Chapter 9
Money Creation and the Money
Supply Determinants and
Process
 Multiple Deposit Creation and the Money
Supply Process
 Four Players
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Central Bank (FED)
Banks
Depositors
Borrowers
Federal Reserve Balance Sheet
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Assets – increase in assets increases the Monetary Base
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Securities – Treasuries
Discount loans to banks
Gold and Special Drawing Rights certificates
Coins
Cash items in process (float)
Physical Plant and others
Liabilities - – increase in liabilities decreases the Monetary Base
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Federal Reserve Notes outstanding – currency in circulation

Printed by the FED
Reserves of banks

Required
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By the reserve requirement (10%)

No interest paid

Excess
U.S. Treasury Deposits
Foreign and other deposits
Deferred-availability cash items (in process) – float

Monetary Base: (bills + treasury currency + coins) + Reserves


MB = C + R
Control of the MB

Open Market Operations
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The most direct method the Fed uses to change the monetary base is open
market operations, which is buying or selling U.S. government securities.
In an open market purchase the Fed buys government securities.
An open market purchase increases either bank reserves or currency in
circulation; therefore it increases the monetary base, which is the sum of
reserves plus currency (B = C + R).

Purchase – buy bonds from the banks, gives them more money to loan

Increases the monetary base
The Fed can reduce the monetary base by an open market sale of government
securities.

Sale – sells bonds to the banks, takes money away from them

Decreases the monetary base
 Discount loans at the discount rate trough the
discount window
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Loan increases the monetary base
Recalling a loan decreases the monetary base
When the Fed lends to depository institutions, the loans
are called discount loans and the interest rate on the
loans is called the discount rate
Deposit Creation
 Deposit Creation
 Start with $10,000 and a rr = 10%
 Bank A……
 Simple Deposit Multiplier
•
Change in Deposits(D) = 1/rr x Change in Reserves (R)
 rr = Reserve Requirements
 The Money Multiplier
 One way the Fed manages the nation’s
money supply is by controlling the monetary
base, which is comprised of all currency in
circulation and reserves held by banks.
 Calculation
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M = m x MB
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C/D = currency-deposit ratio
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R = Reserves
RR = Required Reserves
RR = rr x D
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ER = Excess Reserves
R = RR + ER
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C = Currency
D = Checkable Deposits
ER/D is the Excess Reserve Ratio
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
M = Money Supply = C + D
m is the money multiplier
MB = Monetary Base = R + C
rr = reserve requirement (ratio)
R = (rr x D) + ER
MB = R + C = (rr x D) + ER + C
Since ER =ER/D x D and C = C/D x D
MB = (rr x D) + (ER/D x D) + (C/D x D)
D = (1/(rr + ER/D + C/D x D) x MB
M = D + C = D + (C/D x D) = (1 + C/D) x D
M = ((1 + C/D)/(rr + ER/D + C/D)) x MB
m = (1 + C/D)/(rr + ER/D + C/D)
 Numbers
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rr = .10
C = $400b
D = $800
ER = $.8b
MS = $1200b
m=
MB = 480
 Factors that Determine the Money Supply
 Reserve Requirement (Ratio): rr up, m and MS
down
 C/D: up, then m and MS down
 ER/D: up, then m and MS down
 Changes: The money multiplier = ____
 What if the FED increases the MB by 20 what will
the MS be? MS =
 What will the change in the MB be if the Fed wants
the MS to equal 1400? MB =
Tools

Open Market Operations – the purchasing and selling
of government securities to commercial banks and/or
the public

Open market operations, the purchases and sales of
securities in financial markets by the Fed, are the
dominant means by which the Fed changes the
monetary base.
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The Fed began to use open market purchases as a policy tool
during the 1920s.
The lack of intervention by the Fed during the bank crisis of
the early 1930s led Congress to establish the Federal Open
Market Committee (FOMC) to guide open market operations.
Open market purchases are viewed as expansionary and
open market sales are viewed as contractionary.

The FOMC meets eight times a year and issues a general
directive stating its overall objectives for monetary aggregates
and interest rates.
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The Federal Reserve System’s account manager is responsible for
carrying out open market operations that fulfill the FOMC’s
objectives.
The Open Market Trading Desk, a group of traders at the Federal
Reserve Bank of New York, trades government securities over the
counter electronically with primary dealers.
The account manager can conduct open market operations through
outright purchases and sales of Treasury securities or by using
Federal Reserve repurchase agreements (analogous to
commercial bank repos).
For open market sales, the trading desk often engages in matched
sale-purchase transactions (or reverse repos) in which the Fed
sells securities to dealers who agree to sell them back to the Fed in
the near future.
Open market operations intended to change monetary policy are
known as dynamic transactions, while those aimed at offsetting
fluctuations in the base are called defensive transactions.
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Open market operations have several benefits that other policy tools lack: control,
flexibility, and ease of implementation.
To discern the Fed’s intentions, Fed watchers read carefully the directives issued by
the Fed.
Most used
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Types
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Sandy Krieger, Head of Domestic Open Market Operations
New York District Bank
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Dynamic – designed to change the level of MB and R
Defensive – designed to offset other things that may change the level of MB and R
A day at the Trading Desk
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
To buy bonds the FED offers a higher price which lowers interest rates
To sell bonds the FED offers a lower price which raises interest rates
Traded electronically with primary dealers selected by the FED
Through banks or the nonbank public
Dealers make offers to the FED
Advantages
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Complete control – not subject to the actions of others (banks)
Flexible and precise
Easily reversed
No administrative delays

Discount Policy – loans to member banks
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Discount policy, which includes setting the discount rate and terms of
discount lending, is the oldest of the Federal Reserve’s principal tools for
regulating the money supply.
The Fed influences the volume of discount loans by setting their price
(the discount rate) and by setting their terms.
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An increase in the discount rate reduces the volume of discount loans and
exerts upward pressure on other interest rates.
The Fed uses the discount window to make one of three types of loans:
adjustment credit, seasonal credit, and extended credit.

Primary credit is available to health banks and may be used to for any
purpose.
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Secondary credit is intended for banks not eligible for primary credit and
may not be used to expand a bank’s assets.

Temporary, short-term seasonal credit loans satisfy seasonal liquidity
requirements of smaller depository institutions.
Although the Fed allows banks to borrow from the discount window, it
discourages banks from heavy use of discount loans.
Discount policy offers the Fed certain advantages that the other policy tools do
not have.
The discount window provides the most direct way for the Fed to act as a
lender of last resort to the banking system
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Discount rate changes – mostly ceremonial
Used in a potential financial crisis (Crisis intervention)
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1970
1974
1980
1984
Stock market crash of 10/87
911 0n 9/11/01
Quantity of loans
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Types
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Primary Credit loan – to most sound banks
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Secondary Credit loans – to riskier banks
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Seasonal Credit loans – banks in vacation or agricultural areas
Cost of borrowing from the FED
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Interest rate costs
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Concerns raised about the health of the bank
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Refusal to get a loan if you go to many times
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Moral suasion – rules for discount window operations
FED is the lender of the last resort
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To avert a financial crisis
Announcement effect – FED announces what it is thinking about doing… the market reacts
Problem: banks don’t have to borrow or they may borrow more than expected

Control is not 100%

Reserve Requirement – Percentage of deposits that must be held in the FED

Reserve requirements stem from the Fed’s mandate that banks hold a certain fraction of their
deposits in cash or deposits with the Fed.
•
The Board of Governors sets reserve requirements within congressional limits, under
authority granted by Congress in the Banking Act of 1935.
•
In 1980, the Depository Institutions Deregulation and Monetary Control Act established
uniform reserve requirements for all depository institutions.

The Fed changes reserve requirements much more rarely than it conducts open market
operations.
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Every two weeks, the Fed monitors compliance with its reserve requirements by checking a bank’s
daily balance.
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Ranges from 8% to 20%
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1937 – 20%
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1958 – 13%
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1980 – 12%
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1992 – 10%
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Now
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3% on the first $49.3 million
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10% above $49.3 million
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Advantage
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It effects all banks equally
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Disadvantage
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It is not precise
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Changes would have to be .001% which is not practical
Tool
Action
MB
Money Supply
Open Market
Operations
Buy Bonds
Increases
Increases
Sell bonds
Decreases
Decreases
Raise Rates
Decreases
Decreases
Lower Rates
Increases
Increases
Raise
None
Lowers
Lower
None
Raises
Discount
Window
Reserve
Requirement
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Goals – some conflict
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Major
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High Employment
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Economic Growth – 2 ½ % to 3.5%
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Natural Rate of Unemployment – 6%
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Acceptable
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Frictional – between jobs
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Structural – mismatch of jobs and skills
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Seasonal
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Unacceptable
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Cyclical – due to business cycles
Pollution increases
Price Stability – 4.5%
Minor
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Interest Rate Stability
Financial market stability
Foreign market stability
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Problems in Achieving Monetary Policy Goals
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A policy that is intended to achieve one monetary policy goal may have an
adverse effect on another policy goal.
The Fed’s tools don’t always allow it to achieve its monetary policy goals
directly.
The Fed also faces timing difficulties in using its monetary policy tools.
The source of numerical objectives for unemployment and inflation
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General guidelines for numerical objectives are found in the Employment Act
of 1946 and the Humphrey-Hawkins Full Employment and Balanced
Growth Act of 1978. Full employment is believed to be about 4.0 to 4.5
percent measured unemployment in the mid 2000s.
The goal for inflation depends upon recent experience and the political and
historical environment. Price stability does not necessarily mean zero inflation
but rather low inflation such as in the 1 to 2 percent range.
Sustainable growth is thought to be in the 2.5 to 3.0 percent range.

Targets

Operating

Reserve aggregates
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Reserves
Nonborrowed reserves
Monetary base
Nonborrowed base
Federal Funds Rate
Intermediate
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Monetary aggregates
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M1
M2
M3
Short and long term interest rates
Criteria for choosing a target
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Measurability
Controllable
Have a predictive effect on goals
History – FED has switched its targets many times only recently to the Federal
Funds Rate

Teens – Discount rate
20’s – Open market operations
Prior to the Great depression – Raised the discount rate to reduce credit
Late 30’s – Reserve requirements. Money was no longer backed by gold or silver
40’s – Open market operations
50’s and 60’s – interest rates and money market conditions
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Fed’s independence established
70’s – M1 and M2 through the Federal Funds Rate
Early 80’s – discount rate and Nonborrowed reserves
Late 80’s – interest rates through discount rates and discount loans
90’s and today – Federal Funds rate
9/11/01: Fed averted a financial crisis by lowering the discount rate so that banks could
borrow money to meet financial obligations
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Greenspan was out of the country. Vice Chairman Roger W. Ferguson was in charge
2003 – raised the discount rate above the federal funds rate to discourage banks from
borrowing from the FED
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Check Clearing Act will allow paper reproductions of checks
 Taylor Rule
 Federal Funds Rate = 2.5 + Inflation +
½(Inflation Gap) + ½(GDP Gap)
 Daniel Rule
 FFR = 13.98 – 2.61(Unemployment Rate) +
.01 (CPI)
 93% accuracy