Money, Banking and Financial Markets- Chapter 14 (Money supply process)

3 big players

Central bank

-Federal Reserve System

Bank

-depository institutions, financial intermediaries

Depositors

-individuals, institutions

Fed 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 Fed affect money supply and earn interest)

-discount loans (provide reserves to banks and earn the discount rate)

Monetary Base (aka high-powered money)

MB = C + R

C= currency in circulation

R= total reserves in the banking system

Open market purchase from a bank

Effect of an open market purchase on reserves depends on whether the proceeds from the sale are in currency or in deposits.

Effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase

Factors that affect the monetary base

Float

-Fed credits checks to a bank before it debits the bank

-temporary increase in total reserves in banking systems

Treasury deposits at the Fed

-deposit outflows

Interventions in the foreign exchange market

-decisions by the US temporary to have the Fed intervene also affect the money base

Fed's ability to control the monetary base

Open market operations are controlled by the Fed

Fed cannot predict the amount of borrowing by banks from the Fed

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

Money supply is positively related to both

MBn = non-borrowed monetary base

BR= borrowed reserves from Fed

Fed is still able to control the MB

Open market purchase from a bank (banks sells securities back to fed)

Fed: securities + and reserves +

Banking system: Securities - and reserves +

Open market purchase from nonbank public (person sells bonds to fed & deposits fed check in the bank)

Banking system: reserves + and checkable deposits +

Fed: securities + and reserves +

Open market purchase from nonbank public (person who sold bonds cashes the fed's check)

Nonbank public: securities - and currency +

Fed: securities + and currency +

Summary of open market purchases

Effect of open market purchase on reserves depends on whether proceeds from sale are in currency or in deposits.

Effect of open market purchase on monetary base always increases the monetary base by amount of purchase.

Open market sale (fed sells bonds to individuals who pay with currency)

Nonbank public: securities + and currency -

Fed: securities - and currency -

Loans to financial institutions (fed makes loan to a bank)

Banking system: reserves + and loans/borrowings +

Fed: loans + and reserves +

Float

Fed credits check to a bank before it debits the bank. Temporarily increases total reserves in banking system.

Simple money multiplier equation

change in checkable deposits (D) = 1/r * change in total reserves (R)

Criticisms of the simple model (no banking system and required reserve ratio 100%)

Holding cash stops the process in the model

(currency has no multiple deposit expansion)

Banks may keep some excess reserves

Change in money supply depends on depositor's decision and bank's decisions

Factors which determine the money supply I

Money supply is positively related to changes in nonborrowed monetary base MBn.

Money supply is positively related to changes in borrowed reserves from Fed, BR.

Factors which determine the money supply II

Money supply is negatively related to required reserve ratio.

Money supply is negatively related to currency holdings.

Money supply is negatively related to amount of excess reserves.

Money multiplier

M = M1 (currency + checkable deposits)

M = m * MB

M = D + C

c = C/D and e = ER/D

we know MB = r + e + c

m = (1 + c)/(r + e + c)

Quantitative Easing and Money Supply

(beginning) Fed initiated lending programs and large scale asset-lending

(fall of 2017) purchases of securities had increased 5 times the Fed's BS (bond supply?)

250% increase in monetary base

Expansion of MB known as quantitative easing

Did not lead to equivalent change in MS (excess reserves rose dramatically)