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CH 14

The document summarizes the money supply process involving three key players: the central bank (Federal Reserve), banks, and depositors. It describes how the Federal Reserve uses tools like open market operations and interest on reserves to influence the monetary base and money supply. Banks' ability to create new deposits through fractional-reserve banking multiplies the original monetary expansion. The money multiplier formula shows how currency in circulation, required reserves, and excess reserves determine how much new money is created from a change in reserves.

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52 views

CH 14

The document summarizes the money supply process involving three key players: the central bank (Federal Reserve), banks, and depositors. It describes how the Federal Reserve uses tools like open market operations and interest on reserves to influence the monetary base and money supply. Banks' ability to create new deposits through fractional-reserve banking multiplies the original monetary expansion. The money multiplier formula shows how currency in circulation, required reserves, and excess reserves determine how much new money is created from a change in reserves.

Uploaded by

zephyr zhang
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Chapter 14.

The Money Supply Process


Learning Objectives
• List and describe the “three players” that influence the money supply.
• Classify the factors affecting the Federal Reserve’s assets and liabilities.
• Identify the factors that affect the monetary base and discuss their effects
on the Federal Reserve’s balance sheet.
• Explain and illustrate the deposit creation process using T-accounts.
• List the factors that affect the money supply.
• Summarize how the “three players” can influence the money supply.
• Calculate and interpret changes in the money multiplier.
Three Players in the Money Supply
Process
• The Central bank: Federal Reserve System
• Banks: depository institutions; financial intermediaries
• Depositors: individuals and institutions
The Fed’s Balance Sheet

• Liabilities
– Currency in circulation: in the hands of the public
– Reserves: bank deposits at the Fed and vault cash
• Assets
– Government securities: holdings by the Fed that affect money supply and earn interest
– Discount loans: provide reserves to banks and earn the discount rate
Control of the Monetary Base
• High-powered money

MB = C + R

• C = currency in circulation
• R = total reserves in the banking system
Open Market Purchase from a Bank
Open Market Purchase from a Bank
• Net result is that reserves have increased by $100
• No change in currency
• Monetary base has risen by $100
Open Market Sale
Shifts from Deposits into Currency
Shifts from Deposits into Currency
• Net effect on monetary liabilities is zero
• Reserves are changed by random fluctuations
• Monetary base is a relatively stable variable
Loans to Financial Institutions

• Monetary liabilities of the Fed have increased by $100


• Monetary base also increases by this amount
Other Factors that Affect the Monetary
Base
• Float
• Treasury deposits at the Federal Reserve
• Interventions in the foreign exchange market
Overview of The Fed’s Ability to Control
the Monetary Base
• Open market operations are controlled by the Fed.
• The Fed cannot determine the amount of borrowing by banks from the
Fed.
• Split the monetary base into two components:
MBn = MB - BR

• The money supply is positively related to both the non-borrowed


monetary base MBn and to the level of borrowed reserves, BR, from the
Fed.
Multiple Deposit Creation: A Simple
Model
• Deposit Creation: Single Bank
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Securities -$100m Securities -$100m Checkable +$100m
deposits
Reserves +$100m Reserves +$100m
Loans +$100m
Multiple Deposit Creation: A Simple
Model

• Excess reserves increase


• Bank loans out the excess reserves
• Creates a checking account
• Borrower makes purchases
• The Money supply has increased
Multiple Deposit Creation: A Simple
Model
• Deposit Creation: The Banking System
Creation of Deposits (Assuming 10% Reserve
Requirement and a $100 Increase in Reserves)
Deriving The Formula for Multiple Deposit
Creation
• Assuming banks do not hold excess reserves
• Required Reserves (RR)= Total Reserves (R)
• RR = Required Reserve Ratio (rr) times the total amount of
checkable deposits (D)
• Substituting

rr X D=R
Deriving The Formula for Multiple Deposit
Creation
• Dividing both sides by r
1
𝐷= 𝑋 𝑅
𝑟𝑟
• Taking the change in both sides yields
1
∆ 𝐷= 𝑋 ∆ 𝑅
𝑟𝑟
Critique of the Simple Model
• Holding cash stops the process
– Currency has no multiple deposit expansion
• Banks may not use all of their excess reserves to buy securities
or make loans.
• Depositors’ decisions (how much currency to hold) and bank’s
decisions (amount of excess reserves to hold) also cause the
money supply to change.
Factors that Determine the Money Supply
• Changes in the nonborrowed monetary base MB n
– The money supply is positively related to the non-borrowed monetary
base MBn
• Changes in borrowed reserves from the Fed
– The money supply is positively related to the level of borrowed
reserves, BR, from the Fed
Factors that Determine the Money Supply
• Changes in the required reserves ratio
– The money supply is negatively related to the required reserve ratio.
• Changes in currency holdings
– The money supply is negatively related to currency holdings.
• Changes in excess reserves
– The money supply is negatively related to the amount of excess
reserves.
Overview of the Money Supply Process
The Money Multiplier
• Define money as currency plus checkable deposits: M1
• Link the money supply (M) to the monetary base (MB) and let
m be the money multiplier
M = m ´ MB
Deriving the Money Multiplier
• Assume that the desired holdings of currency C and excess
reserves ER grow proportionally with checkable deposits D.
• Then,
c = {C / D} = currency ratio

e = {ER / D} = excess reserve ratio


Deriving the Money Multiplier
• The total amount of reserves(R) equals the sum of required
reserves (RR) and excess reserves (ER).
• R = RR + ER
• The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
•
• Substituting for RR in the first equation
R=(rr*D)+ER
• The Fed sets rr to less than 1
Deriving the Money Multiplier
• The monetary base MB equals currency (C) plus reserves (R):
𝑀𝑅=𝐶+𝑅=𝐶+(𝑟𝑟 ∗ 𝐷)+𝐸𝑅
• Equation reveals the amount of the monetary base needed to
support the existing amounts of checkable deposits, currency
and excess reserves.
Deriving the Money Multiplier
c = {C / D} Þ C = c ´ D and
e = {ER / D} Þ ER = e ´ D
• Substituting in the previous equation
MB=(rr*D)+(e*D)+(c*D)=(rr+e+c)*D
• Divide both sides by the term in parentheses

=
M=D+C and C=c*D
M=D+(c*D)=(1+c)*D
Deriving the Money Multiplier
• Substituting again

• The money multiplier is then

1+𝑐
𝑚=
𝑟 +𝑒 +𝑐
Intuition Behind the Money 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
$400B
c= = 0.5
$800B
$0.8B
e= = 0.001
$800B
Intuition Behind the Money Multiplier

1+ 0.5 1.5
m= = = 2.5
0.1+ 0.001+ 0.5 0.601

• This is less than the simple deposit multiplier.


• Although there is multiple expansion of deposits, there is no
such expansion for currency

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