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 ec
 MB
M  D  C and C  c  D
M  D  ( c  D )  (1  c )  D
Su bstitu ting ag ain
M 
1 c
r ec
 MB
T he m o ney m ultiplier is then
m
1 c
rec
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