Money Banking and Finance Chapter 17

The Money Supply Process

Copyright Information

• Source: The Economics of Money, Banking, and Financial Markets, Business School Edition, Fifth Edition

• Publisher: Pearson Education, Inc.

• Copyright Years: 2013, 2016, 2019

• All Rights Reserved

Learning Objectives

• List and describe the “three players” that influence the money supply.

• Classify the factors affecting the Federal Reserve’s assets and liabilities.

• 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.

• Summarize how the “three players” can influence the money supply.

• Calculate and interpret changes in the money multiplier.

Three Players in the Money Supply Process

1. The Central Bank: Federal Reserve System

2. Banks: Depository institutions; financial intermediaries

3. Depositors: Individuals and institutions

The Fed’s Balance Sheet

• Assets

  • Securities: Holdings by the Fed that affect the money supply and earn interest.

  • Loans to Financial Institutions: Provide reserves to banks and earn the discount rate.

• Liabilities

  • Currency in circulation: Money in the hands of the public.

  • Reserves: Bank deposits at the Fed and vault cash.

Control of the Monetary Base

• Formula: R = MB = C + R

  • C = currency in circulation

  • R = total reserves in the banking system

Open Market Operations

1. Open Market Purchase from a Bank

• Bank's Assets and Liabilities:

  • Securities decrease by $100m

  • Reserves increase by $100m

• Federal Reserve's Balance Sheet:

  • Securities increase by $100m

  • Reserves increase by $100m

• Result: Reserves increased by $100m, Monetary Base has risen by $100.

2. Open Market Purchase from the Nonbank Public

• Nonbank Public's Balance Sheet:

  • Assets: Securities decrease by $100m

  • Currency increases by $100m

• Federal Reserve's Balance Sheet:

  • Securities increase by $100m

  • Reserves increase by $100m

• Result: Monetary Base has risen by $100 million.

3. Open Market Sale to Nonbank Public

• Nonbank Public's Balance Sheet:

  • Assets: Securities increase by $100m

  • Currency decreases by $100m

• Federal Reserve's Balance Sheet:

  • Securities decrease by $100m

  • Currency in circulation decreases by $100m

• Result: Monetary Base reduced by the amount of the sale; reserves remain unchanged.

Total Reserves

1. Required Reserves

• Definition: Amount of funds that a bank is required to hold in reserve to meet liabilities.

2. Excess Reserves

• Definition: Funds held by a bank that exceed the required minimum, which can be used for loans or investments.

Assessment Examples

1. Problem: Excess Reserves Calculation

   • Given vault cash, deposits at the Fed, and required reserves, calculate excess reserves for First National Bank.

2. Problem: Required Reserve Ratio Calculation

   • Given vault cash, excess reserves, and demand deposits, calculate amount on deposit with the Federal Reserve.

Summary of Open Market Purchase Effects

• Open market purchases increase monetary base:

  • Effect depending on whether bond proceeds remain in currency or in deposits.

  • However, universally increases the monetary base by the amount of purchase.--

Other Monetary Base Factors

• Float: Temporary imbalance in the Federal Reserve’s balance sheet due to check processing delays.

• Treasury Deposits: Affect the money supply by changing reserves when the Treasury Department holds or releases cash.

• Foreign Exchange Market Interventions: Buying/selling foreign currency affects the monetary base.

Monetary Base Control by the Fed

• Components of Monetary Base:

  • MB_n = MB - BR

• Relationship: Money supply is positively related to non-borrowed monetary base MB_n and borrowed reserves BR .

Multiple Deposit Creation: A Simple Model

Deposit Creation Process

• T-account structure for banks showing how deposits are impacted by reserve changes. Example:

  1. Bank Assets: Reserves increase by $100m.

  2. Liabilities: Required reserves adjusted accordingly.

  3. Subsequent banks receive part of this in loans and maintain required reserves leading to further deposit creation.

Theory Behind Deposit Creation

• Initial increase in reserves leads to multiplication through a defined reserve ratio.

  • For example, with a 10% reserve requirement and a $100 increase in reserves, deposits can increase significantly across multiple banks.

Critique of the Simple Model

1. Cash Holdings: Holding cash stops the deposit expansion process because currency does not contribute to bank reserves.

2. Excess Reserves Utilization: Banks might not utilize all excess reserves to issue loans.

3. Behavioral Factors: The decisions of depositors and banks regarding reserves heavily influence money supply.

Factors Determining Money Supply

1. Changes in Non-borrowed Monetary Base: Directly impacts money supply positively.

2. Changes in Borrowed Reserves from the Fed: Positive correlation to money supply as institutions borrow more.

3. Required Reserves Ratio: Higher ratios negatively relate, reducing multiple deposit expansion capabilities.

4. Currency Holdings Changes: Increased currency holdings negatively impact the money supply.

5. Excess Reserves Changes: Increased excess reserves result in lower money creation through loans.

Overview of Money Supply Process

M1 Money Multiplier

• Definition:

  • Money Supply (M1) is defined as the sum of currency and checkable deposits.

• Formula:

• M = m imes MB

  • Where m is the money multiplier.

Deriving the M1 Money Multiplier

1. Currency and Excess Reserves Relationship:

   • Define ratios:

   • Currency Ratio: c = rac{C}{D}

   • Excess Reserves Ratio: e = rac{ER}{D}

2. Total Reserves Calculation:

   • R = RR + ER

   • Where RR = r imes D (with r being the required reserve ratio).

3. Monetary Base Formula:

   • MB = C + R = C + (r imes D) + ER

Assessment on Reserve Ratio Effects

• Change in required reserve ratio leads to effects in the size of the multiplier and thus the calculations of overall money supply variations.

• Example: If the required reserve ratio is decreased, it leads to a potential increase in money multiplier based on stable currency-to-deposit and excess-reserve ratios.

Quantitative Easing and the Money Supply, 2007–2017

• Context: Following the 2007 global financial crisis, the Fed initiated various lending and asset-purchase programs aimed at stabilizing the economy.

• Result: By late 2017, asset purchases led to a quintupling of the Fed's balance sheet and a 350% increase in the monetary base.