1. Chapter 14 The Money Supply Process

2. © 2013 Pearson Education, Inc. All rights reserved.14-2 Three Players in the Money Supply Process Central bank (Federal Reserve System) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions)

3. © 2013 Pearson Education, Inc. All rights reserved.14-3 The Fed’s Balance Sheet Liabilities –Currency in circulation: in the hands of the public –Reserves: bank deposits at the Fed and vault cash Assets –Government securities: holdings by the Fed that affect money supply and earn interest –Discount loans: provide reserves to banks and earn the discount rate Federal Reserve System AssetsLiabilities SecuritiesCurrency in circulation Loans to Financial Institutions Reserves

4. © 2013 Pearson Education, Inc. All rights reserved.14-4 Control of the Monetary Base

5. © 2013 Pearson Education, Inc. All rights reserved.14-5 Open Market Purchase from a Bank Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 Banking SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities$100mSecurities+$100mReserves+$100m Reserves+$100m

6. © 2013 Pearson Education, Inc. All rights reserved.14-6 Open Market Purchase from the Nonbank Public Person selling bonds to the Fed deposits the Fed’s check in the bank Identical result as the purchase from a bank Banking SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Reserve s +$100mCheckable deposits +$100mSecurities+$100mReserves+$100m

7. © 2013 Pearson Education, Inc. All rights reserved.14-7 Open Market Purchase from the Nonbank Public (cont’d) The person selling the bonds cashes the Fed’s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase Nonbank PublicFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities-$100mSecurities+$100mCurrency in circulation +$100m Currency+$100m

8. © 2013 Pearson Education, Inc. All rights reserved.14-8 Open Market Purchase: Summary 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 the monetary base always increases the monetary base by the amount of the purchase

9. © 2013 Pearson Education, Inc. All rights reserved.14-9 Open Market Sale Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves Nonbank PublicFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities+$100mSecurities-$100mCurrency in circulation -$100m Currency-$100m

10. © 2013 Pearson Education, Inc. All rights reserved.14-10 Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Checkable deposits -$100mReserves-$100mCheckable deposits -$100m Currency+$100m Federal Reserve System AssetsLiabilities Currency in circulation +$100m Reserves-$100m Net effect on monetary liabilities is zero; Reserves are changed by random fluctuations; Monetary base is a more stable variable

11. © 2013 Pearson Education, Inc. All rights reserved.14-11 Loans to Financial Institutions Monetary liabilities of the Fed have increased by $100 Monetary base also increases by this amount Banking SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Reserve s +$100mLoans+$100mLoans+$100mReserves+$100m (borrowing from Fed)

12. © 2013 Pearson Education, Inc. All rights reserved.14-12 Other Factors that Affect the Monetary Base Float Treasury deposits at the Federal Reserve Interventions in the foreign exchange market

13. © 2013 Pearson Education, Inc. All rights reserved.14-13 Overview of The Fed’s Ability to Control the Monetary Base Open market operations are controlled by the Fed The Fed cannot determine the amount of borrowing by banks from the Fed Split the monetary base into two components MB n = MB - BR The money supply is positively related to both the non-borrowed monetary base MB n and to the level of borrowed reserves, BR, from the Fed

14. © 2013 Pearson Education, Inc. All rights reserved.14-14 Multiple Deposit Creation: A Simple Model First National Bank AssetsLiabilitiesAssetsLiabilities Securities-$100mSecurities-$100mCheckable deposits +$100m Reserves+$100mReserves+$100m Loans+$100m First National Bank AssetsLiabilities Securities-$100m Loans+$100m Deposit Creation: Single Bank Excess reserves increase; Bank loans out the excess reserves; Creates a checking account; Borrower makes purchases; The Money supply has increased

15. © 2013 Pearson Education, Inc. All rights reserved.14-15 Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100 m Checkable deposits +$100 m Reserves+$10Checkable deposits +$100 m Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Checkable deposits +$90Reserves+$9Checkable deposits +$90 Loans+$81 Multiple Deposit Creation: A Simple Model (Cont’d) Deposit Creation: The Banking System

16. © 2013 Pearson Education, Inc. All rights reserved.14-16 Table 1 Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves)

17. © 2013 Pearson Education, Inc. All rights reserved.14-17 Deriving The Formula for Multiple Deposit Creation

18. © 2013 Pearson Education, Inc. All rights reserved.14-18 Critique of the Simple Model Holding cash stops the process –Currency has no multiple deposit expansion Banks may not use all of their excess reserves to buy securities or make loans. Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change.

19. © 2013 Pearson Education, Inc. All rights reserved.14-19 Factors that Determine the Money Supply Changes in the nonborrowed monetary base MB n –The money supply is positively related to the non-borrowed monetary base MB n Changes in borrowed reserves from the Fed –The money supply is positively related to the level of borrowed reserves, BR, from the Fed

20. © 2013 Pearson Education, Inc. All rights reserved.14-20 Factors that Determine the Money Supply (cont’d) Changes in the required reserves ratio –The money supply is negatively related to the required reserve ratio. Changes in currency holdings –The money supply is negatively related to currency holdings. Changes in excess reserves –The money supply is negatively related to the amount of excess reserves.

21. © 2013 Pearson Education, Inc. All rights reserved.14-21 Overview of the Money Supply Process Summary Table 1 Money Supply Response

22. © 2013 Pearson Education, Inc. All rights reserved.14-22 The Money Multiplier Define money as currency plus checkable deposits: M1 Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

23. © 2013 Pearson Education, Inc. All rights reserved.14-23 Deriving the Money Multiplier Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D. Then, c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio

24. © 2013 Pearson Education, Inc. All rights reserved.14-24 Deriving the Money Multiplier (cont’d)

25. © 2013 Pearson Education, Inc. All rights reserved.14-25 Deriving the Money Multiplier (cont’d) The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + (r x D) + ER Equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.

26. © 2013 Pearson Education, Inc. All rights reserved.14-26 Deriving the Money Multiplier (cont’d)

27. © 2013 Pearson Education, Inc. All rights reserved.14-27 Intuition Behind the Money Multiplier

28. © 2013 Pearson Education, Inc. All rights reserved.14-28 Application: The Great Depression Bank Panics, 1930–1933, and the Money Supply Bank failures (and no deposit insurance) determined: –Increase in deposit outflows and holding of currency (depositors) –An increase in the amount of excess reserves (banks) For a relatively constant MB, the money supply decreased due to the fall of the money multiplier.

29. © 2013 Pearson Education, Inc. All rights reserved.14-29 Figure 1 Deposits of Failed Commercial Banks, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309.

30. © 2013 Pearson Education, Inc. All rights reserved.14-30 Figure 2 Excess Reserves Ratio and Currency Ratio, 1929–1933 Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

31. © 2013 Pearson Education, Inc. All rights reserved.14-31 Figure 3 M1 and the Monetary Base, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

32. © 2013 Pearson Education, Inc. All rights reserved.14-32 APPLICATION The 2007-2009 Financial Crisis and the Money Supply During the recent financial crisis, as shown in Figure 4, the monetary base more than tripled as a result of the Fed's purchase of assets and new lending facilities to stem the financial crisis Figure 5 shows the currency ratio c and the excess reserves ratio e for the 2007-2009 period. We see that the currency ratio fell somewhat during this period, which our money supply model suggests would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion. However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e

33. © 2013 Pearson Education, Inc. All rights reserved.14-33 Figure 4 M1 and the Monetary Base, 2007-2009 Source: Federal Reserve; www.federalreserve.gov/releases.www.federalreserve.gov/releases

34. © 2013 Pearson Education, Inc. All rights reserved.14-34 Figure 5 Excess Reserves Ratio and Currency Ratio, 2007-2009 Source: Federal Reserve; www.federalreserve.gov/releases.www.federalreserve.gov/releases