The Money Supply Process Chapter 14 1 Players in the Money Supply Process Central bank (Federal Reserve System) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions) 2 Fed’s Balance Sheet Federal Reserve System Liabilities Government securities Currency in circulation Discount loans Reserves Monetary Liabilities Assets Currency in circulation: in the hands of the public Reserves: bank deposits at the Fed and vault cash Assets Government securities: holdings by the Fed that affect money supply and earn interest Discount loans: provide reserves to banks and earn 3 the discount rate Monetary Base H igh-pow ered m oney MB = C + R C = currency in circulation R = total reserves in the banking system 4 Open Market Purchase from a Bank Banking System Assets Liabilities Securities -$100 Reserves +$100 Federal Reserve System Assets Liabilities Securities +$100 Reserves +$100 Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 5 Open Market Purchase from Nonbank Public I Banking System Assets Reserves Federal Reserve System Liabilities +$100 Checkable deposits +$100 Assets Securities Liabilities +$100 Reserves +$100 Person selling bonds to the Fed deposits the Fed’s check in the bank Identical result as the purchase from a bank 6 Open Market Purchase from Nonbank Public II Nonbank Public Assets Liabilities Securities -$100 Currency +$100 Federal Reserve System Assets Liabilities Securities +$100 Currency in circulation +$100 The person selling the bonds cashes the Fed’s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase 7 Open Market Purchase: Summary The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase 8 Open Market Sale Nonbank Public Assets Liabilities Securities +$100 Currency -$100 Federal Reserve System Assets Securities Liabilities -$100 Currency in circulation -$100 Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves 9 Shifts from Deposits into Currency Nonbank Public Assets Banking System Liabilities Checkable deposits -$100 Currency +$100 Assets Reserves Liabilities -$100 Checkable deposits -$100 N et effect Federal Reserve System Assets o n m o n etary liab ilities Liabilities Currency in circulation +$100 Reserves -$100 is zero R eserv es are ch an g ed b y ran d o m flu ctu atio n s M o n etary b ase is a m o re stab le v ariab le 10 Making a Discount Loan to a Bank Banking System Assets Reserves Federal Reserve System Liabilities +$100 Discount loans +$100 (borrowing from Fed) Assets Discount loan Liabilities +$100 Reserves +$100 (borrowing from Fed) Monetary liabilities of the Fed have increased by $100 Monetary base also increases by this amount 11 Paying Off a Discount Loan from the Fed Banking System Assets Reserves Federal Reserve System Liabilities -$100 Discount loans -$100 (borrowing from Fed) Assets Discount loans Liabilities -$100 Reserves -$100 (borrowing from Fed) Net effect on monetary base is a reduction Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System 12 Other Factors Affecting the Monetary Base Float Treasury deposits at the Federal Reserve Interventions in the foreign exchange market 13 Fed’s Ability to Control the Monetary Base Open market operations are controlled by the Fed The Fed cannot determine the amount of borrowing by banks from the Fed Split the monetary base into two components MBn= MB - BR The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Fed 14 Deposit Creation: Single Bank First National Bank Assets First National Bank Liabilities Assets Liabilities Securities -$100 Securities -$100 Checkable deposits Reserves +$100 Reserves +$100 Loans +$100 First National Bank Assets Liabilities Securities -$100 Loans +$100 +$100 E xcess reserves increase B ank loans out the excess reserves C reates a checking account B orrow er m akes purchases T he m oney supply has increased 15 Deposit Creation: The Banking System Bank A Assets Reserves Bank A Liabilities +$100 Checkable deposits Assets +$100 Reserves Loans Bank B Assets Reserves Liabilities +$10 Checkable deposits +$100 +$90 Bank B Liabilities +$90 Checkable deposits Assets +$90 Reserves Loans Liabilities +$9 Checkable deposits +$90 +$81 16 Creation of Deposits (10% reserve requirement and a $100 increase in reserves) 17 The Formula for Multiple Deposit Creation A ssum ing banks do not hold excess reserves R equired R eserves ( R R ) = T otal R eserves ( R ) R R = R equired R eserve R atio ( r ) tim es the total am ount of checkable deposits ( D ) S ubstituting r D =R D ividing both s ides by r D = 1 R r T aking the change in both sides yields D = 1 r R 18 Critique of the Simple Model Holding cash stops the process Currency has no multiple deposit expansion Banks may not use all of their excess reserves to buy securities or make loans. Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change. 19 Money Supply Response Player Fed uses the tools (1) Open market purchase (2) Lowering the discount rate (3) Increasing the required reserve ratio 20 The Money Multiplier Define money as currency plus checkable deposits: M1 M=C+D Link the money supply (M) to the monetary base (MB) and let m be the money multiplier M m MB MB = C + R M = m(MB) 21 Deriving the Money Multiplier I Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D. Then, c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio 22 Deriving the Money Multiplier II T he total am ount of reserves ( R ) equals the sum of required reserves ( R R ) and excess reserves ( E R ). R = RR + ER T he total am ount of required reserves eq uals the required reserve ratio tim es the am ount of checkable deposits RR = r × D S ubsituting for R R in the first equation R = (r × D ) + E R T he Fed sets r to less than 1 23 Deriving the Money Multiplier III The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + (r x D) + ER Equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves. 24 Deriving the Money Multiplier IV c = {C / D } C = c D and e = {ER / D} ER = e D Su bstitu ting in the previo us eq uation M B (r D ) (e D ) (c D ) (r e c) D D ivid e bo th sides by the term in parenth eses D 1 r ec MB M D C and C c D M D ( c D ) (1 c ) D Su bstitu ting ag ain M 1 c r ec MB T he m o ney m ultiplier is then m 1 c rec 25 Intuition Behind the Money Multiplier r req u ired reserv e ratio = 0 .10 C cu rren cy in circu latio n = $ 4 0 0 B D ch eck ab le d ep o sits = $ 8 0 0B E R ex cess reserv es = $ 0 .8 B M m o n ey su p p ly (M 1 ) = C D = $ 1 ,20 0 B c $4 0 0 B 0 .5 $8 0 0 B e $ 0 .8 B 0 .0 0 1 $ 8 00 B m 1 0 .5 0 .1 0 .0 0 1 0 .5 1 .5 2 .5 0 .6 01 T h is is less th an th e sim p le d ep o sit m u ltiplier A lth o u g h th ere is m u ltip le ex p an sio n o f d ep o sits, th ere is n o su ch ex p an sion fo r cu rren cy 26 Application: The Great Depression Bank Panics, 1930 - 1933. Bank failures (and no deposit insurance) determined: Increase in deposit outflows and holding of currency (depositors) An increase in the amount of excess reserves (banks) For a relatively constant MB, the money supply decreased due to the fall of the money multiplier. 27 Deposits of Failed Commercial Banks, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309. 28 Excess Reserves Ratio and Currency Ratio, 1929–1933 Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333. 29 30 M1 and the Monetary Base, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867– 1960 (Princeton, NJ: Princeton University Press, 1963), p. 333. 31 32 MONETARY STATISTICS DURING GREAT DEPRESSION Currency Res/Dep Reserves M1 Dec-29 3.85 0.075 3.15 45.9 Dec-30 3.79 0.082 3.31 44.1 Dec-31 4.59 0.095 3.11 37.3 Dec-32 4.82 0.109 3.18 34.0 Dec-33 4.85 0.133 3.45 30.8 Why did money supply fell during the Great Depression even though the Fed kept reserves up? What would M value be in 1932 if reserve ratio did not change? 33