Principles of Macroeconomics 10: The Monetary Base and Money Supply
Understanding the Monetary Base
The monetary base is determined by the Federal Reserve (FED).
Definition: Currency + funds that banks have in their reserve accounts.
Reserves are accounts banks hold at the FED, similar to personal accounts at commercial banks.
FED engages in monetary policy to affect the monetary base indirectly.
Money Supply Measures
Money supply includes currency and deposits:
M1: Includes only checking deposits (most liquid).
M2: Includes M1 + savings accounts + certain CDs (less liquid).
The Role of the FED
The FED can print currency and manage reserves in banks' accounts.
Currency affects both monetary base and, indirectly, the money supply.
Deposits themselves (owned by individuals) do not appear directly on the FED's balance sheet.
Reserves and Deposits Relationship
Conceptual Framework: Starting with a scenario with no currency simplifies the analysis.
In a currency-free world, all transactions occur via electronic deposits.
The monetary base consists entirely of bank reserves.
Banking System Basics
Every bank's balance sheet represents:
Assets: Loans, investments, reserves.
Liabilities: Customer deposits.
Reserves are always less than deposits because:
Banks are not required to hold 100% as reserves.
Banks allocate reserves for loans and other profit-generating activities.
Reserve Ratio and Money Multiplier
Banks decide on a target reserve ratio (e.g., 10%) to manage liquidity and cover withdrawals.
Money Multiplier: The ratio defining how many times the monetary base can expand into the money supply:
Formula: Money Supply (M) = Monetary Base (MB) x Money Multiplier (m).
Multiplier can be mathematically derived as:[ m = \frac{1}{RR} ]where ( RR ) is the reserve ratio.
Impact of Lending on Money Supply
When banks lend reserves:
Borrower spends funds, leading to deposits at other banks.
Deposits create new reserves through the lending process, expanding the money supply.
Lend out a percentage of reserves based on the reserve ratio leads to subsequent lending cycles.
Each cycle produces diminishing returns in the amount of new deposits generated.
Open Market Operations
Open Market Operations (OMOs) are FED actions to manage monetary policy through buying and selling securities:
Open Market Purchase: Increases monetary base; FED buys securities and credits banks' reserve accounts.
Open Market Sale: Decreases monetary base; banks pay with reserves.
Execution of OMOs directly affects the monetary base (M0).
Interactions of Currency and Money Creation
The presence of currency does not alter the overall process but may affect the magnitude of the multiplier:
If recipients choose to hold cash rather than deposit it, the multiplier decreases.
The monetary supply is influenced not only by the reserve ratio but also by the public's preference for holding cash vs. deposits.
Economic Market Crises Effects
Financial crises impact banks' willingness to lend and consumers' trust:
In a recession, banks may increase reserve ratios, leading to lower lending and reduced money supply.
Bank runs heighten cash-holding behavior, further affecting bank vulnerabilities and decreasing money multiplier.
Historical Context: The Great Depression
During the Great Depression (1929-1933):
Monetary Base: Remained stable with minimal variations.
Money Supply (M1): Experienced drastic declines, highlighting the inability of FED to fully control money supply.
Rise in currency ratio indicated a public preference for cash over deposits as confidence in banks waned.
Summary of Key Takeaways
The FED can influence, but not wholly control, the money supply through monetary base management.
Economic conditions, market confidence, and reserve ratios all play critical roles in how the money supply evolves.
Understanding the dynamics of reserves, lending, and it’s connection to the money supply is essential for analyzing monetary policy efficacy.