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8/3/2019 The Money Supply Model
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Money Supply
8/3/2019 The Money Supply Model
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Learning Objectives
Review the money supply expansion process.
Learn how to derive the M1 model.
Understand how the interaction of the money
multiplier and base determine M1.
Understand the role of the Federal Reserve, the
commercial banking system, and the non-bankpublic in the money creation process.
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The Money Supply
M1: Currency + travelers checks + checkable
deposits
M2: M1 + small time deposits + overnightrepurchase agreements + overnight
Eurodollars + money market mutual fund
balances
M3: M2 + large denomination time deposits +term repurchase agreements + term
Eurodollars + institutions only money
market fund balances
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The Creators of Money
The three major players whose decisions andactions determine the rate of growth in the
money supply are:
The Federal Reserve (Fed) Sets reserve requirements
Operates the discount window
Engages in open market operations
The Commercial Banking System Accepts deposits and makes loans
Sets excess reserves
The Non-Bank Public
Holds either deposits or cash
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Money Creation Banks create money in their normal, day-to-
day profit seeking activities
Banks do not try to create money Money creation occurs because we have a
fractional reserve commercial banking
system. Banks must hold a fraction of their deposits idle
as reserves. They may lend the remainder.
As they make loans, new deposits are created,
causing the money supply to expand.
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Bank Reserves Total Reserves = Required reserves plus
excess reserves
Required reserves = Deposits times reserve
requirement
Excess reserves = Total reserves minus
required reserves
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Money Creation: SummaryNew Deposit Required Reserves Excess Reserves New Loan
$100 $100$100 $10.00 $ 90 $ 90
$ 90 $ 9.00 $ 81 $ 81
$ 81 $ 8.10 $ 72.90 $ 72.90
$ 72.90 $ 7.29 $ 65.61 $ 65.61
$ 65.61 $ 6.51 $ 59.05 $ 59.05
$1,000 $100 $900 $900
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The M1 Model: Derivation
Definitions:
M1 = D + C
Base = R + C
Total Deposits = D
Assumptions:
r = R/D = required reserve ratio for deposits
e = E/D = the excess reserve ratio
c = C/D = the ratio of currency to deposits
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The M1 Model: Derivation
Model:
B = R + C
R = rD + E
D = D
C = cD
E = eD
B = rD + eD + cD
B = D(r + e + c)1
( r + e + c)
BD =
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The M1 Model: Derivation
Model:
M1 = D + C
M1 = D + cD
M1 = D(1 + c) Factor out D
M1 = 1 + c
r + e + c B
M1 = Multiplier x Base
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Money MultiplierT
erms Changes in r
If r increases, the multiplier decreases
If r decreases, the multiplier increases
The money multiplier and M1 are
negatively related.
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Money MultiplierT
erms Changes in c
If c increases, reserves drain from the banking
system.
Fewer reserves mean less expansion of deposits.
If c decreases, reserves in the banking system
increase. More reserves mean more expansion of deposits.
The money multiplier and M1 are
negatively related.
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Money MultiplierT
erms Changes in e
An increase in e means banks are holding more
excess reserves and lending less.
A decrease in e means banks are holding fewer
excess reserves and lending more.
The money multiplier and M1 arenegatively related.
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The Money Supply: Summary The money supply equals the monetary base
times the money multiplier
The monetary base (base) is defined as:
Base = Reserves + Currency
Base can be controlled by the Federal Reserve
T
he multiplier reflects the ability of the bankingsystem to expand deposits
The multiplier = 1 + c/(r + e + c)
The value of the multiplier is determined by the Fed,
banks, and the members of the non-bank public.
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Open Market OperationsFed Bank
Presidents
Federal Open
Market Comm.
Fed Board of
Governors
Securities
Dealers
Federal Reserve
Bank of New York
Commercial
Banks
Change
in
Reserves
Change in
Money
Supply
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Open Market Operations When the Fed buys Treasury bonds from a
bank, it pays for the bonds by crediting the
bank with an increase in reserves.
When the Fed sells Treasury bonds to a
bank, it accepts payment for the bonds by
debiting the banks reserve position at theFed
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Discount Loans When the Fed makes a discount loan to a
bank, the bank is credited with an increase
in reserves.
When a bank repays the Fed, the banks
reserves are debited.
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Reserve Requirements If the Fed increases reserve requirements,
banks have fewer excess reserves to lend,
causing the expansion of deposits to
decrease.
If the Fed decreases or eliminates reserve
requirements, banks have more excessreserves to lend, permitting the expansion of
deposits to increase.
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Excess Reserves Banks determine the level of excess
reserves
Increases in excess reserves diminish the
expansion of deposits.
Decreases in excess reserves increase the
expansion of deposits
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8/3/2019 The Money Supply Model
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Central Bank Policy Channels
Policy
Tools
Level & Growth
Bank Reserves
Cost & Availability
of Credit
Size and Growth
Rate of Money
Supply
Market Value
of Securities
Volume
and
Growth
of
Borrowing
and
Spending
by the
Public
Full
Employment
Growth
Price
Stability