1. 1 Chapter 15: Multiple Deposit Creation and the Money Supply Process

2. 2 Questions addressed in this chapter: What is money supply? What is money supply process? How money supply level is determined? Who controls money supply? What cause money supply to change? How can we improve the control of money supply? The relationship between deposits and money supply. How deposits are created? How banking system creates deposits?

3. 3 1- The Four Players in the Money Supply Process: A- The Central Bank (the most important player): the central bank conduct monetary policy B- Banks (depository institutions). C- Depositors. D- Borrowers.

4. 4 2- The Central bank's balance sheet: AssetsLiabilities Government Securities Currency in circulation Discount Loans Reserves Liabilities: Currency in circulation and reserves are called "monetary liabilities". Monetary base: the sum of the Fed's monetary liabilities and the U.S. treasury Monetary liabilities. 1. Currency in circulation. 2. Reserves. Assets: The importance of assets components. 1. Government securities. 2. Discount loans.

5. 5 3- Control of the Monetary Base: The monetary base or the "high-powered money" (MB) = Currency in circulation (C) + Total Reserves in banking system (R), or: MB = C + R The central bank controls monetary base through:

6. 6 1. Open market Operations (OMO): A. Open market purchase from a bank: Example: The Fed purchase $100 of bonds from a bank and pays with check. The bank can deposit the $100 check in its account in the Fed, or the bank can cash in the $100 check for currency. The Banking System AssetsLiabilities Securities - 100 Reserves + 100 The Fed AssetsLiabilities Securities + 100Reserves + 100 The net result of this open market purchase is that reserves have (increased by ($100). While currency in circulations constant, monetary base has increased by ($100).

7. 7 B. Open market purchase from the Nonbank public: First: Assume that the other party (the nonbank) deposits the Fed's check in a local bank Nonbank public Assets Liabilities Securities - 100 Checkable deposits + 100 if the bank deposit the check in its account with the fed: Banking System AssetsLiabilities Reserves+100Checkable deposits + 100 the effect of the Fad's balance sheet that it (gained\lost) ($100) of securities while it has an (increase\decrease) of ($100) of reserves in liabilities:

8. 8 The Fed AssetsLiabilities Securities +100Reserves + 100

9. 9 When the Fed's check is deposited in a bank, the net result of the Fed's open market purchase from the nonbank public is identical to the effect of its open market purchase from a bank: Reserves increase by the amount of the open market purchase, and the monetary base increase by the same amount.

10. 10 Second: assume now that the third party cashes the Fed's check for currency: Nonbank Public A L Securities -100 Currency +100 Fed AL Securities +100 Currency in circulation +100

11. 11 The net effect: reserves are unchanged while currency in circulation increases by the ($100), thus monetary base increases by the ($100) while reserves unchanged.

12. 12 The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits. The effect of an open market purchase on monetary base is always the same whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits.

13. 13 2. Open market sale: If the Fed sells ($100) of bonds to a bank or a nonbank public, MB will decline by ($100). Example: The Fed sells ($100) bond to an individual who pays with currency. Nonbank Public A L Securities +100 Currency -100 The Fed A L Securities -100 Currency in circulation -100

14. 14 The effect of an open market sale of ($100) bond is to reduce monetary base by ($100). Note that reserves are unchanged. (falls if pays with check). Conclusion: The effect of open market operations on MB is more certain than the effect on reserves.

15. 15 Open market purchase: 1- If the proceeds are kept in currency, open market purchase has no effect on reserves. 2- If the proceeds are kept as deposits, open market purchase increases reserves by the same amount of open market purchase. 3- MB: the MB increases by same amount of the purchase.

16. 16 Open market sale: Sale of bonds reduces MB by same amount: 4- Reserves unchanged if pays by currency. 5- Reserves falls if pays by check. Therefore: the Fed can control MB with open market operations more effectively than it can control reserves.

17. 17 Shifts from Deposits into Currency: Even if the Fed doesn’t conduct open market operations, a shift from deposits to currency will affect reserves but no effect on MB: MB = R + C This is why the Fed has more control over MB than over reserves

18. 18 Example: You close your account (100) in cash: NonBank public AL D -100 C +100 The Banking System AL R -100D -100 The Fed AL R -100 C +100

19. 19 Example: You close your account (100) in cash: NonBank public AL D -100 C +100 The Banking System AL R -100D -100 The Fed AL R -100 C +100

20. 20 Example: You close your account (100) in cash: NonBank public AL D -100 C +100 The Banking System AL R -100D -100 The Fed AL R -100 C +100 MB unaffected, but R are. MB is more stable than R.

21. 21 Control of Monetary Base: 1.Open market operations 2.Discount loans 3.Reserve requirement (r ratio) 4.Other Factors

22. 22 Discount loans: Example: The Fed makes ($100) discount loan to bank (A), bank (A) reserves increase by ($100): Bank (A) AL Reserves +100 Discount loans +100 The Fed AL Discount loans +100 Reserves +100 Monetary liabilities of the Fed (?) increased by ($100)

23. 23 MB increased by ($100). Now, when the bank pays off the loan: Bank (A) AL Reserves -100Discount loans -100 The Fed AL Discount loans -100Reserves -100

24. 24 Net effect: When ($100) discount loan is made to a commercial bank, monetary liability of the Fed and thus MB is increased by the ($100). When ($100) discount loan is paid off, monetary liability of the Fed and thus MB is decreased by the ($100).

25. 25 4- Other factors affecting MB: A. Float: Occurs from the Fed check-clearing process: when clearing a check, the Fed first credits the amount of the check to the bank that deposited the check (increases bank reserves), but later on, debits the bank on which the check is drawn (decreases bank reserves). This will result in a brief increase in total reserves of the banking system.

26. 26 B. Treasury deposits at the Fed: When the U.S. Treasury moves deposits from commercial banks to its account at the Fed, it causes a deposit outflows, thus reduces reserves and thus the MB. These are short-term fluctuations; the Fed can control MB very accurately.