1. Copyright © 2002 Pearson Education, Inc. Slide 17-1 The Money Supply Process

2. Copyright © 2002 Pearson Education, Inc. Slide 17-2 The Fed and the Monetary Base The Fed can control the money supply by changing the monetary base. The monetary base is equal to currency in circulation and reserves held by banks. The Fed’s principal liabilities are currency in circulation and reserves. The Fed’s principal assets are government securities and discount loans.

3. Copyright © 2002 Pearson Education, Inc. Slide 17-3 Changing the Monetary Base The Fed changes the monetary base by changing the levels of its assets. In an open market purchase the Fed buys government bonds and increases the base. In an open market sale the Fed sells government bonds and decreases the base. The Fed can also change reserves and the base through changes in discount loans.

4. Copyright © 2002 Pearson Education, Inc. Slide 17-4 The Effect of Open Market Operations

5. Copyright © 2002 Pearson Education, Inc. Slide 17-5 The Effect of Discount Loans

6. Copyright © 2002 Pearson Education, Inc. Slide 17-6 Multiple Deposit Creation

7. Copyright © 2002 Pearson Education, Inc. Slide 17-7 The Simple Deposit Multiplier The money multiplier links monetary base changes to changes in the money supply. Simple deposit multiplier:  D =  R {1/(R/D )}; where D = deposits, R = reserves, and R/D = required reserve ratio.

8. Copyright © 2002 Pearson Education, Inc. Slide 17-8 Decisions of the Nonbank Public The simple deposit multiplier model incorrectly assumes no currency and no excess reserves. Behavior of the nonbank public and banks influences the money supply. The ratio of cash to checkable deposits is called the currency-deposit ratio, (C/D). Changes in C/D by nonbank public will change the money supply.

9. Copyright © 2002 Pearson Education, Inc. Slide 17-9 Determinants of the Currency- Deposit Ratio

10. Copyright © 2002 Pearson Education, Inc. Slide 17-10 Bank Behavior: Excess Reserves and Discount Loans Banks sometimes hold excess reserves, reducing the size of the money multiplier. Banks’ decisions to incur discount loans affect the size of the monetary base. Banks generally hold small levels of excess reserves, but the amount fluctuates over time. The level of discount loans is determined by banks.

11. Copyright © 2002 Pearson Education, Inc. Slide 17-11 Excess Reserves and Discount Loans (1959-2000)

12. Copyright © 2002 Pearson Education, Inc. Slide 17-12 Determinants of Excess Reserves and Discount Loans

13. Copyright © 2002 Pearson Education, Inc. Slide 17-13 Deriving the Money Multiplier and the Money Supply The money supply equals the money multiplier times the monetary base. The monetary base = nonborrowed base + discount loans. The money multiplier depends on the required reserve ratio, ER/D, and C/D.

14. Copyright © 2002 Pearson Education, Inc. Slide 17-14 M = m B Variation in Money Multiplier Affects Money Supply Growth

15. Copyright © 2002 Pearson Education, Inc. Slide 17-15 Variables in the Money Supply Process

16. Copyright © 2002 Pearson Education, Inc. Slide 17-16 The Federal Reserve’s Balance Sheet

17. Copyright © 2002 Pearson Education, Inc. Determining the Monetary Base The simple expression, B = C + R, can be expanded to B = Federal Reserve Notes + Reserve deposits by depository institutions + Treasury currency outstanding. The above expression can be expanded to include all sources of monetary base changes.

18. Copyright © 2002 Pearson Education, Inc. Slide 17-18 Sources of Changes in the Monetary Base

19. Copyright © 2002 Pearson Education, Inc. The Federal Budget Deficit and the Monetary Base The federal budget deficit = public bond purchases + monetary base increases. If the Fed buys Treasury debt to finance budget deficits, it is monetizing the debt. Financing spending by taxes or by selling bonds to the public won’t affect the base. Financing spending by selling bonds that the Fed ultimately buys increases the base.