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Chapter 18The Fed, Depository Institutions, and the
Money Supply Process
©2000 South-Western College Publishing
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Open market operations
The buying and selling of government securities by
the Fed
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Effect of Open Market Operations on Reserves
•When the Fed buys securities, reserves of depository institutions RISE•When the Fed sells securities, reserves of depository institutions fall
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Open Market Operations
Interest Rates
Deposit Creation
Money Supply
Credit Availability
Reserves Lending
Exhibit 18 - 1
The Money Supply Process
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Effect of Open Market Operations on Reserves
Exhibit 18 - 2
FedAssets Liabilities
(1) + $1,000 securities (3) + $1,000 depositpurchased from the due HLTpublic
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Effect of Open Market Operations on Reserves
Exhibit 18 - 2 cont.
PublicAssets Liabilities
(1) - $1,000 securities sold to the Fed public
(2) + $1,000 depositsin the form of checksreceived from Fed anddeposited in HLT
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Effect of Open Market Operations on Reserves
Exhibit 18 - 2 cont.
HLT National BankAssets Liabilities
(3) + $1,000 reserves (2) + $1,000 depositin the form of deposits by the publicby the Fed
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Effect of Discount Loans on Monetary Base
Exhibit 18 - 3
FedAssets Liabilities
+ $1,000 discount loans + $1,000 deposits due HLT
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Effect of Discount Loans on Monetary Base
Exhibit 18 - 3 cont.
HLT National BankAssets Liabilities
+ $1,000 reserves + $1,000 discount loans
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Factors that Affect the Reserves of Depository Institutions
Exhibit 18 - 4
Open Market Purchases Increases in discount loans
Open Market Sales Decrease in discount loans
Factors that increase reserves
Factors that decrease reserves
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Offsetting Open Market Operations
Open market purchases or sales to offset changes in the monetary base from other factors
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Federal Reserve Float
The excess in reserves that results from a check being credited to one bank (or other depository institution) before it is debited from another
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Total ReservesRequired reserves plus
excess reserves
Required Reserves
The amount of reserve assets that the Fed requires a
depository institution to hold
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Excess Reserves
Reserves over and above those required by the Fed
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Loan and Deposit Expansion at HLT National Bank
Exhibit 18 - 5
Assets LiabilitiesTotal reserves $1,000 Checkable deposits $1,000
Assets Liabilities
Required reserves $100 Checkable deposits $1,000Excess reserves $900 New checkable Loan $900 deposits $900Total $1,900 Total $1,900
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What is loaned up?
When a bank has no excess reserves left to serve as a basis for lending
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Transactions between HLT National and Second National Bank
Exhibit 18 - 6
HLT National BankAssets Liabilities
Total Reserves Checkable Deposits $100 $1,000Loan $900Total $1,000 $1,000
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Transactions between HLT National and Second National Bank
Exhibit 18 - 6 cont.
Second National BankAssets Liabilities
Total Reserves Checkable Deposits $900 $900
Total $900 $900
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Transactions of Second National and Third National Bank
Exhibit 18 - 7
Second National BankAssets Liabilities
Total Reserves Checkable Deposits $90 $900Loans $810Total $900 $900
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Transactions of Second National and Third National Bank
Exhibit 18 -7 cont.
Third National BankAssets Liabilities
Total Reserves Checkable Deposits $810 $810 Total $810 $810
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Required Reserve Ratio( rD )
The fraction of deposits that depository institutions are
required to hold as required reserve assets
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Simple Money Multiplier
The reciprocal of the required reserve ration, I/rD
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(18-1) RR = rD D(18-2) ER = TR RR
(18-3) TR = RR = rD D
(18-4) D = TR / rD (or) D = 1 / rD TR
(18-5) L = D = 1 / rD TR
RR = Required Reserve AssetsrD = Required Reserve RatioD = Deposit Liabilities
ER = Excess Reserves TR = Total Reserves
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Fractional Reserve Banking System
A banking system in which individual banks hold reserve assets equal to a fraction of deposit liabilities
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The Required Reserve Ratio and the Simple Money Multiplier
Exhibit 18 - 8
rD Simple Money Multiplier
.05 1 / .05 = 20 .10 1 / .10 = 10 .20 1 / .20 = 5 .25 1 / .25 = 4 .50 1 / .50 = 2
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The Money Supply and the Monetary Base
= $487.3
= Monetary Base
$470.4
Exhibit 18 -9
March 1999, billions * Travelers’ Checks included
$620.3 +
Currency in the Public’s hands*
$44.9 $470.4*
Reserves + Currency in the Public’s
hands*
Checkable Deposits
= $1,090.7
= M1+
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Monetary Base
Reserves plus currency in the hands of the public, denoted as MB
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Money Multiplier
The multiple of the change in the monetary base by which the money supply will change
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Factors that Affect the Money MultiplierAn Increase in ...c (the desired ratio of currency to checkable deposits)
e (the ratio of excess reserves held to checkable deposits)
rD (the required reserve ratio)
Caused by ...The decision by the public to increase their holdings of currency relative to deposits
The decision by the depository institutions to hold more excess reserves
The decision by the Fed to increase the required reserve ratio
Results in ...
A decrease in the money multiplier and a decrease in the money supply
Exhibit 18 -12
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Factors that Affect the Money Multiplier
A Decrease in ...c (the desired ratio of currency to checkable deposits)
e (the ratio of excess reserves held to checkable deposits)
rD (the required reserve ratio)
Caused by ...The decision by the public to decrease their holdings of currency relative to deposits
The decision by the depository institutions to hold fewer excess reserves
The decision by the Fed to decrease the required reserve ratio
Results in ...
An increase in the money multiplier and a increase in the money supply
Exhibit 18 -12 cont.
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Major Assets of the Fed*
1. Gold and SDRs Certificate Accounts and other Assets in Foreign Currencies2. Loans3. Securities4. Floats
*See Figure 18-13 for detailed list.
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Repurchase Agreement
An arrangement whereby the New York Fed agrees to buy securities from the securities dealers with whom it does business regularly and the dealers agree to repurchase the securities on a specific day in the near future
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Reverse Repurchase Agreement
An arrangement whereby the New York Fed agrees to sell securities with dealers with whom it regularly does business and the Fed agrees to repurchase the securities on a specific day in the near future
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Major Liabilities of the Fed
1. Federal Reserve Notes2. Bank Deposits
