Money Supply Process

Fundamentals of Finance – Lecture 6

Four Players in the Money Supply Process

• Central bank

• Banks (depository institutions; financial intermediaries)

• Depositors (individuals and institutions)

• Borrowers

The Central Bank’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 CB that affect money

supply and earn interest– Discount loans: provide reserves to banks and earn the discount

rate

Central Bank

Assets Liabilities

Securities Currency in circulation

Loans to Financial Institutions

Reserves

Control of the Monetary Base

High-powered money

= +

= currency in circulation

= total reserves in the banking system

MB C R

C

R

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 System Central Bank

Assets Liabilities Assets Liabilities

Securities - $100m Securities +$100m Reserves +$100m

Reserves +$100m

Open Market Purchase from the Nonbank Public

• Person selling bonds to the CB deposits the CB’s check in the bank

• Identical result as the purchase from a bank

Banking System Central Bank

Assets Liabilities Assets Liabilities

Reserves +$100m Checkable deposits

+$100m Securities +$100m Reserves +$100m

Open Market Purchase from the Nonbank Public (cont’d)

• The person selling the bonds cashes the CB’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 Public Central Bank

Assets Liabilities Assets Liabilities

Securities -$100m Securities +$100m Currency in circulation

+$100m

Currency +$100m

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.

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 Public Central Bank

Assets Liabilities Assets Liabilities

Securities +$100m Securities -$100m Currency in circulation

-$100m

Currency -$100m

Shifts from Deposits into Currency

Nonbank Public Banking System

Assets Liabilities Assets Liabilities

Checkable deposits

-$100m Reserves -$100m Checkable deposits

-$100m

Currency +$100m

Central Bank

Assets Liabilities

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

Loans to Financial Institutions

• Monetary liabilities of the Fed have increased by $100• Monetary base also increases by this amount

Banking System Central Bank

Assets Liabilities Assets Liabilities

Reserves +$100m Loans +$100m Loans +$100m Reserves +$100m

(borrowing from CB) (borrowing from CB)

Other Factors that Affect the Monetary Base

• Float• Treasury deposits at the Central Bank• Interventions in the foreign exchange market

Overview of The Central Bank’s Ability to Control the Monetary Base

• Open market operations are controlled by the CB

• The CB cannot determine the amount of borrowing by banks from the CB

• Split the monetary base into two components MBn= MB - BR

• The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the CB

Multiple Deposit Creation: A Simple Model

Bank A Bank A

Assets Liabilities Assets Liabilities

Securities -$100m Securities -$100m Checkable deposits

+$100m

Reserves +$100m Reserves +$100m

Loans +$100m

Bank A

Assets Liabilities

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

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +$100m Checkable deposits

+$100m Reserves +$10 Checkable deposits

+$100m

Loans +$90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +$90 Checkable deposits

+$90 Reserves +$9 Checkable deposits

+$90

Loans +$81

Multiple Deposit Creation: A Simple Model (Cont’d)

Deposit Creation: The Banking System

Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves)

Bank 1

Assets Liabilities

Reserves+100 Deposits+100

Bank 1

Пасиви

Reserves +10 Deposits +100Loans +90

Reserves + 9 Deposits + 90Loans + 81

Bank 2

Deposits + 81Loans + 72.9

Bank 3

Reserves + 8.1

Bank Deposits Reserves Loans∆D ∆R ∆L

1 100 10 90

2 90 9 81

3 81 8.1 72.9

.......

Bankingsystem

1000 100 900

- Required reserve ratio

- Deposit multiplier

Reserve requirement rd = 10%

Assets

Multiple Deposit Contraction

The multiple deposit creation process should also work in reverse. When the Central Bank withdraws reserves from the banking system, there should be a multiple contraction of deposits.

In fact, the contraction in deposits will be

D = (1/ r ) R

Example:

If R = -100 and (1/ r ) = 10 because rd =10%, then D = -1000.

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.

M m MB

The Money Supply and 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

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 ratioe = {ER/D} = excess reserves ratio

Deriving the Money Multiplier (cont’d)

The total amount of reserves ( ) equals the sum of

required reserves ( ) and excess reserves ( ).

The total amount of required reserves equals the required

reserve ratio times the amount of

R

RR ER

R = RR + ER

checkable deposits

Subsituting for RR in the first equation

The Fed sets r to less than 1

RR = r × D

R = (r × D) + ER

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.

Deriving the Money Multiplier (cont’d)

c = {C / D} C = c D and

e = {ER / D} ER = e D

Substituting in the previous equation

MB (r D) (eD) (c D) (r e c)D

Divide both sides by the term in parentheses

D 1

r e cMB

M D C and C c D

M D (c D) (1 c)D

Substituting again

M 1 c

r e cMB

The money multiplier is then

m 1 c

r e c

Intuition Behind the Money Multiplier

r required reserve ratio = 0.10

C currency in circulation = $400B

D checkable deposits = $800B

ER excess reserves = $0.8B

M money supply (M1) = C D = $1,200B

c $400B

$800B0.5

e $0.8B

$800B0.001

m 10.5

0.10.0010.5 1.5

0.6012.5

This is less than the simple deposit multiplier

Although there is multiple expansion of deposits,

there is no such expansion for currency

Factors that Determine the Money Supply

• 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.

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.

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.

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.

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.

The 2007-2009 Financial Crisis and the Money Supply

• During the recent financial crisis, 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.

• The currency ratio fell somewhat during this period, which the 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.

M1 and the Monetary Base, 2007-2009

Source: Federal Reserve; www.federalreserve.gov/releases.

Excess Reserves Ratio and Currency Ratio, 2007-2009

Source: Federal Reserve; www.federalreserve.gov/releases.