The Money Supply Process - Lecture Notes

Overview

This chapter focuses on the processes that influence the money supply within an economy, emphasizing the roles of different players, the Federal Reserve's balance sheet, and mechanisms of deposit creation.

Three Players in the Money Supply Process
  1. The Central Bank (Federal Reserve System)
    • Conducts monetary policy through interest rate adjustments, reserve requirements, and open market operations.
    • Sets goals for inflation, employment, and economic growth.
  2. Banks
    • Depository institutions that act as financial intermediaries, accepting deposits and making loans.
    • Influence the money supply by extending credit and creating deposits through lending.
  3. Depositors
    • Individuals and institutions that hold deposits in banks.
    • Their saving and spending behavior affects overall money supply and economic activity.
The Fed's Balance Sheet

Assets:

  • Securities: Holdings by the Fed affecting money supply and earning interest, including Treasury securities and mortgage-backed securities.
  • Loans to Financial Institutions: Shortfall loans providing liquidity in times of financial stress, enabling banks to meet withdrawal demands from depositors.

Liabilities:

  • Currency in Circulation: Currency in the hands of the public, which drives spending and economic activity.
  • Reserves: Bank deposits at the Fed plus vault cash (required and excess reserves), which determine banks' ability to create additional loans.
Key Concept

An increase in currency and reserves directly contributes to the money supply, establishing a liquidity foundation that influences interest rates and lending behavior.

Control of the Monetary Base (High-Powered Money)

Monetary base ($MB$) formula:
MB=C+RMB = C + R
where:

  • $C$: Currency in circulation
  • $R$: Total reserves in the banking system
Open Market Operations

The Fed controls the monetary base primarily through buying or selling securities and distributing loans to banks, using strategic timing and volume to influence market liquidity.

Open Market Purchases and Sales

  1. Purchase from a Bank:
    • Fed buys $100 million of bonds, increasing reserves by $100 million and thereby the monetary base by the same amount.
  2. Purchase from Nonbank Public:
    • If proceeds are deposited into banks, the monetary base remains unchanged in strength but the reserves increase correspondingly.
    • If cash is taken out, the monetary base increases by the purchase amount, as cash is withdrawn from circulation leading to a decrease in bank reserves.
  3. Open Market Sale:
    • When the Fed sells securities, the monetary base declines by the sale amount while reserves do not change immediately, impacting overall liquidity negatively.
Changes in Currency Holdings

When there is a shift of $100 million from deposits to currency (e.g., during the holiday season), deposits at banks decrease but currency in circulation increases. This shift keeps the net monetary liabilities unchanged but affects the banks' liquidity positions.

Loans to Financial Institutions

When the Fed loans $100 million to banks, the monetary base increases by this amount, which subsequently increases reserves in the banking system, allowing banks to lend more, thereby influencing the money supply.

Other Factors Influencing the Monetary Base
  1. Float: Temporary increases in reserves when checks are processed between banks can affect liquidity due to timing differences.
  2. Treasury Deposits: Movements of funds from private banks to Treasury accounts at the Fed, which can reduce reserves in the banking system, impacting their ability to lend to customers.
Money Supply Factors

The money supply is influenced by various components:

  • Non-Borrowed Monetary Base (MBₙ): Increasing due to open market purchases supports additional lending.
  • Borrowed Reserves (BR): Increases when banks borrow from the Fed, which directly affects their lending capacity.
  • Required Reserve Ratio ($r$): An increase in this ratio generally leads to a decreased money supply since banks can lend less, resulting in tighter credit conditions.
  • Excess Reserves: The more excess reserves banks hold, the less they engage in aggressive lending practices, leading to a reduced money multiplication effect.