How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply: Means of Payment
Measuring the Money
Supply, May 2007
M2: A Broader Definition of Money
What about Credit Cards and Debit Cards?
How Banks Create Money
Balance Sheet for Wachovia
Bank, December 31, 2006
Reserves Deposits that a bank keeps as cash in its vault or on deposit with
the Federal Reserve = R
Required reserves Reserves that a bank is legally required to hold, based on
its checking account deposits = RR.
Required reserve ratio The minimum fraction of deposits banks are required
by law to keep as reserves RR = r D.
How Banks Create Money in a Fractional Reserve Banking
System: Using T-Accounts
How Banks Create Money
Now PNC has excess
reserves and can make
a loan
How Banks Create Money:
The multiple creation of money and credit
BANK
Wachovia
INCREASE IN CHECKING ACCOUNT DEPOSITS
$1,000
PNC
+ 900
(= 0.9 x $1,000)
Third Bank
+ 810
(= 0.9 x $900)
Fourth Bank
+ 729
(= 0.9 x $810)
.
+•
.
+•
.
+
Total Change in Checking Account
Deposits
=$10,000
Deposit multiplier The ratio of the
amount of deposits created by banks Simple deposit multiplier = 1/r
to the amount of new reserves.
The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:
People hold currency and banks hold excess reserves, slowing multiple
creation of deposits and credit
Reserves Deposits that a bank keeps as cash in its vault or on deposit with
the Federal Reserve = R = RR + ER = rD + eD
Required reserves Reserves that a bank is legally required to hold, based on
its checking account deposits = RR.
Required reserve ratio The minimum fraction of deposits banks are required
by law to keep as reserves RR = r D.
Excess reserves Reserves that banks hold over and above the legal
requirement. ER = e D
The Money Supply Model
• Money = Currency plus checkable deposits: M1
M=C+D
• The monetary base (MB)—the assets of the central bank—
“backs” the money supply
• The CB’s assets = MB =The CB’s liabilities = C + R
• The Fed controls the monetary base (MB) better than it
controls reserves … but it doesn’t perfectly control MB
MB = MBn + BR
• The money supply (M) is a multiple m of the monetary base
M = m x MB = m x (MBn + BR)
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
D
 MB
r ec
M  D  C and C  c  D
M  D  (c  D)  (1 c)  D
Substituting again
1 c
M 
 MB
r ec
The money multiplier is then
1 c
m
r ec
Factors that Affect
The Money Multiplier
• Changes in the required reserve ratio r
– The money multiplier and the money supply are negatively
related to r
• Changes in the currency ratio c
– The money multiplier and the money supply are negatively
related to c
• Changes in the excess reserves ratio e
– The money multiplier and the money supply are negatively
related to the excess reserves ratio e
– The excess reserves ratio e is negatively related to the
market interest rate
– The excess reserves ratio e is positively related to
expected deposit outflows
Money and the Great Depression
• The Great Contraction in monetarist analysis
• Banking Crises
– Currency holdings
– Excess reserve holdings
– Monetary contraction