves.
To derive the money multiplier formula in terms of the currency ratio c = 5C>D6
and the excess reserves ratio e = 5ER>D6, we rewrite the last equation, specifying C
as c * D and ER as e * D:
MB = (rr * D) + (e * D) + (c * D) = (rr + e + c) * D
We next divide both sides of the equation by the term inside the parentheses to get an
expression linking checkable deposits D to the monetary base MB:
1
D = * MB (3)
rr + e + c
Using the M1 definition of the money supply as currency plus checkable deposits
(M = D + C) and again specifying C as c * D, we get
M = D + (c * D) = (1 + c) * D
 CHAPTER 15 The Money Supply Process 405

Substituting in this equation the expression for D from Equation 3 yields

1 + c
M = * MB (4)
rr + e + c
We have derived an expression in the form of our earlier Equation 2. As you can
see, the ratio that multiplies MB is the money multiplier, which tells how much the
money supply changes in response to a given change in the monetary base (high-pow-
ered money). The money multiplier m is thus
1 + c
m = (5)
rr + e + c
It is a function of the currency ratio set by depositors c, the excess reserves 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’s 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 = checkable deposits = $1,600 billion
ER = excess reserves = $2,500 billion
M = money supply (M1) = C + D = $2,800 billion

From these numbers we can calculate the values for the currency ratio c and the excess
reserves 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 deposits 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 far less than the simple
deposit multiplier of 10 found earlier in the chapter. There are two reasons for this result.
First, although deposits undergo multiple expansion, currency does not. Thus, if some
portion of the increase in high-powered money finds its way into currency, this portion
does not undergo multiple deposit expansion. In our simple model earlier in the chapter,
we did not allow for this possibility, and so the increase in reserves led to the maximum
amount of multiple deposit creation. However, in our current model of the money multi-
plier, the level of currency does rise when the monetary base MB and checkable deposits D
increase, because c is greater than zero. As previously stated, any increase in MB that goes
406 PART 4 Central Banking and the Conduct of Monetary Policy

into an increase in currency is not multiplied, so only part of the increase in MB is available
to support checkable deposits that undergo multiple expansion. The overall level of mul-
tiple deposit expansion must be lower, meaning that the increase in M, given an increase in
MB, is smaller than indicated by the simple model earlier in the chapter.
Second, since e is positive, any increase in the monetary base and deposits leads to
higher excess reserves. When there is an increase in MB and D, the resulting increase
in excess reserves means that the amount of reserves used to support checkable depos-
its does not increase as much as it otherwise would. Hence the increase in checkable
deposits and the money supply are lower, and the money multiplier is smaller.
Prior to 2008, the excess reserves ratio e was almost always very close to zero (less
than 0.001), and so its impact on the money multiplier (Equation 5) was essentially
irrelevant. When e is close to zero, the money multiplier is always greater than 1, and
it was around 1.6 during that period. However, as we will see in the next chapter, non-
conventional monetary policy during the global financial crisis caused excess reserves
to skyrocket to over $2 trillion. Such an extraordinarily large value of e caused the
excess reserves factor in the money multiplier equation to become dominant, and so
the money multiplier fell to below 1, as discussed above.

Money Supply Response to Changes in the Factors

By recognizing that the monetary base is MB = MBn + BR, we can rewrite Equation 2 as
M = m * (MBn + BR) (6)
Now we can show algebraically all the results given in Summary Table 1, which
shows how the money supply responds to the changes in the factors.
As you can see from Equation 6, a rise in MBn or BR raises the money supply M
because the money multiplier m is always greater than zero. We can see that a rise in the
required reserve ratio rr lowers the money supply by calculating the value of the money
multiplier (using Equation 5) in our numerical example when rr increases from 10% to
15% (leaving all other variables unchanged). The money multiplier then becomes
1 + 0.75 1.75
m = = = 0.71
0.15 + 1.56 + 0.75 2.46
which, as we would expect, is less than 0.73.
Similarly, we can see that a rise in excess reserves lowers the money supply by
calculating the money multiplier when e is increased from 1.56 to 3.0. The money mul-
tiplier decreases from 0.73 to
1 + 0.75 1.75
m = = = 0.45
0.1 + 3.00 + 0.75 3.85
We can also analyze what happens in our numerical example when there is a rise
in the currency ratio c from 0.75 to 1.50. In this case, something peculiar happens.
Instead of falling, the money multiplier rises from 0.73 to
1 + 1.50 2.50
m = = = 0.78
0.1 + 1.56 + 1.50 3.20
At first glance, this result might seem counterintuitive. After all, a dollar of mon-
etary base that goes into currency only increases the money supply by one dollar,
whereas a dollar of monetary base that goes into deposits leads to multiple deposit
expansion that increases the money supply by a factor of 10. Thus it seems as though
 CHAPTER 15 The Money Supply Process 407

the shift from deposits to currency should lower the overall amount of multiple expan-
sion and hence the money supply. This reasoning is correct, but it assumes a small
value of the excess reserves ratio. Indeed, that is the case during normal times, when
the excess reserves ratio is near zero. However, in our current situation, in which the
excess reserves ratio e is abnormally high, when a dollar moves from deposits into cur-
rency, the amount of excess reserves falls by a large amount, which releases reserves to
support more deposits, causing the money multiplier to rise.8

A P P L I C AT I O N Quantitative Easing and the Money Supply,

2007–2017
When the global financial crisis began in the fall of 2007, the Fed initiated lending pro-
grams and large-scale asset-purchase programs in an attempt to bolster the economy. By
2017, these purchases of securities had led to a quintupling of the Fed’s balance sheet
and an over 350% increase in the monetary base. These lending and asset-purchase pro-
grams, discussed further in Chapter 16, resulted in a huge expansion of the monetary
base and have been given the name “quantitative easing.” As our analysis in this chapter
indicates, such a massive expansion of the monetary base could potentially lead to a
large expansion of the money supply. However, as shown in Figure 1, when the mon-
etary base increased by more than 350%, the M1 money supply only rose by only 150%.
How can we explain this result using our money supply model?
The answer is that despite the huge increase in the monetary base, the money sup-
ply rose by much less because the money multiplier fell by around 50%. To explain this
decline in the money multiplier, let’s look at Figure 2, which shows the currency ratio
c and the excess reserves ratio e for 2007–2017. We see that the currency ratio had a
slight downward trend, which would have raised, not lowered, the money multiplier.
Instead, we have to look to the extraordinary rise in the excess reserves ratio e, which
climbed by more than a factor of 1,000 after September 2007.
What explains this substantial increase in the excess reserves ratio e? The Fed’s
actions created far more reserves than were needed for banks to meet their reserve
requirements. Banks were willing to hold the huge increases in excess reserves because,
after the Fed began paying interest on these reserves starting in 2008, the interest rate
on reserves often exceeded the rate at which the banks could lend them out in the
federal funds market. Because excess reserves had a very small or even negative cost,
banks were willing to tolerate a much higher excess reserves ratio e. As predicted by
our money supply model, the huge increase in e sharply lowered the money multiplier,
and so the money supply did not undergo that large an expansion, despite the huge
increase in the monetary base. ◆

8
All the above results can be derived more generally from the Equation 5 formula for m as follows. When rr or e
increases, the denominator of the money multiplier increases, and therefore the money multiplier must decrease.
As long as rr + e is less than 1 (as is usually the case), an increase in c raises the denominator of the money mul-
tiplier proportionally by more than it raises the numerator. The increase in c causes the money multiplier to fall.
On the other hand, when rr + e is greater than 1 (the current situation), an increase in c raises the numerator of
the money multiplier proportionally by more than it raises the denominator, so the money multiplier rises. For
more background on the currency ratio c, consult the third appendix to this chapter at www.pearson.com/mylab/
economics. Recall that the money multiplier in Equation 5 is for the M1 definition of money. Appendix 2 to
Chapter 15 at www.pearson.com/mylab/economics discusses how the multiplier for M2 is determined.
408 PART 4 Central Banking and the Conduct of Monetary Policy

Money Supply
Monetary base
($ billions)

5000

4000

3000

M1
2000

1000
Monetary Base

0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

FIGURE 1 M1 and the Monetary Base, 2007–2017

The money supply rose by only 150% despite the increase in the monetary base of over 350%.
Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/BOGMBASE; https://fred
.stlouisfed.org/series/M1SL.

2.00

1.75
Currency ratio (c)
1.50

1.25

1.00

0.75

0.50 Excess reserves

ratio (e)
0.25

0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

FIGURE 2 Excess Reserves and Currency Ratio, 2007–2017

The currency ratio c was relatively steady during this period, whereas the excess reserves ratio e
rose by a factor of over 1,000.
Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/EXCSRESNS; https://fred
.stlouisfed.org/series/CURRCIR; https://fred.stlouisfed.org/series/TCDNS.
 CHAPTER 15 The Money Supply Process 409

SUMMARY
1. The three players in the money supply process are 5. The simple model of multiple deposit creation has seri-
the central bank, banks (depository institutions), and ous deficiencies. Decisions by depositors to increase
depositors. their holdings of currency or by banks to hold excess
2. Four items in the Fed’s balance sheet are essential to our reserves will result in a smaller expansion of depos-
understanding of the money supply process: the two lia- its than is predicted by the simple model. All three
bility items, currency in circulation and reserves, which players—the Fed, banks, and depositors—are impor-
together make up the monetary base; and the two asset tant in the determination of the money supply.
items, securities and loans to financial institutions. 6. The money supply is positively related to the nonbor-
3. The Federal Reserve controls the monetary base rowed monetary base MBn, which is determined by
through open market operations and extensions of open market operations, and the level of borrowed
loans to financial institutions and has better control reserves (lending) from the Fed, BR. The money sup-
over the monetary base than over reserves. Although ply is negatively related to the required reserve ratio,
float and Treasury deposits with the Fed undergo sub- rr, and excess reserves. The money supply is also nega-
stantial short-run fluctuations, which complicate con- tively related to holdings of currency but only if excess
trol of the monetary base, they do not prevent the Fed reserves do not vary much when there is a shift between
from accurately controlling it. deposits and currency. The model of the money sup-
ply process takes into account the behavior of all three
4. A single bank can make loans up to the amount of its
players in the money supply process: the Fed through
excess reserves, thereby creating an equal amount of
open market operations and setting of the required
deposits. The banking system can create a multiple
reserve ratio; banks through their decisions to borrow
expansion of deposits, because as each bank makes a
from the Federal Reserve and hold excess reserves; and
loan and creates deposits, the reserves find their way to
depositors through their decisions about the holding of
another bank, which uses them to make loans and cre-
currency.
ate additional deposits. In the simple model of multiple
deposit creation, in which banks do not hold on to excess 7. The monetary base is linked to the money supply using
reserves and the public holds no currency, the multiple the concept of the money multiplier, which tells us how
increase in checkable deposits (simple deposit multiplier) much the money supply changes when the monetary
equals the reciprocal of the required reserve ratio. base changes.

KEY TERMS
borrowed reserves, p. 394 money multiplier, p. 403 primary dealers, p. 391
discount rate, p. 390 multiple deposit creation, p. 395 required reserve ratio, p. 390
excess reserves, p. 390 nonborrowed monetary base, p. 394 required reserves, p. 390
float, p. 394 open market operations, p. 391 reserves, p. 390
high-powered money, p. 389 open market purchase, p. 391 simple deposit multiplier, p. 398
monetary base, p. 389 open market sale, p. 391

QUESTIONS
Select questions are available in 0\/DE�(FRQRPLFV at 1. Classify each of these transactions as an asset, a liability,
www.pearson.com/mylab/economics. Unless otherwise noted, or neither for each of the “players” in the money supply
the following assumptions are made in all questions: The required process—the Federal Reserve, banks, and depositors.
reserve ratio on checkable deposits is 10%, banks do not hold any a. You get a $10,000 loan from the bank to buy an
excess reserves, and the public’s holdings of currency do not change. automobile.
410 PART 4 Central Banking and the Conduct of Monetary Policy

b. You deposit $400 into your checking account at the 8. “The Fed can perfectly control the amount of the mon-
local bank. etary base, but has less control over the composition
c. The Fed provides an emergency loan to a bank for of the monetary base.” Is this statement true, false, or
$1,000,000. uncertain? Explain.
d. A bank borrows $500,000 in overnight loans from 9. The Fed buys $100 million of bonds from the public
another bank. and also lowers the required reserve ratio. What will
e. You use your debit card to purchase a meal at a res- happen to the money supply?
taurant for $100. 10. Describe how each of the following can affect the
2. The First National Bank receives an extra $100 of money supply: (a) the central bank; (b) banks; and
reserves but decides not to lend out any of these (c) depositors.
reserves. How much deposit creation takes place for the 11. “The money multiplier is necessarily greater than 1.”
entire banking system? Is this statement true, false, or uncertain? Explain your
3. Suppose the Fed buys $1 million of bonds from the answer.
First National Bank. If the First National Bank and all 12. What effect might a financial panic have on the money
other banks use the resulting increase in reserves to multiplier and the money supply? Why?
purchase securities only and not to make loans, what 13. During the Great Depression years from 1930 to 1933,
will happen to checkable deposits? both the currency ratio c and the excess reserves ratio e
4. If a bank depositor withdraws $1,000 of currency from rose dramatically. What effect did these factors have on
an account, what happens to reserves, checkable depos- the money multiplier?
its, and the monetary base? 14. In October 2008, the Federal Reserve began paying
5. If a bank sells $10 million of bonds to the Fed to pay interest on the amount of excess reserves held by banks.
back $10 million on the loan it owes, what is the effect How, if at all, might this affect the multiplier process
on the level of checkable deposits? and the money supply?
6. If you decide to hold $100 less cash than usual and there- 15. The money multiplier declined significantly during the
fore deposit $100 more cash in the bank, what effect will period 1930–1933 and also during the recent finan-
this have on checkable deposits in the banking system if the cial crisis of 2008–2010. Yet the M1 money supply
rest of the public keeps its holdings of currency constant? decreased by 25% in the Depression period but increased
7. “The Fed can perfectly control the amount of reserves by more than 20% during the recent financial crisis.
in the system.” Is this statement true, false, or uncer- What explains the difference in outcomes?
tain? Explain.

APPLIED PROBLEMS
Select applied problems are available in 0\/DE�(FRQRPLFV b. The central bank sells securities to the commercial bank.
at www.pearson.com/mylab/economics. Unless otherwise c. The commercial bank repays the loan to the central bank.
noted, the following assumptions are made in all of the applied
18. If the Fed lends five banks a total of $100 million but
problems: The required reserve ratio on checkable deposits is
10%, banks do not hold any excess reserves, and the public’s depositors withdraw $50 million and hold it as cur-
holdings of currency do not change. rency, what happens to reserves and the monetary
base? Use T-accounts to explain your answer.
16. If the Fed sells $2 million of bonds to the First National
Bank, what happens to reserves and the monetary base? 19. Using T-accounts, show what happens to checkable
Use T-accounts to explain your answer. deposits in the banking system when the Fed lends
$1 million to the First National Bank.
17. For the following operations, what happens to the
central bank’s and commercial bank’s reserves and 20. Using T-accounts, show what happens to checkable
the monetary base? Use T-account to show changes in deposits in the banking system when the Fed sells
balances. Assume that the amount is $10 million. $2 million of bonds to the First National Bank.
a. The central bank provides loan to commercial bank. 21. If the Fed buys $1 million of bonds from the First
National Bank, but an additional 10% of any deposit
 CHAPTER 15 The Money Supply Process 411

is held as excess reserves, what is the total increase in a. Calculate the money supply, the currency deposit ratio,
checkable deposits? (Hint: Use T-accounts to show what the excess reserve ratio, and the money multiplier.
happens at each step of the multiple expansion process.) b. Suppose the central bank conducts an unusually
22. If reserves in the banking system increase by $1 billion large open market purchase of bonds held by banks
because the Fed lends $1 billion to financial institutions, of $1,300 billion due to a sharp contraction in the
and checkable deposits increase by $9 billion, why isn’t economy. Assuming the ratios you calculated in part (a)
the banking system in equilibrium? What will continue to remain the same, predict the effect on the money supply.
happen in the banking system until equilibrium is reached? c. Suppose the central bank conducts the same open
Show the T-account for the banking system in equilibrium. market purchase as in part (b), except that banks
23. Suppose the central bank of your country increases choose to hold all of these proceeds as excess
reserves by purchasing $1 million worth of bonds reserves rather than loan them out, due to fear of a
from banks and that the banking system in your econ- financial crisis. Assuming that currency and deposits
omy is in equilibrium. What will happen to the level remain the same, what happens to the amount of
of checkable deposits? Use T-accounts to explain your excess reserves, the excess reserve ratio, the money
answer. supply, and the money multiplier?
24. If the Fed sells $1 million of bonds and banks reduce d. Following the financial crisis in 2008, the Federal
their borrowings from the Fed by $1 million, predict Reserve began injecting the banking system with
what will happen to the money supply. massive amounts of liquidity, and at the same time,
25. Suppose that the required reserve ratio is 9%, currency in very little lending occurred. As a result, the M1
circulation is $620 billion, the amount of checkable depos- money multiplier was below 1 for most of the time
its is $950 billion, and excess reserves are $15 billion. from October 2008 through 2011. How does this
scenario relate to your answer to part (c)?

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in 0\/DE�(FRQRPLFV c. Assuming a required reserve ratio rr of
and are available for practice or instructor assignment. 11%, calculate the value of the money
1. Go to the St. Louis Federal Reserve FRED database, multiplier m.
and find the most current data available on Currency 2. Go to the St. Louis Federal Reserve FRED database,
(CURRNS), Total Checkable Deposits (TCDNS), and find data on the M1 Money Stock (M1SL) and
Total Reserves (RESBALNS), and Required Reserves the Monetary Base (AMBSL).
(RESBALREQ). a. Calculate the value of the money multiplier
a. Calculate the value of the currency deposit using the most recent data available and the
ratio c. data from five years prior.
b. Use RESBALNS and RESBALREQ to cal- b. Based on your answer to part (a), how
culate the amount of excess reserves, and much would a $100 million open market
then calculate the value of the excess purchase of securities affect the M1 money
reserve ratio e. Be sure the units of total and supply today and five years ago?
required reserves are the same when you do
the calculations.

WEB EXERCISES
1. Go to http://www.federalreserve.gov/boarddocs/hh/ 2. Go to http://www.federalreserve.gov/releases/h6/hist/
and find the most recent monetary policy report of the and find the historical report of M1 and M2 by clicking
Federal Reserve. Read the first two parts of the report, on the “Data Download Program.” Compute the growth
which summarizes Monetary Policy and the Economic rate of each aggregate over each of the past three years.
Outlook. Write a one-page summary of each of these Does it appear that the Fed has been increasing or
parts of the report. decreasing the rate of growth of the money supply? Is
412 PART 4 Central Banking and the Conduct of Monetary Policy

this consistent with your understanding of the needs of a. What is the current reserve balance?
the economy? Why? b. What is the change in reserve balances since a
3. An important aspect of the supply of money is reserve year ago?
balances. Go to http://www.federalreserve.gov/Releases/ c. Based on your results in parts (a) and (b), does it
h41/ and locate the most recent release. This site reports appear that the money supply should be increasing
changes in factors that affect depository reserve balances. or decreasing?

WEB REFERENCES
https://www.federalreserve.gov/publications/annual-report http://www.federalreserve.gov/Releases/h3/
.htm The Federal Reserve website reports data about aggregate
See the most recent Federal Reserve financial statement. reserves and the monetary base. This site also reports on the
http://www.richmondfed.org/about_us/visit_us/tours/ volume of borrowings from the Fed.
money_museum/index.cfm?WT.si_n=Search&WT.si_x=3 http://www.federalreserve.gov/Releases/h6/
A virtual tour of the Federal Reserve Bank of Richmond’s This site reports data on M1 and M2, as well as other data
money museum. on the money supply.