Chapter 17. Money Supply Process Fed Balance Sheet Fed and the Monetary Base Deposit Creation The money multiplier Fed Balance Sheet Fed and the Monetary Base Deposit Creation The money multiplier

The money supply process who determines the money supply?  the Federal Reserve  banks  depositors  borrowers who determines the money supply?  the Federal Reserve  banks  depositors  borrowers

The Fed’s balance sheet Assets U.S. government bonds  necessary for open market operations Gold, SDRs  used for international debts Assets U.S. government bonds  necessary for open market operations Gold, SDRs  used for international debts

other assets  foreign bonds, currency  physical assets cash in collection discount loans  Fed loans to banks other assets  foreign bonds, currency  physical assets cash in collection discount loans  Fed loans to banks

Fed is self-funding open market operations discount loans both are also key to controlling money supply open market operations discount loans both are also key to controlling money supply

LiabilitiesLiabilities Federal reserve notes  U.S. currency  exchangeable for more notes Reserves  deposits by banks  required + excess U.S. Treasury deposits Federal reserve notes  U.S. currency  exchangeable for more notes Reserves  deposits by banks  required + excess U.S. Treasury deposits

monetary base (MB) currency + reserves C + R also called “high-powered money” $1 increase in MB will cause > $1 increase in money supply currency + reserves C + R also called “high-powered money” $1 increase in MB will cause > $1 increase in money supply

Controlling MB open market operations  Fed buys and sells Treasury securities  affect size of monetary base use T accounts to track the effect open market operations  Fed buys and sells Treasury securities  affect size of monetary base use T accounts to track the effect

exampleexample open market purchase $100 million  Fed buys $100 million in Tbonds  Fed buys from a bank open market purchase $100 million  Fed buys $100 million in Tbonds  Fed buys from a bank increase in bank reserves of $100 million

if Fed buys Tbonds from public, & public deposits in account if Fed buys Tbonds from public, & public deposits in account increase in bank reserves of $100 million

discount loans  Fed loans to bank  Fed credits bank’s reserve account discount loans  Fed loans to bank  Fed credits bank’s reserve account

reserves increase MB increases reserves increase MB increases

Deposit creation Fed increases reserves by $1, deposits increase by > $1  multiple deposit creation how? Fed increases reserves by $1, deposits increase by > $1  multiple deposit creation how?

exampleexample Fed buys $100 securities from bank  bank securities decrease $100  bank reserves increase $100 Fed buys $100 securities from bank  bank securities decrease $100  bank reserves increase $100

$100 increase in reserves are excess reserves,  banks lends them out by crediting checking account $100 increase in reserves are excess reserves,  banks lends them out by crediting checking account

borrower takes $100 loan and deposits in bank A  reserves increase at bank A  deposits increase at bank A borrower takes $100 loan and deposits in bank A  reserves increase at bank A  deposits increase at bank A

required reserve ratio = 10% bank A must keep $10  free to lend $90 required reserve ratio = 10% bank A must keep $10  free to lend $90

borrower at bank A takes $90 loan and deposits in bank B

bank B must keep $9  free to lend $81 bank B must keep $9  free to lend $81

where are we? initial $100 open market purchase checking deposits so far: $100 + $90 + $81 = $271 money has been created initial $100 open market purchase checking deposits so far: $100 + $90 + $81 = $271 money has been created

simple money multiplier how much money creation is possible? change in deposits = change in reserves x 1 reserve req.

$100 increase in reserves, $1000 increase in deposits $100 increase in reserves, $1000 increase in deposits change in deposits = $100x 1.10 = $1000

simple money multiplier leaves out 2 possibilities: (1) borrowers take some of loan as cash (2) banks hold some excess reserves need a more complex multiplier leaves out 2 possibilities: (1) borrowers take some of loan as cash (2) banks hold some excess reserves need a more complex multiplier

a better money multiplier a better money multiplier how $1 change in MB will affect MS: M = m x MB how $1 change in MB will affect MS: M = m x MB

r D = required reserve ratio C/D = ratio of currency to deposits ER/D = ratio of excess reserves to deposits m = r D + ER/D + C/D 1 + C/D

exampleexample r D =.10 C = $400 billionD = $800 billion ER = $.8 billion or $800 million = 2.5 $1 increase in MB, $2.5 increase in M m =

Factors affecting m changes in r D changes in C/D changes in ER/D changes in r D changes in C/D changes in ER/D

changes in r D higher reserve requirement  fewer excess reserves to lend  smaller amount of deposit creation higher reserve requirement  fewer excess reserves to lend  smaller amount of deposit creation higher r D smaller multiplier

exampleexample r D was.10 suppose it rises to.20 r D was.10 suppose it rises to.20 m = 2.14 m =

changes in C/D higher C/D  currency does not expand like deposits  smaller amount of deposit creation higher C/D  currency does not expand like deposits  smaller amount of deposit creation higher C/D smaller multiplier

exampleexample original example: C/D =.5 suppose C/D =.8 original example: C/D =.5 suppose C/D =.8 m = =

changes in ER/D higher ER/D  banks hold more ER, lend less  smaller amount of deposit creation higher ER/D  banks hold more ER, lend less  smaller amount of deposit creation higher ER/D smaller multiplier

exampleexample original example: ER/D =.001 suppose ER/D =.005 original example: ER/D =.001 suppose ER/D =.005 m = =

what affects ER/D, C/D? as interest rates rise  opportunity cost of holding ER and case rise  (money could be earning interest) as interest rates rise  opportunity cost of holding ER and case rise  (money could be earning interest) higher i ER/D, C/D fall

expected deposit outflows increase  must hold more ER  ER/D would rise expected deposit outflows increase  must hold more ER  ER/D would rise

Great Depression big contraction in M1 big increases in ER/D and C/D  depositors withdrew cash  banks increase ER due to increase in deposit outflow big contraction in M1 big increases in ER/D and C/D  depositors withdrew cash  banks increase ER due to increase in deposit outflow

as C/D and ER/D rise,  money multiplier declines  M1 declines by 25% from as C/D and ER/D rise,  money multiplier declines  M1 declines by 25% from