Money Supply Process
Fundamentals of Finance – Lecture 6
Four Players in the Money Supply Process
• Central bank
• Banks (depository institutions; financial
intermediaries)
• Depositors (individuals and institutions)
• Borrowers
The Central Bank’s Balance Sheet
Central Bank
Assets
Liabilities
Securities
Currency in circulation
Loans to Financial
Institutions
Reserves
• Liabilities
– Currency in circulation: in the hands of the public
– Reserves: bank deposits at the Fed and vault cash
• Assets
– Government securities: holdings by the CB that affect money
supply and earn interest
– Discount loans: provide reserves to banks and earn the discount
rate
Control of the Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
Open Market Purchase from a Bank
Banking System
Assets
Central Bank
Liabilities
Securities
- $100m
Reserves
+$100m
Assets
Securities
Liabilities
+$100m Reserves
• Net result is that reserves have increased by $100
• No change in currency
• Monetary base has risen by $100
+$100m
Open Market Purchase from the Nonbank Public
Banking System
Assets
Reserves
+$100m
Central Bank
Liabilities
Checkable
deposits
+$100m
Assets
Securities
Liabilities
+$100m
Reserves
+$100m
• Person selling bonds to the CB deposits the CB’s check in the
bank
• Identical result as the purchase from a bank
Open Market Purchase from
the Nonbank Public (cont’d)
Nonbank Public
Assets
Liabilities
Securities
-$100m
Currency
+$100m
Central Bank
Assets
Securities
Liabilities
+$100m Currency in
circulation
+$100m
• The person selling the bonds cashes the CB’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
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.
Open Market Sale
Nonbank Public
Assets
Liabilities
Securities
+$100m
Currency
-$100m
Central Bank
Assets
Securities
Liabilities
-$100m Currency in
circulation
-$100m
• 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
Shifts from Deposits into Currency
Nonbank Public
Assets
Banking System
Liabilities
Checkable
deposits
-$100m
Currency
+$100m
Assets
Reserves
Liabilities
-$100m Checkable
deposits
-$100m
Central Bank
Assets
Liabilities
Currency in
circulation
+$100m
Reserves
-$100m
•Net effect on monetary liabilities is zero; Reserves are
changed by random fluctuations; Monetary base is a more
stable variable
Loans to Financial Institutions
Banking System
Assets
Reserves
Central Bank
Liabilities
+$100m Loans
+$100m
(borrowing from CB)
Assets
Loans
Liabilities
+$100m Reserves
(borrowing from CB)
• Monetary liabilities of the Fed have increased by $100
• Monetary base also increases by this amount
+$100m
Other Factors that Affect the Monetary Base
• Float
• Treasury deposits at the Central Bank
• Interventions in the foreign exchange market
Overview of The Central Bank’s Ability to
Control the Monetary Base
• Open market operations are controlled by the CB
• The CB cannot determine the amount of borrowing by banks
from the CB
• Split the monetary base into two components
MBn= MB - BR
• The money supply is positively related to both the nonborrowed monetary base MBn and to the level of borrowed
reserves, BR, from the CB
Multiple Deposit Creation:
A Simple Model
Deposit Creation: Single Bank
Bank A
Assets
Bank A
Liabilities
Assets
Liabilities
Securities
-$100m
Securities
-$100m Checkable
deposits
Reserves
+$100m
Reserves
+$100m
Loans
+$100m
+$100m
Bank A
Assets
Liabilities
Securities
-$100m
Loans
+$100m
•Excess reserves increase; Bank loans out the excess reserves; Creates
a checking account; Borrower makes purchases; The Money supply has
increased
Multiple Deposit Creation: A Simple
Model (Cont’d)
Deposit Creation: The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100m
Checkable
deposits
Assets
+$100m
Reserves
+$10
Loans
+$90
Bank B
Assets
Reserves
Checkable
deposits
+$100m
Bank B
Liabilities
+$90
Liabilities
Checkable
deposits
Assets
+$90
Reserves
Loans
Liabilities
+$9
+$81
Checkable
deposits
+$90
Creation of Deposits (assuming 10% reserve
requirement and a $100 increase in reserves)
Reserve requirement rd = 10%
Bank 1
Assets
Liabilities
Bank
Deposits+100
Reserves+100
Bank 1
Assets
Пасиви
Deposits +100
Reserves +10
Loans +90
Deposits
Reserves
Loans
∆D
∆R
∆L
1
100
10
90
2
90
9
81
3
81
8.1
72.9
1000
100
900
.......
Bank 2
Reserves + 9
Loans + 81
Banking
system
Deposits + 90
Bank 3
- Required reserve ratio
- Deposit multiplier
Reserves + 8.1
Loans + 72.9
Deposits + 81
Multiple Deposit Contraction
The multiple deposit creation process should also work in reverse.
When the Central Bank withdraws reserves from the banking
system, there should be a multiple contraction of deposits.
In fact, the contraction in deposits will be
D = (1/ r )  R
Example:
If R = -100 and (1/ r ) = 10 because rd =10%, then
D = -1000.
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.
The Money Supply and Money Multiplier
• Define money as currency plus checkable
deposits: M1
• Link the money supply (M) to the monetary
base (MB) and let m be the money multiplier
M  m  MB
Deriving the Money Multiplier
• 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
Deriving the Money Multiplier (cont’d)
The total amount of reserves (R) equals the sum of
required reserves (RR) and excess reserves (ER).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = r × D
Subsituting for RR in the first equation
R = (r × D) + ER
The Fed sets r to less than 1
Deriving the Money Multiplier (cont’d)
• 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.
Deriving the Money Multiplier (cont’d)
c = {C / D}  C = c  D and
e = {ER / D}  ER = e  D
Substituting in the previous equation
MB  (r  D)  (e  D)  (c  D)  (r  e  c)  D
Divide both sides by the term in parentheses
1
 MB
r  e c
M  D  C and C  c  D
D
M  D  (c  D)  (1 c)  D
Substituting again
1 c
 MB
r  ec
The money multiplier is then
M
m
1 c
r ec
Intuition Behind the Money Multiplier
r  required reserve ratio = 0.10
C  currency in circulation = $400B
D  checkable deposits = $800B
ER  excess reserves = $0.8B
M  money supply (M1) = C  D = $1,200B
$400B
 0.5
$800B
$0.8B
e
 0.001
$800B
1 0.5
1.5
m

 2.5
0.1 0.001 0.5 0.601
This is less than the simple deposit multiplier
Although there is multiple expansion of deposits,
there is no such expansion for currency
c
Factors that Determine the Money Supply
• Changes in the required reserves ratio
– The money supply is negatively related to the
required reserve ratio.
• Changes in currency holdings
– The money supply is negatively related to currency
holdings.
• Changes in excess reserves
– The money supply is negatively related to the
amount of excess reserves.
The Great Depression Bank Panics, 1930–1933,
and the Money Supply
• 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.
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.
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.
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.
The 2007-2009 Financial Crisis and the Money Supply
• During the recent financial crisis, the monetary base more
than tripled as a result of the Fed's purchase of assets and
new lending facilities to stem the financial crisis.
• The currency ratio fell somewhat during this period, which
the money supply model suggests would raise the money
multiplier and the money supply because it would increase
the overall level of deposit expansion. However, the effects
of the decline in c were entirely offset by the extraordinary
rise in the excess reserves ratio e.
M1 and the Monetary Base, 2007-2009
Source: Federal Reserve; www.federalreserve.gov/releases.
Excess Reserves Ratio and Currency Ratio,
2007-2009
Source: Federal Reserve; www.federalreserve.gov/releases.