Chapter 14 The Money Supply Process

1. Chapter 14 The Money Supply Process

2. Three Players in the Money Supply Process Nonbank Public’s Balance Sheet

3. Three Players in the Money Supply Process Bank A’s Balance Sheet • Reserves: assets not lent out by banks Banks are Required to hold a fraction of Reserves (RR) Reserves in Excess of RR are called excess reserves (RE) If r = 10%, RE= 50, and D= 3000, then RR = DXr = 3000 X0.1 = 300 R = RR + RE = $350

4. Three Players in the Money Supply Process 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

5. The Monetary Base The Fed’s Balance Sheet High-powered money MB = C + R • 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

6. Controlling the Monetary Base Open Market Purchase from Bank A • Net result is that reserves have increased by $100m • No change in currency • Monetary base has risen by $100m

7. Controlling the Monetary Base Open Market Purchase from the Nonbank Public • The person selling the bonds cashes the Fed’s check • Reserves are unchanged • Currency in circulation rises by the amount of the open market purchase • Monetary base increases by the amount of the open market purchase

8. Controlling the Monetary Base 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 Bank A • Monetary base has risen by $100m • No change in currency

9. Controlling the Monetary Base Open Market Sale to Bank A • Net result is that reserves have decreased by $100m • No change in currency • Monetary base has fallen by $100m

10. Controlling the Monetary Base Open Market Sale to the Nonbank Public • 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

11. Controlling the Monetary Base Open Market Sale to the Nonbank Public • Person buying bonds from the Fed writes the Feda check for the amount • Identical result as the sale to Bank A

12. Controlling the Monetary Base • Shifts from Deposits into Currency • No change in monetary base • Thus, reserves are changed by random fluctuations • Thus, monetary base is a more stable variable

13. Controlling the Monetary Base Loans to Financial Institutions • Monetary base also increases by the amount of the D loan

14. Controlling the Monetary Base Other Factors that Affect the Monetary Base • Float, which is the bump in the MB due to the check clearing process • Treasury moving deposits from banks to the Fed drops the MB • Interventions in the foreign exchange market 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 • It hinders it by keeping the discount rate above the federal funds rate • Split the monetary base into two components MBn = MB – RB MBn = (R + C)– RB MBn = (RB+ RN+ C)– RB MBn = RN+ C • The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, RB

15. Multiple Deposit Creation: A Simple Model • Fed purchases $100m in securities from First National bank • Excess reserves increase

16. Multiple Deposit Creation: A Simple Model • Fed purchases $100m in securities from First National bank • Excess reserves increase • Bank loans out the excess reserves • Creates a checking account for the borrower

17. Multiple Deposit Creation: A Simple Model • Fed purchases $100m in securities from First National bank • Excess reserves increase • Bank loans out the excess reserves • Creates a checking account for the borrower • The Money supply has increased • Borrower makes purchases • The $100m gets deposited at Bank A

18. Multiple Deposit Creation: A Simple Model

19. Multiple Deposit Creation: A Simple Model

20. Multiple Deposit Creation: A Simple Model

21. Multiple Deposit Creation: A Simple Model

22. Multiple Deposit Creation: A Simple Model Table 1 simple money multiplier

23. Multiple Deposit Creation: A Simple Model Table 1 simple money multiplier

24. Multiple Deposit Creation: A Simple Model Deriving the simple money multiplier DD = 100 + 100(.9) + 100(.9)(.9) + 100(.9)(.9)(.9)+ … = 100(.9)0+ 100(.9)1+ 100(.9)2+ 100(.9)3+ … = 100S 0.9i = 100 = 100 = 100· 10 = DR· m r

25. Multiple Deposit Creation: A Simple Model Deriving the simple money multiplier • With R = RR + RE, assuming RE = 0 implies R = RR R= r · D • Dividing both sides by ryields • Taking the change in both sides yields

26. Multiple Deposit Creation Deriving the money multiplier • If the propensity of holding cash increases for firms and consumers • holding cash stops the process of lending money into existence • currency has no multiple deposit expansion • MS is negatively related to currency holdings • If the propensity of holding cash (reserves) for banks increases • excess reserves increases • Buying securities falls • Making C&I loans falls • Excess reserves have no multiple deposit expansion • MS is negatively related to the amount of excess reserves • If the Fed increases r • The money supply is negatively related to the required reserve ratio.

27. Multiple Deposit Creation Table 1

28. Multiple Deposit Creation Deriving the money multiplier • If the propensity to hold currency (C) and the propensity to hold excess reserves (RE) grow proportionally with checkable deposits (D), then c= C/D e = RE/ D currency ratio excess reserves ratio

29. Multiple Deposit Creation Deriving the money multiplier • With c = C / D and e = RE/ D C = c · D and RE = e · D • Recall total reserves is given by the following R= RR + RE R= r · D + e· D • The monetary base MB equals currency (C) plus reserves (R): MB = C + R MB = c · D+ r · D + e· D MB = (c + r+ e)· D

30. Multiple Deposit Creation Deriving the money multiplier • Dividing both sides by D’s coefficient yields • Define money as currency plus checkable deposits (M1): M= C + D M = c · D + D M = (c + 1)· D • Replace D above with what it equals:

31. Multiple Deposit Creation Properties of the money multiplier • If the propensities to hold currency and excess reserves are zero, The money multiplier becomes the simple money multiplier

32. Multiple Deposit Creation Properties of the money multiplier • Suppose the propensity to hold excess reserves increases. Thus, an increase in the propensity to hold excess reservesdecreases the money supply This also implies that an increase in the required reserves ratiodecreases the money supply

33. Multiple Deposit Creation Properties of the money multiplier • Suppose the propensity to hold currency increases. Thus, an increase in the propensity to hold currency will generally decrease the money supply

34. Multiple Deposit Creation Example: money multiplier • Suppose r = 0.1, C = $400b, D = $800b, and RE = $0.8b c = C / D = 400/800 = 0.5 e = RE / D= 0.8/800 = 0.001 This is much smaller than the simple money multiplier = 10

35. Application: The Great Depression Bank Panics, 1929-1933, 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. Figure 1 Deposits of Failed Commercial Banks Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309.

36. Application: The Great Depression Bank Panics, 1929-1933, and the Money Supply 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. Figure 2 Excess Reserves Ratio and Currency Ratio Figure 3 M1 and the Monetary Base

37. Application: The 2007-2009 Financial Crisis and the Money Supply Figure 4 M1 and the Monetary Base, 2007-2009 Figure 5 Excess Reserves Ratio and Currency Ratio Source: Federal Reserve; www.federalreserve.gov/releases.