Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. CHAPTER 21 The Fed, Depository Institution, and the Money Supply Process

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Money Supply Process Money Supply Credit Availability Deposit Creation Interest Rates Open Market Operations LendingReserves

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Effect of Open Market Operations on Reserves Assets (1) + $1,000 securities purchased from the public Liabilities (3) + $1,000 deposit due HLT Assets (1) - $1,000 securities sold to the Fed (2) + $1,000 deposits in the form of checks received from Fed and deposited in HLT LiabilitiesAssets (3) + $1,000 reserves in the form of Deposits at the Fed Liabilities (2) + $1,000 deposits by the public FEDPUBLICHLT NATIONAL BANK

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Effect of Discount Loans on the Monetary Base Assets + $1,000 discount loans Liabilities + $1,000 discount due HLT Liabilities + $1,000 discount loans Assets + $1,000 reserves FEDHLT NATIONAL BANK

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Factors That Affect the Reserves of Depository Institutions Factors that increase reserves: Factors that decrease reserves: Open Market Purchases Increases in Discount Loans Open Market Sales Decreases in Discount Loans

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Loan and Deposit Expansion at HLT National Bank HLT National Bank AssetsLiabilities Total reserves$1,000Checkable deposits$1,000

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Transactions between HLT National Bank and Second National Bank HLT National Bank Assets Liabilities Total reserves $100 Checkable deposits $1,000 Loan 900 Total $1,000 $1,000 Assets Liabilities Total reserves $900 Checkable deposits $900 $900 $900 Second National Bank

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Transactions of Second National Bank and Third National Bank Second National Bank Assets Total reserves$ 900 Loans 810 Total$1,710 Liabilities Checkable deposits$ 900 Check able deposits 810 $1,710 The proceeds of the loan from Second National are spent and deposited in the university’s account at Third National. Second National loses $810 in reserve assets, and the $810 deposit of the loan proceeds is extinguished. The resulting balance sheet of Second National and Third National are as follows: Second National Bank Assets Liabilities Total reserves $ 90 Checkable deposits $900 Loans 810 Total $ 900$900 Third National Bank Assets Liabilities Total reserves $810 Checkable deposits $810 $810$810

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Required Reserve Ration and the Simple Money Multiplier r D Simple Money Multiplier 1/.05 = 20 1/.10 = 10 1/.20 =5 1/.25 =4 1/.50 =2

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. An Inverted Pyramid Representing the Money Supply and the Monetary Base Checkable + Deposits $580.6 Currency in the Public’s Hands* + $562.4 Reserves + Currency in the Public’s Hands* $ $562.4 *Traveler’s checks are included in this category. SOUCRCE: Federal Reserve Statistical Release, H3 and H6, September 27, The money supply and monetary base figures are as of August 2001 and are in billions of dollars. = $602.3 = Monetary Base = $1, = M1

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Multiple Expansion of Deposits and Loans in the Banking System with an Initial Increase in Reserve of $1,000 and a Multiplier of 10 Initial reserves provided Expansion Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6 Stage 7 Stage 8 Stage 9 Stage 10 - Stage 20 Final Total Deposits $1,000 $1,900 2,710 3,440 4,100 4,690 5,220 5,700 6,130 6,510 6, ,900 $10,000 Required Reserves $100 $ $1,000 Excess Reserves $900 $ $0 Total Reserves $1,000 1, ,000 $1,000 Loans -- $900 1,710 2,439 3,095 3,690 4,221 4,680 5,130 5,517 5, ,902 $9,000 Total Assets RR + ER + Loans TR + Loans $1,000 $1,900 2,710 3,439 4,100 4,690 5,200 5,700 6,130 6,510 6, ,900 $10,000 SOURCE: Adopted from Modern Money Mechanics (Chicago: Federal Reserve Bank of Chicago, 1992).

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Multiplier Effect of an Increase in Reserves SOURCE: Federal Reserve Bulletin Final 1, Total Deposit 1,000 10,000

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Factors That Affect the Money Multiplier c (the desired ration of currency to checkable deposits) e (the ratio of excess reserves held to checkable deposits) r D (the required reserve ratio An Increase in …Caused by …Results in … The decision by the public to increase holdings of currency relative to deposits The decision by depository institutions to hold more excess reserves The decision by the Fed to increase the required reserve ratio A decrease in the money multiplier and a decrease in the money supply A Decrease in …Caused by …Results in … cerDcerD The decision by the public to decrease holdings of currency relative to deposits The decision by depository institutions to hold fewer excess reserves The decision by the Fed to decrease the required reserve ratio An increase in the money multiplier and an increase in the money supply

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Fed’s Balance Sheet as of May 31, 2001 (in Millions of Dollars) Assets 1.Gold certificate account 2.Special drawing rights certificate account 3.Coin Loans 4.To depository institutions 5.Other 6.Acceptances held under repurchase agreements 7.Repurchase agreements—triparty a Federal agency oblicationsb 8.Bought outright 9.Held under repurchase agreements 10.Total U.S. Treasury securities b 11.Bought outright c 12.Bills 13.Notes 14.Bonds 15.Held under repurchase agreements 16.Total loans and securities 17.Items in process of collection 18.Bank premises $11,046 2,200 1, , , , , , ,035 7,670 1,504

Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Fed’s Balance Sheet as of May 31, 2001 (in Millions of Dollars) (continued) Assets 19.Denominated in foreign currencies d 20.All othere 21.Total assets 22.Federal Reserve notes 23.Reverse repurchase agreements-triparty a 24.Total deposits 25.Depository institutions 26.U.S. Treasury—General account 27.Foreign—Official accounts 28.Other 29.Deferred credit items 30.Other liabilities and accrued dividends f 31.Total liabilities 32.Capital paid in 33.Surplus 34.Other capital accounts 35.Total liabilities and capital accounts $14,759 18, ,730 Liabilities 569, ,040 19,238 4, ,910 3, ,351 Capital Accounts 7,070 6, ,730 SOURCE: Federal Reserve Bulletin (August 2001): A10.