10/30/2018. Chapter 17. The Money Supply Process. Preview. Learning Objectives

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1 Chapter 17 The Money Supply Process Preview This chapter provides an overview of how the banking system create and describes the basic principles of the money supply creation process Learning Objectives List and describe the three players that influence the money supply actually four players. Identify the factors that affect the monetary base and discuss their effects on the Federal Reserve s balance sheet. Explain and illustrate the deposit creation process using T-accounts. 1

2 Mishkin says three players in the Money Supply Process actually four players 1. The Central bank: Federal Reserve System 2. Banks: depository institutions; financial intermediaries 3. Depositors: individuals and institutions 4. Borrowers: Banks create money when they make loans How Banks Create Money M1 is currency +. By granting loans, banks create money. The balance sheet on the left is an example of a? The Fed s Balance Sheet Major Assets and Liabilities Federal Reserve System Securities Assets Loans to Banks Liabilities Currency in circulation Reserves Liabilities Currency in circulation: in the hands of the public Reserves: bank at the Fed and vault cash Assets Government securities: holdings by the Fed that affect money supply and earn interest Discount loans (loans to banks): provide reserves to banks and earn the discount rate 2

3 Control of the Monetary Base High-powered money MB = C + R C = currency in circulation R = total reserves in the banking system Open Market Purchase (Fed Buys Securities) from a Bank Banking System Federal Reserve System Securities -$100m Securities +$100m Reserves +$100m Reserves +$100m Net result is that reserves have increased by $100 No change in currency Monetary base has increased by $100 Open Market Purchase from the Nonbank Public Reserves Banking System Federal Reserve System +$100m Checkable +$100m Securities +$100m Reserves +$100m Person selling bonds to the Fed the Fed s check in the bank Same result as the purchase from a bank reserves have increased by $100 no change in currency monetary base has increased by $100 3

4 Open Market Purchase from the Nonbank Public seller holds cash Nonbank Public Federal Reserve System Securities -$100m Securities +$100m Currency in circulation Currency +$100m +$100m 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 $100 - the amount of the open market purchase Open Market Purchase: Summary The effect on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in. The effect on the monetary base always increases the monetary base by the amount of the purchase. The effect of open market operations on the monetary base is much more certain than the effect on reserves. Open Market Sale (Fed Sells Bonds) to the Public) Nonbank Public Federal Reserve System Securities +$100m Securities -$100m Currency in circulation Currency -$100m -$100m Reduces the monetary base by the amount of the sale Reserves remain unchanged 4

5 Shifts from Deposits into Currency Checkable Currency Nonbank Public Banking System -$100m Reserves -$100m Checkable +$100m Federal Reserve System -$100m Assets Currency in circulation Reserves Liabilities +$100m -$100m Net effect on monetary liabilities is zero Monetary base is unchanged, it is a relatively stable variable Loans to Financial Institutions Banking System Federal Reserve System Reserves +$100m Loans +$100m Loans +$100m Reserves +$100m Monetary liabilities of the Fed have increased by $100 Monetary base also increases by $100. 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 = MB n + 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. 5

6 Multiple Deposit Creation: Fed buys $100m in Bonds from First National Bank Deposit creation by single bank - 10% reserve requirement First National Bank First National Bank Securities -$100m Securities -$100m Checkable Reserves +$100m Reserves +$100m Loans +$100m +$100m Excess reserves increase buy $100 Bank lends the excess reserves Creates a checking account Borrower makes purchases The Money supply has increased by $100. First National Bank Assets Liabilities Securities -$100m Loans +$100m Multiple Deposit Creation: Fed buys $100m in Bonds from First National Bank Reserves Deposit creation by single bank - 10% reserve requirement Second Bank Second Bank +$100m Checkable +$100m Reserves Loans +$90 +$10 Checkable +$100m Reserves Third Bank Third Bank +$90 Checkable +$90 Reserves +$9 Checkable Loans +$81 +$90 Table 1 Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves) 6

7 Deriving The Formula for the Simple Deposit Multiplier Assuming banks do not hold excess reserves Required Reserves ( RR) = Total Reserves ( R) RR = Required Reserve Ratio ( r) times the total amount of checkable ( D) Substituting r D = R Dividing both sides by r 1 D = R r Taking the change in both sides yields 1 D = R r Simple is Too Simple Holding cash stops the process Currency has no multiple deposit expansion Banks may not lend 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. Factors that Determine the Money Supply Changes in the monetary base The money supply is positively related to the monetary base MB 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. 7

8 The Money Multiplier Use M1 Definition: currency plus checkable Link the money supply (M) to the monetary base (MB) and let m be the money multiplier M m MB Deriving the Money Multiplier Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable D. Define: c = (C/D) = currency ratio e = (ER/D) = excess reserves ratio Deriving the Money Multiplier The total amount of reserves ( R) equals the sum of required reserves ( RR) and excess reserves ( ER). R = RR + ER The total amount of required reserves equals the required reserve ratio times the amount of checkable RR = r D Subsituting for RR in the first equation R = (r D) + ER The Fed sets r to less than 1 8

9 Deriving the Money Multiplier The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + (r x D) + ER This equation shows the amount of the monetary base needed to support the existing amounts of checkable, currency and excess reserves. Deriving the Money Multiplier c = {C / D} C = c D and e = {ER / D} ER = e D Substituting in the previous equation MB (r D) (e D) (c D) (r e c) D Divide both sides by the term in parentheses 1 D r e c MB M D C and C c D M D (c D) (1 c) D Substituting again M 1 c r e c MB The money multiplier is then m 1 c r e c Example - r required reserve ratio = 0.10 C currency in circulation = $400B D checkable = $800B ER excess reserves = $0.8B M money supply (M1) = C D = $1,200B c $400B $800B 0.5 e $0.8B $800B m This is less than the simple deposit multiplier Although there is multiple expansion of, there is no such expansion for currency 9

10 Quantitative Easing and the Money Supply, When the global financial crisis began in 2007, the Fed initiated lending programs and large-scale asset-purchase programs in an attempt to bolster the economy. By June 2014, purchases of securities had led to a quintupling of the Fed s balance sheet. The lending and asset-purchase programs resulted in a huge expansion of the monetary base and have been given the name quantitative easing. The Federal Reserve Balance Sheet: June 2003 Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETS LIABILITIES Gold $ 11,045 $593,031 Federal Reserve notes (outstanding) Loans to banks 36,538 U.S. Treasury securities 550,314 20,359 Bank reserves (from depository institutions) 6,219 U.S. Treasury Deposits All other assets 46,268 24,556 All other liabilities and net worth Total $ 644,165 $644,165 Total Source: Federal Reserve Bulletin, August 2003, Table Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis (Millions of Dollars) ASSETS LIABILITIES Gold $ 11,037 $777,769 Federal Reserve notes (outstanding) Loans to banks 1,342 Deposits: U.S. Treasury securities 779,642 12,771 Bank reserves (from depository institutions) 4,572 U.S. Treasury deposit All other assets 82,451 79,360 All other liabilities and net worth Total $ 874,472 $874,472 Total Source: Board of Governors of the Federal Reserve System. 10

11 THE FEDERAL RESERVE BALANCE SHEET: August 2009 ASSETS LIABILITIES Gold $ 11,037 $872,150 Federal Reserve notes (outstanding) Loans to banks 339,335 Deposits: U.S. Treasury securities 705, ,650 Bank reserves (from depository institutions) 261,487 U.S. Treasury All other assets 936, ,447 All other liabilities and net worth Total $ 1,991,734 $1,991,734 Total Credit facilities set up during the financial crisis. Source: Board of Governors of the Federal Reserve System. THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETS LIABILITIES Gold $ 11,037 $1,122,000 Federal Reserve notes (outstanding) Loans to banks 449 Deposits: U.S. Treasury securities 1730,000 1,795,000 Bank reserves (from depository institutions) Mortgages 1,083,000 42,000 U.S. Treasury All other assets 234, ,000 All other liabilities and net worth Total $ 3,075,000 $3,075,000 Total Source: Board of Governors of the Federal Reserve System. THE FEDERAL RESERVE BALANCE SHEET: February 2015 Very much the same today ASSETS LIABILITIES Gold $ 11,037 $1,315,000 Federal Reserve notes (outstanding) Loans to banks 59 Deposits: U.S. Treasury securities 2,450,000 2,748,000 Bank reserves (from depository institutions) Mortgages 1,731,000 65,000 U.S. Treasury All other assets 290, ,000 All other liabilities (reverse Repo) and net worth Total $ 4,481,000 $4,481,000 Total Source: Board of Governors of the Federal Reserve System. 11

12 The increase in the monetary base did not lead to an equivalent change in the money supply because excess reserves increased dramatically Source: Federal Reserve Bank of St. Louis, FRED database: Excess Reserves Ratio and Currency Ratio, Source: Federal Reserve Bank of St. Louis, FRED database: The Limits on the Central Bank s Ability to Control the Quantity of Money 12

13 The Limits on the Central Bank s Ability to Control the Quantity of Money The various factors affecting the money supply change over time. Market interest rates affect the cost of holding both excess reserves and currency. As interest rates increase, we expect to see {ER/D} and {C/D} fall. This increases the money multiplier and the quantity of money. Uncertainty increases {ER/D} and {C/D}. The Limits on the Central Bank s Ability to Control the Quantity of Money If these changes in the money multiplier were predictable, the central bank might choose to exploit this link in its policymaking. But, the money multiplier is too variable. The relationship between the monetary base and the quantity of money is not something that a central bank can exploit for short-run policy purposes. For short-run policy, interest rates have become the monetary policy tool of choice. Case Study: The Great Depression Bank Panics, Bank failures (and no deposit insurance) caused: Increase in deposit outflows and holding of currency (depositors) An increase in the amount of excess reserves (banks) 13

14 Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c? Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base,