Lecture 9

The Money Supply Process

Content

• Introduction
• The central bank’s balance sheet
• The central bank’s assets
• The central bank’s liabilities
• The monetary base
• Control of the monetary base
• Other factors affecting the monetary base
• Deposit creation
• Deposit creation at a single bank
• Deposit creation in a system of banks
2
Content

• Critique of the simple model

• The money multiplier
• Factors affecting the quantity of money
• The money multiplier and the Great
Depression
• The money base and money multiplier,
2007 – 2010
• The limits on the central bank’s ability to
control the quantity of money
3
Readings

• Mishkin (2021), The Economics of

Money, Banking, and Financial
Markets, 13th edition, Pearson,
Chapter 15

• Cecchetti and Schoenholtz (2010),

Money, Banking, and Financial
Markets, 3rd edition, McGraw-Hill,
Chapters 17
4
Introduction

• During the September 11, 2001 crisis, the

financial community was on the edge of a
system-wide collapse.
• Because of the immediate action of the
Fed officials, the financial system held
together, and most of us never realized
how close we came to catastrophe.
• This was one of the greatest successes of
modern central banking.
5
Introduction

• The financial system, one of the

terrorists’ primary targets, returned to
near normal within weeks.
• Many of the Fed’s actions in the crisis of
2007-2009 were unprecedented or had
not been seen since the 1930s.
• For the first time since the Great
Depression, the Fed lent to nonbanks
and even to nonfinancial companies.
6
Introduction

• During the Great Depression, Fed

officials didn’t fully understand how
their actions affected the supply of
credit in the economy.
• The financial system collapsed
because Fed officials had failed to
provide the liquidity that sound
banks needed to stay in business.

7
Introduction
• We need to understand how the central bank
interacts with the financial system.
• What is it that central banks buy and sell?
• What are the assets and liabilities on their
balance sheets?
• How do they control those assets and liabilities,
and why might they want to hide them from the
public?
• How is the central bank’s balance sheet
connected to the money and credit that flow
through the economy?
• Where do the trillions of dollars in our bank
accounts actually come from? 8
The Central Bank’s Balance Sheet

• There are numerous financial

transactions leading to changes in the
central bank’s balance sheet.
• The structure of the balance sheet gives
us a window through which we can study
how the institution operates.
• Central banks publish their balance
sheets regularly.
– Publication is a critical part of the
transparency that makes monetary policy
effective.
9
The Central Bank’s Balance Sheet

• We will focus on a stripped-down

version of the balance sheet.
• These are the major assets and
liabilities that appear in every central
bank’s balance sheet in one form or
another
The central bank’s balance sheet
Assets Liabilities
Government securities Currency in circulation
Reserves of foreign cur- Government’s account
rency
Discount loans Bank reserves
10
The Central Bank’s Balance Sheet

• The central bank’s balance sheet shows

three basic assets:
– Securities,
– Foreign exchange reserves, and
– Loans.
• The first two are needed so that the
central bank can perform its role as the
government’s banks.
• The loans are a service to commercial
banks.
11
The Central Bank’s Balance Sheet

1. Securities are the primary asset of most

central banks.
– Traditionally, central banks exclusively held
Treasury securities, which are virtually free
of default risk.
– During the 2007-2009 crisis, some central
banks chose to acquire a variety of risky
assets.
– The quantity of securities it holds is
controlled through purchases and sales
known as open market operations.
12
The Central Bank’s Balance Sheet

2. Foreign exchange reserves are the

central bank’s and government’s
balances of foreign currency.
– These are held in the form of bonds
issued by foreign governments.
– These reserves are used in foreign
exchange interventions, when officials
attempt to change the market values of
various currencies.

13
The Central Bank’s Balance Sheet

3. Loans are usually extended to

commercial banks.
– In 2008 and 2009, the Fed made substantial
loans to nonbanks as well.
• Discount loans are the loans the Fed makes
when commercial banks need short-term
cash.
• Through its liquid securities holdings the
Fed controls the federal funds rate and
the availability of money and credit.
14
15
The Central Bank’s Balance Sheet

• On the liabilities side of the central bank’s

balance sheet, we see three major entries:
– Currency,
– The government's deposit account, and
– The deposit accounts of the commercial banks.
• The first two items allow the central bank
to perform its role as the government’s
bank, while the third allows it to fulfill its
role as the bankers’ bank.

16
The Central Bank’s Balance Sheet

1. Currency. Nearly all central banks

have a monopoly on the issuance of
the currency used in everyday
transactions.
– Currency circulating in the hands of the
nonbank public is the central bank’s
principal liability.

17
The Central Bank’s Balance Sheet
2. Government’s account. Governments
need a bank account like the rest of us.
– The central bank provides the government
with an account into which the government
deposits funds (mostly tax revenue) and from
which the government makes payments.
– By shifting funds between its accounts at
commercial banks and the Fed, the Treasury
usually keeps its account balance at the Fed
fairly constant.

18
The Central Bank’s Balance Sheet

3. Commercial Bank accounts (reserves).

– Commercial bank reserves are the sum of two
parts:
• Deposits at the central bank, plus
• The cash in the bank’s own vault.
– In the same way that you can take cash out of
a commercial bank, the bank can withdraw its
deposits at the central bank.
• Vault cash is part of reserves.
– Reserves are assets of the commercial banking
system and liabilities of the central bank.
19
The Central Bank’s Balance Sheet

• While banking system reserves usually

aren’t the central bank’s largest liability,
they are the most important in determining
the amount of money in the economy.
• Central banks run their monetary policy
operations through changes in these
reserves.
• There are two types of reserves.
• Required reserves that banks must hold, and
• Excess reserves, which banks hold voluntarily.

17-20
21
• The Fed’s response to the crisis of 2007-2009
transformed the size and composition of its
assets and liabilities in unprecedented fashion.
• The Fed’s actions helped to prevent a repeat of
the plunge of the money supply and nominal
GDP that occurred in the Great Depression.
• The following table contrasts the balance sheet
at an early state in the crisis with that after the
worst of the crisis has passed.

22
23
Importance of Disclosure

• Every central bank publishes a

statement of the bank’s own
financial condition.
• Without public disclosure of the level
and change in the size of foreign
exchange reserves and currency
holdings, it is impossible for us to tell
whether the policymakers are doing
their job properly.

24
Importance of Disclosure
• Publication of the balance sheet is an
essential aspect of central bank
transparency.
• A sign of trouble is misrepresentation of
the central bank’s financial position.
– In 1986 the president of the Philippines ordered
the central bank to print enormous amount of
money.
– They had been restricted in doing so by the
IMF, so the IMF was monitoring the serial
numbers on new bills.
– So instead of printing one bill per serial
number, the central bank printed three. 25
The Monetary Base
• Together, currency in the hands of the public
and reserves in the banking system make up
the monetary base.
– This is the privately held liabilities of the central
bank.
– It is also called high-powered money.
• The central bank can control the size of the
monetary base.
– When the monetary base increases by a dollar,
the quantity of money typically rises by several
dollars.
26
Changing the Size and
Composition of the Balance Sheet
• Policymakers can enlarge or reduce their assets
and liabilities at will, without asking anyone.
• What is the difference between a purchase you
make and one the central bank makes?
– To pay for the bond, the central bank writes a $1
million check payable to the bond dealer.
– The dealer’s commercial bank account is credited with
$1 million when the check is deposited.
– The commercial bank then sends the check back to
the central banks.
– The central bank credits the reserve account of the
bank presenting the $1 million. 27
Changing the Size and
Composition of the Balance Sheet

• The central bank can simply buy

things and then create liabilities to
pay for them.
– It can increase the size of its balance
sheet as much as it wants.
• We will look at four types of
transactions taken by the central
bank.
– Each of these have an impact on both
the central bank’s balance sheet and
the banking system’s balance sheet.
28
Changing the Size and
Composition of the Balance Sheet
1. Open Market Operation.
– Buying or selling a security initiated by the
central bank.
2. Foreign Exchange Intervention.
– Buy or sell foreign exchange reserves initiated
by the central bank.
3. Extend a discount loan.
– Initiated by commercial banks.
4. Decision by an individual to withdraw cash
from their bank.
– Initiated by the nonbank public.
29
Open Market Operations

• When the Fed buys or sells securities

in financial markets, it engages in
open market operations.
• To see how the process works, we
can track the purchase of $1 billion
in U.S. Treasury bonds from a
commercial bank.

30
Open Market Operations

• The Fed transfers $1 billion into the reserve

account of the seller, called a T-account.
• The Fed’s assets and liabilities both go up $1
billion, increasing the monetary base by the
same amount.
• Both the $1 billion in securities and in reserves
are banking system assets.
31
Open Market Operations

• Notice that the reserves are an asset

to the banking system but a liability
to the Fed.
– This is similar to the balance in your
bank account is your asset, but it is your
bank’s liability.
• If the Fed sells a U.S. Treasury bond
through an open market sale, the
impact on everyone’s balance sheet
is reversed. 32
Foreign Exchange Intervention
• What if the U.S. Treasury instructs the Fed to
buy $1 billion worth of euros.
– They buy German government bonds, denominated
in euros, from foreign exchange departments of
large commercial banks and pay for them with
dollars.
• The $1 billion payment is credited directly to the
reserve account of the bank from which the
bonds were bought.
– This has a similar effect on the balance sheet as the
open market operation.
33
Foreign Exchange Intervention

• The Fed’s assets and liabilities both rise by

$1 billion, and the monetary base expands
with them.
• In both cases, the banking system’s
securities portfolio falls by $1 billion and
reserves balances rise by an equal
amount.

34
Discount Loans

• The commercial banks ask for loans, the

Fed does not force them.
• A borrowing bank must provide
collateral.
– This usually takes the form of U.S. Treasury
bonds, but the Fed has been willing to
accept a broad range of securities and
loans as collateral.
• This changes the balance sheet of both
institutions.
35
Discount Loans

• For the borrowing bank, it is a liability matched by

an offsetting increase in the level of its reserve
account.
• For the Fed, the loan is an asset that is created in
exchange for a credit to the borrower’s reserve
account.
• The extension of credit to the banking system
raises the level of reserves and expands the
monetary base.

36
Cash Withdrawal

• The Fed can always shift its holdings

of various assets.
– But the same is not true of its liabilities.
• Because the Fed stands ready to
exchange reserves for currency on
demand, it does not control the mix
between the two.
– The nonbank public, those who hold
cash, controls that.

37
Cash Withdrawal
• When you take cash from an ATM, you are
changing the Fed’s balance sheet.
– By moving your own assets out of your bank and
into currency, you force a shift from reserves to
currency on the Fed’s balance sheet.
• The transaction involves three balance
sheets:
– The nonbank public,
– The banking system, and
– The central bank.

38
Cash Withdrawal

• Your assets shift from checkable de-

posits to cash with no change in liabili-
ties.
• Cash inside the bank, vault cash, counts
as bank reserves.
– By withdrawing cash from your bank, you
decreased the banking system’s reserves.
– This is a change in the bank’s T-account.
• For the Fed, the change comes in the
composition of the Fed’s liabilities.
39
Cash Withdrawal
• You changed the amount of currency
outstanding, showing up on the Fed’s
balance sheet as shift from reserves to
currency.
• There is no change in the monetary base.

40
Changing the Size and
Composition of the Balance Sheet

• Open market operations and foreign

exchange interventions are both
done at the discretion of the central
bank.
• The level of discount borrowing is
decided by the commercial banks.
• The nonbank public decides how
much currency to hold.

17-41
The Central Bank’s Balance Sheet:
Summary

17-42
• Days after September 11, 2001, some very
large banks were forced to temporarily close.
• Although these banks could receive payments
to their accounts at the Fed, they couldn’t
make payments.
– The banks were limiting liquidity.
• The Fed responded by increasing its security
holdings by more than $70 billion, made $8
billion in discount loans, and bought almost
$20 billion worth of euros. 43
• Because civilian planes were grounded, paper
checks could not reach the district for collection.
• The amount of a credited but uncollected check
is called float.
– By Thursday, 9/13, float had exploded, rising from its
usual level of about $0.5 billion to $50 billion.
• Because the banking system withstood the
enormous shock and was able to meet its
commitments, people’s finances were more or
less unaffected.
44
The Deposit Expansion Multiplier

• Central bank liabilities form the base on

which the supplies of money and credit are
built.
– This is why they are called the monetary base.
– The central bank controls the monetary base.
• Our primary interest, however, is in the
broader measure of money which are
multiples of the monetary base.
– M1.
– M2.
45
The Deposit Expansion Multiplier

• M1 and M2 are the money we think

of as available for transactions.
• What is the relationship between the
central bank’s liabilities and these
broader measure of money?
• How do reserves become bank
deposits?
• This happens in a process called
multiple deposit creation.
46
Deposit Creation at a Single Bank

• We have an open market purchase in

which the Fed buys $100,000 worth of
securities from a bank called First Bank.
– The bank’s total assets are unchanged.
– $100,000 shifts out of securities into
reserves.
• Reserves typically bear a lower interest
rate, so if the bank does nothing, its
revenues will fall and so will profits.
– Remember these are excess reserves.
47
Deposit Creation at a Single Bank

• So now First Bank loans out the reserves to

a customer, Office Builders Inc. (OBI).
– OBI’s checking account is credited with
$100,000.
– OBI writes checks totaling $100,000.
– As the checks are paid, OBI’s checking account
balance falls, and
– First Bank’s reserve account balance falls.
• The loan replaces the securities as an asset
on First Bank’s balance sheet.
48
Deposit Creation in a Single Bank

49
Deposit Creation in a System of Banks

• All the checks that OBI wrote end up

in someone else’s bank account.
• Only the Fed can create and destroy
the monetary base.
• But the nonbank public determines
how much of it ends up as reserves
in the banking system and how much
in currency.

50
Deposit Creation in a System of Banks

• We start with the following

assumptions:
– Banks hold no excess reserves.
– The reserve requirement ratio is 10%.
– Currency holding does not change when
deposits and loans change.
– When a borrower writes a check, none of
the recipients of the funds deposit them
back in the bank that initially made the
loan.
51
Deposit Creation in a System of Banks

• OBI pays $100,000 to American Steel.

• American Steel deposits $100,000 into
Second Bank.
• Second Bank’s reserve account at the
Fed is credited with $100,000.
• Second Bank will make a loan of its now
excess reserves minus the 10% they are
required to hold.
• The new loan is deposited into Third
Bank and the process continues.
52
Deposit Creation in a System of Banks

53
54
Deposit Creation in a System of Banks

55
Deposit Creation in a System of Banks

• We can derive a formula for the

deposit expansion multiplier.
– That is the increase in commercial bank
deposits following a one-dollar open
market purchase.
– This continues to assume there are no
excess reserves and no changes in the
amount of currency help by the nonbank
public.

56
Deposit Creation in a System of Banks

• Let’s being by assuming there is only

one bank and everyone must use it.
• The level of reserves, then, is just the
required reserve ratio rD times its
deposits.
• If required reserves are RR and
deposits are D, then the level of
reserves can be expressed as:
RR = rDD.
57
Deposit Creation in a System of Banks

• Any change in deposits creates a

corresponding change in reserves:
ΔRR = rDΔD
• The change in deposits is:
1
D  RR
rD
• For each dollar increase in reserves,
deposits increase by (1/rD).

58
Deposit Creation in a System of Banks

• This is the simple deposit expansion

multiplier.
• For example: rD 0.10
D $100,000
1
RR  ($100,000)
0.10
RR $1,000,000

• An open market sale will decrease deposits

in the same way.

59
The Monetary Base and
the Money Supply
• The simple deposit expansion multiplier is
too simple.
• In deriving it, we ignored a few details:
– We assumed banks lend out all their excess
reserves, but banks do hold some of their
excess reserves.
– We ignored the fact that the nonbank public
holds cash.
• As people’s account balances rise, they tend to hold
more cash.
• Both of these affect the relationship
among reserves, the monetary base, and
the money supply. 60
Deposit Expansion With
Excess Reserves and Cash Withdrawals

• Now let’s assume:

– Checking account holders withdraw 5% of
cash.
– Banks hold excess reserves of 5% of
deposits.
• From our previous example, if American
Steel takes some of the $100,000 in
cash and Second Bank wishes to hold
excess reserves, then the next loan
cannot be $90,000.
61
Deposit Expansion With
Excess Reserves and Cash Withdrawals
• American Steel holds the 5% in cash
leaving $95,000 in checking account.
• Second Bank holds 5% excess reserves,
so they are left with $80,750 to loan out.
– Remember they hold 10% as required by the
Fed and 5% excess reserves for a total of
15%.
• We can follow this as we did before to
show the smaller the deposit expansion
becomes if we take excess reserves and
cash withdrawals into account.
62
Deposit Expansion With
Excess Reserves and Cash Withdrawals

63
The Arithmetic of the
Money Multiplier
• We can derive the money multiplier.
– This shows how the quantity of money is
related to the monetary base.
• If we label the quantity of money M
and the monetary base MB, the
money multiplier m is defined as:
M = m x MB

64
The Arithmetic of the Money Multiplier

• We will start with the following relationships:

– Money equals currency, C, plus checkable
deposits, D,
– The monetary base MB equals currency plus
reserves in the banking system R, and
– Reserves equal required reserves RR plus excess
reserves ER.
M=C+D
MB = C + R
R = RR + ER
65
The Arithmetic of the Money Multiplier

• Starting with banks, we know that their

holdings of required reserves depends on
the required reserve ratio rD.
• The amount of excess reserve a bank holds
depends on the costs and benefits of
holding them.
– The higher the interest rate on loans, the lower
banks’ excess reserves, and
– The greater banks’ concern over the possibility
of deposit withdrawals, the higher their excess
reserves. 66
The Arithmetic of the Money Multiplier

• Labeling the excess reserve-to-

deposit ratio {ER/D}, we can rewrite
the reserve equation as:
R = RR + ER
= rDD + {ER/D}D
= (rD + {ERD})D
• Banks hold reserves as a proportion
of their deposits.

67
The Arithmetic of the Money Multiplier

• The currency-to-deposit ratio, {C/D}, is

the fraction of deposits that people hold
as currency.
C = {C/D}D
• The decision of how much currency to hold
depends on the costs and benefits as well.
– The cost of currency is the interest it would
earn on deposit.
– The benefit is its lower risk and greater
liquidity.

68
The Arithmetic of the Money Multiplier

• Putting this all together, we can see to

following.
MB = C + R
= {C/D}D + (rD + {ER/D})D
= ({C/D} + rD + {ER/D})D
• The monetary base has three uses:
– Required reserves,
– Excess Reserves, and
– Cash in the hands of the nonbank public.
69
The Arithmetic of the Money Multiplier

• We can do the same with the

equation for money.
M=C+D
= {C/D}D + D
= ({C/D} + 1)D

70
The Arithmetic of the Money Multiplier

• We can use the equation for MB to

solve for deposits:
1
D x MB
{C/D}  rD  {ER/D}

• And substituting D into the money

equation:
{C / D}  1
M x MB
{C/D}  rD  {ER/D}
71
• This tells us that the quantity of
money in the economy depends The
Arithmetic of the Money Multiplier on:
1. The monetary base, which is controlled
by Fed,
2. The reserve requirement,
3. The bank’s desire to hold excess
reserves, and
4. The nonbank public’s demand for
currency.
72
The Arithmetic of the Money Multiplier

• What is the impact of each of these?

1. If the monetary base increases, the quantity of
money increases.
2. An increase in either the reserve requirement
or banks’ excess reserve holding reduces
money.
3. When an individual withdraws cash, he or she
increases the currency in the public and
decreases reserves.
• The decline in reserves creates a multiple deposit
contraction.
• The money supply contracts. 73
Factors Affecting
the Quantity of Money

74
The money multiplier and
the Great Depression

• Bank failures (and

no deposit
insurance)
determined:
– Increase in deposit
outflows and
holding of currency
(depositors)
– An increase in the
amount of excess
reserves (banks)
Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson
Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ:
Princeton University Press, 1963), p. 333. 75
The money multiplier and
the Great Depression
• In the 1930s the Fed saw
its balance sheet growing.
• Officials did not realize that
the money multiplier was
falling.
• Without knowing it, the Fed
ran a contractionary policy
during the Depression.
• Central bankers need to
look at both the monetary
base and the money
multiplier to see if policies
are working. 76
The money multiplier and
the Great Depression

Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960
(Princeton, NJ: Princeton University Press, 1963), p. 333.
77
The money base and money multiplier,
2007 - 2010

78
• The central bank supplies the monetary base, but
it is banks and the banking system that supply
money.
• When the crisis peaked in September 2008, the
deposit expansion multiplier plummeted to a
fraction of its normal value.
• The standard process of deposit expansion
assumes that banks will lend out most of
additional dollar reserves supplied by the Fed.
• However, banks panicked and sought to hold
more excess reserves collapsing the deposit
expansion multiplier.
79
The Limits on the Central Bank’s
Ability to Control the Quantity of Money

• The various factors affecting the

quantity of money change over time.
– Market interest rates affect the cost of
holding both excess reserves and
currency.
– As interest rates increase, we expect to
see {ER/D} and {C/D} fall.
• This increases the money multiplier and the
quantity of money.

80
The Limits on the Central Bank’s
Ability to Control the Quantity of Money

• If these changes in the money multiplier

were predictable, the central bank might
choose to exploit this link in its
policymaking.
• Although this made sense in the U.S. in
the 1930s, it no longer does.
– For emerging countries like China and India it
might still.
• In countries like the U.S., Europe, and
Japan, the link has become too weak and
unpredictable to be exploited. 81
The Limits on the Central Bank’s Ability
tto Control the Quantity of Money

• The money multiplier is just too variable.

• The relationship between the monetary
base and the quantity of money is not
something that a central bank can exploit
for short-run policy purposes.
• For short-run policy, interest rates have
become the monetary policy tool of choice.
• In a financial crisis, other balance-sheet
tools help address liquidity needs and
market disruptions more directly.
82
The Limits on the Central Bank’s
Ability to Control the Quantity of Money

83