1 Lecture 28: Money supply Mishkin Ch14 – part B page

2 Introduction What affect money supply? Money supply = monetary multiplier *money base Monetary multiplier Money base

3 Open market operations are controlled by the Fed. The Fed cannot determine the amount of borrowing by banks from the Fed (discount loans). Split the monetary base into two components  Discount loans: borrowed reserves, BR  Remainder: non-borrowed monetary base, MB n, (MB n = MB - BR ) M = m*(MB n + BR) What affect monetary base?

4 Factors that determine the money supply Previously we knew that required reserve ratio (r), currency ratio (c), and excess reserves ratio (e) negatively affect monetary multiplier (m) and thus negatively affect money supply. The money supply is positively related to nonborrowed monetary base (MB n ). The money supply is positively related to borrowed reserve from the Fed (MR).

5 Changes in the nonborrowed monetary base (MB n ) M = m*(MB n + BR) The Fed’s open market purchase  increase in nonborrowed monetary base (MB n )  increase in monetary base (MB)  support more currency and deposits  increase money supply (M). The money supply (M) is positively related to the nonborrowed monetary base (MB n ). How about open market sale?

6 Changes in the borrowed reserves (MR) from the Fed M = m*(MB n + BR) If discount loans increase  borrowed reserves (BR) increase  monetary base (MB) increase  support more currency and deposits and thus a higher money supply. The money supply is positively related to the level of borrowed reserves, BR, from the Fed.

7 Overview of the money supply process

8 Application I : explain money supply movements

change in MB (mainly MB n ) is important for long-term movements. change in m (currency ratio c) is important for short-term movements.

10 Explain money supply movements – cont’d Over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base, which is controlled by the Fed’s open market operations.

11 Application II : bank panics and reduction in money supply

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13 Application: bank panics and money supply – cont’d Bank panics  relative risks of deposits increase, relative expected return of deposits decrease  demand for deposits decrease  people shift to holding cash  currency ratio c increase  money multiplier m decrease  money supply decrease. In times of uncertainty  expected deposit outflow increases  banks would increase excess reserves ratio e  money multiplier m decrease  money supply decrease.

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15 Application: bank panics and money supply – cont’d Although the Fed tried its best to increase monetary base, it can not fully offset the negative effect of money multiplier on money supply.

16 Recap The relationship between money supply and:  excess reserve ratio  interest rate, expected deposit outflow  currency ratio (short-term effects)  Nonborrowed monetary base  open market operation (long-term effects)