Money Multiplier

• money multiplier (MM): the amount the money supply expands with each dollar increase in reserves

  • MM = deposits/reserves

2 Major Tools To Control the Money Supply

1. open market operations

2. paying interest on reserves held by banks at the Federal Reserve

Open Market Operations

• open market operations: the buying and selling of government bonds by the Federal Reserve

  • objectives:

    • influence the growth of the money supply

    • influence interest rates

• the Federal Reserve changes the money supply by buying or selling short-term government bonds (T-Bills for short)

  • if they buy government bonds, the money supply increases:

    • to pay for the T-Bills, the Federal Reserve electronically increases the reserves of the seller, usually a bank or large dealer (MB increases)

    • with more reserves, the bank makes additional loans, which are used to buy goods and pay wages

    • people will deposit some of these payments into other banks (checking deposits increases, M1 increases)

    • the new deposits increase the reserves of other banks, which will also make more loans (this is the beginning of the “money multiplier” process)

• summary:

  • the Federal Reserve can increase/decrease reserves at banks by buying/selling government bonds

    • the increase/decrease in reserve boosts/reduces the money supply through the money multiplier process

    • size of multiplier isn’t fixed but depends on how much of their assets the bank wants to hold as reserves

• when the Federal Reserve buys or sells bonds, it changes the monetary base and also influences the interest rates

• when the Federal Reserve buys bonds, it increases money supplies and lowers interest rates

  • the lower interest rates increase the quantity of loans demanded

• when the Federal Reserve sells bonds, the process works in reverse

• summary:

  • when the Federal Reserve buys or sells bonds, it changes the monetary base and influences interest rates at the same time

  • buying bonds stimulates the economy through higher money supplies and lower interest rates

  • when the Federal Reserve sells bonds, the process works in reverse (selling bonds dampens the economy through lower money supplies and higher interest rates)