Chapter 14 Money Supply Process

Money Supply Overview

  • The chapter provides extensive information on the processes through which commercial banks create deposits.

  • It discusses the fundamental principles regarding the creation of the money supply.

What is Money?

  • Conceptual Definition:

    • Money is defined as something that is utilized to purchase goods and services.

  • Monetary Aggregate M1:

    • M1 is defined as the sum of Currency + Demand deposits (checking accounts)

  • Monetary Base:

    • MB = Bank Reserves = currency in circulation

  • Mechanism of Money Distribution:

    • The involvement of three key players in the money supply process:

    • The Central Bank (Federal Reserve System)

    • Banks (Depository Institutions and Financial Intermediaries)

    • Depositors (Individuals and Institutions)

Role of the Central Bank

  • Central Bank Overview:

    • Examining the Central Bank's balance sheet is essential for clarifying its role in the money supply process.

  • Balance Sheet Components:

    • Liabilities:

    • Currency in circulation: The cash held by the public

    • Reserves: Bank deposits at the Fed and vault cash

    • Assets:

    • Government Securities: Holdings by the Fed impacting the money supply and earning interest

    • Discount Loans: Provide reserves to banks and earn interest at the discount rate

Central Bank & Money Supply Control

  • Monetary Base Control:

    • The Central Bank controls the monetary base, defined as:

    • MB=ext{Currency}+ext{Bank Reserves}

  • Mechanisms for Increasing Monetary Base:

    • The Central Bank increases the monetary base through:

    • Open market operations (buying bonds or making loans to banks).

  • Open Market Operations Explained:

    • Open Market Purchase Process:

    • A bond as an asset (not money) is sold to the Central Bank, which pays cash.

    • The individual receiving cash experiences an increase in currency in circulation, resulting in a larger monetary base.

    • Open Market Sale Process:

    • Conversely, when selling a bond, the Central Bank receives cash, which decreases currency in circulation, thus lowering the monetary base.

Impact of Open Market Operations on Money Supply

  • Effects on Currency and Reserves:

    • The outcome of operations depends on whether the buyer is a bank or an individual:

    • Reserves increase if a bank receives cash and keeps it in the vault.

    • Currency supply remains stable as vast majority transactions impact bank deposits.

  • Involvement of Banks and Depositors:

    • The results of an open market purchase on reserves depend on how proceeds are dealt with (kept as currency or deposited).

    • The monetary base always increases by the purchase amount regardless.

Multiple Deposit Creation

  • Illustrative Example of Multiple Deposit Creation:

    • If the Fed buys a $100 bond from Todd:

    • Todd deposits this $100 in his bank, which increases reserves; monetary base increases by $100.

    • Todd's bank lends $90 to Vic, who then deposits this amount in his bank:

    • Vic's bank reserves also increase.

    • Total checkable deposits rise:

    • Todd’s account: $100; Vic’s account: $90; Total: $190 increase in deposits.

  • Continuity of Process:

    • This process continues with others obtaining loans, thereby increasing total money in circulation.

Data on Deposit Creation

  • Summary of Bank Transactions:

    • The following structure illustrates the flow of funds:

  • Total Impact:

    • The model demonstrates the cumulative effect on deposits, loans, and reserves throughout various banks leading to a substantial increase in the overall money supply (M1).

Determinants of Money Supply Change

  • Components Analysis:

    • The overall money supply increases depends on:

    • The initial purchase by the Fed

    • How much money bank customers choose to keep as currency versus deposit

    • Lending practices of banks

  • Money Supply Formula:

    • MS = m imes MB

    • Where “m” is the money multiplier, dependent on actions of banks and depositors.

Deriving the Money Multiplier

  • Ratio Definitions:

    • c = Currency Ratio: c=\frac{C}{D}

    • where C = currency held, D = checkable deposits

    • e = Excess Reserves Ratio: e=\frac{ER}{D}

    • r = Required Reserves Ratio: r=\frac{RR}{D}

    • where RR is the required reserves

  • Multiplier Calculation:

Examples and Calculations of Money Supply

  • Sample Values:

  • o } 2.5$$

Changes Affecting Money Multiplier

  • Factors Influencing Money Supply:

    • Required reserves ratio changes:

    • Money supply is negatively related to required reserve ratio

    • Currency holdings alterations:

    • Money supply is also negatively impact the money supply.

    • Excess reserves ratio fluctuations:

    • Excess reserves fluctuations negatively impact the money supply as well.

Central Bank Influence on Money Supply

  • Role of Central Bank:

    • Although the multiplier fluctuates, any shifts can be adjusted by altering the monetary base (MB).

    • The Central Bank can effectively control the money supply via the purchased and sold bonds; it operates differently than simply printing additional cash.

Methods to Decrease the Money Supply

  • Central Bank Actions:

    • The primary method for reducing money supply is through bond sales.

    • The selling of bonds decreases the money available hence leading to:

    • A lower monetary base

    • Diminished loan availability and deposit creation capacity.

2007 - 2009 Economic Crisis

  • Concerns and Reactions:

    • During the financial crisis, fears arose regarding the Fed's potential to create runaway inflation due to extensive bond purchases.

    • Inflation is ultimately linked to an excessive money supply rather than merely an increased monetary base.

Conclusion from Historical Context

  • Monetary Base vs. Money Supply Dynamics:

    • During this period, although the Monetary Base was notably raised, it was in response to a significant decline in the money multiplier.

    • The Central Banks' intervention through operations successfully avoided deflationary conditions, which could have been devastating.

Final Example - Calculating Money Supply Dynamics

ER = TR - RR

RR = 0.1 × 500 = 50

100 - 50 = 50

ER = 50

e = ER/D

e = 50/500

e = 0.1

c = C/D

c = 5/500

c = 0.01

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

m = (1 + 0.01) / 0.1 + 0.1 + 0.01)

m = 4.81

MB = C + R

MB = 5 + 100

MB = 105

MS = C + D

MS = 5 + 500

MS = 505