Chapter Sixteen
Monetary Control
Monetary Control
• The Fed does not control the money
supply directly, but indirectly through
adjustments to its monetary base
• This base supports a larger money supply
through the money-multiplier process
• The money supply is a measure of the
amount of money held in the economy,
such as M1 or M2
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The Money Supply
• Money supply = Money multiplier ×
Monetary base
• Money supply: M1 or M2 or M3
• Monetary base: determined by Federal
Reserve; equal to reserves + currency
held by nonbank public
• Money multiplier: depends on
decisions by people, banks, and the Fed
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Money Creation and Destruction
• Fed influences money supply by affecting banks’
reserves, mainly through open-market
operations
• The Fed’s main asset is its portfolio of securities
• Banks create and destroy money by changing
amount of outstanding loans
– Money is “created” when more loans are made
available through banks, and destroyed when fewer
loans are given
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Federal Reserve Balance Sheet,
12/31/2004 ($ billions)
Assets
Liabilities + Capital
Securities
750.86
781.55
64.05
Monetary
Base
Other
Liabilities
Capital
Discount
Loans
Other
0.04
Total
814.95
Total
814.95
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9.86
23.54
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Open-Market Operations
• Open-market purchase: Fed buys
securities from government securities
dealers, adds reserves to bank
• Fed’s assets (securities) increase;
monetary base (bank reserves) increase
• Open-market sale: Fed sell securities;
gets reserves from banks; Fed assets
decline; monetary base declines
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How Banks Create Money
1. Fed buys securities in open market
2. First Bank gets reserves and now has excess
reserves
3. First Bank makes additional loans
4. Funds go to Second Bank, which now has
excess reserves
5. Second Bank makes additional loans
6. Third Bank has excess reserves ...
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Effect of $4 Million Open-Market Purchase
Bank
New
Deposits
Additional
Reserves
First
4.00
0.400
Loans
Made
3.60
Second
3.60
0.360
3.24
Third
3.24
0.324
2.92
Fourth
2.92
0.292
2.63
...
...
...
40.00
4.000
36.00
Total
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The Money Multiplier
• The money
multiplier is the
ratio of the money
supply to the
monetary base.
mm = M ÷ MB
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Money Multiplier (cont’d)
• The multiple amount by which the money
supply increases from an open-market
purchase of $4 million equals:
1/q = 1/0.1 = 10
(q = reserve requirement)
ΔM = mm × ΔMB
if mm is constant
Ex: ΔM = mm × ΔMB = 10 × 4 = 40
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Realistic Money Multipliers
• Simple examples thus far…i.e., money created
by banks and deposited in banks stays in banks
• For a more realistic example examine
– How the monetary base is split into reserves and
currency held
– How different measures of money are split into their
components
– How banks split between required & excess reserves
and required clearing balances.
– How people split holdings into different assets
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Realistic Money Multipliers (cont’d)
• Monetary base is equal to the amount of
reserves held by banks plus the amount of
currency held by the nonbank public
MB
=
R
+
C
• Different measures of the money supply will
have different multipliers.
M1 = D + C
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Realistic Money Multipliers (cont’d)
• Different measures of the money supply
will have different multipliers
M2 = D + C + N + MMF
(MMF signifies money market mutual funds.)
• The M2 multiplier is the ratio of M2 to the
monetary base:
Mm2 = M2 / MB
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Bank Reserves
• Banks hold reserves both because of reserve
requirements and because they may have agreed to
hold required clearing balances (RCB) at the Fed
• Required clearing balances help to ensure that banks
have plenty of funds at the Fed to cover daily
transactions and help check-clearing process run
smoothly
Reserves = Required reserves + Excess reserves +
Required clearing balances
R = RR + ER + RCB
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Deriving the Multipliers
mm1 
mm2 
1 C
RR
D
 ER
1 C
RR
D
D
N
D
 ER
D
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D
 RCB
D
C
D
 MMF
D
 RCB
D
D
C
D
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How People & Banks Affect
the Money Supply
• Changes in the multiplier affect the money
supply simultaneously
• Who determines multipliers?
– People: C/D (the ratio of currency to deposits), N/D
(ration of non-transactions deposits to transaction
deposits), MMF/D (money market mutual funds to
transaction deposits)
– Banks: ER/D (excess reserves to deposits), RCB/D
(required clearing balances to deposits)
– The Fed: RR/D (required reserves to deposits)
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How People & Banks Affect
the Money Supply (cont’d)
Please insert Table 16.3
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How People & Banks Affect
the Money Supply (cont’d)
Figure 16.1 Money Multipliers
The rate of decline in the M1 multiplier increased in the 1990s with
the advent of sweep accounts
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How People & Banks Affect
the Money Supply (cont’d)
Figure 16.2a Components of the Numerator of the M1 Money Multiplier
Both components of the M1 multiplier rose rapidly beginning in 1995
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How People & Banks Affect
the Money Supply (cont’d)
Figure 16.2b Components of the Numerator of the M2 Money Multiplier
The components of the M2 numerator also rose sharply after 1995
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How People & Banks Affect
the Money Supply (cont’d)
Figure 16.3a Components of the Denominator of the Money Multipliers
(Other Than C/D)
The components of the denominator of the multipliers
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How People & Banks Affect
the Money Supply (cont’d)
Figure 16.3b Components of the Denominator of the Money Multipliers
Movements in the denominator are dominated by movements in the ratio
of currency to transactions deposits over time
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The Tools of Monetary Policy
1.
2.
3.
•
Open-market operations
Changes in the discount rate
Changes in reserve requirements
Bank’s reserves can be broken down into
those borrowed from the Fed:
Monetary base = reserves + currency
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Open-Market Operations
• The most commonly used tool
• Example: People demand more money
during the holidays, so the Fed increases the
monetary base to prevent the decline in the
multiplier from affecting M1
• Defensive open-market operations are
undertaken because of seasonal effects or
temporary changes in market demand
• Dynamic open-market operations are
undertaken when the Fed wants to actively
change monetary policy
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Discount Lending
M = mm × (DL + NBR + C)
•
•
•
The discount rate is the interest rate
banks pay when they borrow from the
Fed at the discount window
When the discount rate is higher, fewer
loans are made
The Fed takes a haircut on loan’s
collateral (requires collateral valued at
more than the amount of the loan)
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Discount Lending (cont’d)
•
Primary credit discount loan
–
–
–
•
requires CAMELS rating of 1, 2, or 3
no questions asked
primary credit discount rate currently set at 1
percentage point above federal funds rate target
Secondary credit discount loan
–
–
–
CAMELS rating of 4 or 5
questions asked
secondary credit discount rate currently set at ½
percentage point above primary credit discount rate
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Discount Lending (cont’d)
•
Seasonal credit discount loan
– program to lend at the discount window for
small banks
– for small banks with seasonal demands for
credit (eg. farm banks)
– rate equals ½ average fed funds rate + ½
average rate on negotiable CDs over twoweek maintenance period
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Discount Lending (cont’d)
• How do changes in the discount rate affect
the money supply?
• An increase in the amount of discount
loans increases the money supply by the
amount of the increase in the discount
loans times the money multiplier
M = mm × (DL + NBR + C)
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Reserve Requirements
M = mm × (DL + NBR + C)
•
•
Increases in the reserve requirements
reduce the multiplier because banks hold
more reserves and lend less
Not often used to affect the money
supply—too blunt a tool
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The Tools of Monetary Policy
Please insert Table 16.4
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The Market for Bank Reserves
• Fed intervenes daily in market for bank reserves,
so it needs a good model of the reserve market.
• Split reserves into parts
– Discount loans that depend on the federal funds rate
(discount loans for profit DL-Profit)
– Non-Borrowed Reserves (NBR) supplied by the Fed
– Discount loans that do not depend on the federal
funds rate, which include seasonal discount loans +
secondary credit discount loans by weak banks with
problems + primary credit discount loans by good
banks with temporary problems (DL-Business)
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The Market for Bank Reserves (cont’d)
• Supply curve for reserves
– Vertical segment: NBR + DL-Business
– Horizontal segment: DL-Profit
• Horizontal segment starts at primary credit discount rate (d)
• Demand curve for reserves
– Downward sloping, as banks desire more reserves,
the cheaper they are
• Equilibrium point determines equilibrium fed
funds rate
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The Market for Bank Reserves (cont’d)
The demand curve slopes downward because banks want to hold more
reserves when the federal funds rate is lower
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The Market for Bank Reserves (cont’d)
The supply of reserves is vertical when ffr is less than the
primary discount rate, and horizontal when they are equal
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The Market for Bank Reserves (cont’d)
Equilibrium in the reserves market occurs at the intersection of supply
and demand; in this case there are no primary credit discount loans
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The Market for Bank Reserves (cont’d)
The Open-Market Desk’s Job
– Daily analysis of the reserves market
– Estimates the amount of reserves available in
the market each day
– Determine NBR to get ffr* equal to FOMC’s
target rate
– Engage in open-market operations each day
based on the current level of NBR and the
desired level
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The Market for Bank Reserves (cont’d)
When ffr exceeds the Fed’s target, If the Fed engages in purchases in
the amount of ∆R, equilibrium ffr will equal the target
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The Market for Bank Reserves (cont’d)
If demand for reserves is D2 instead of D1, ffr will rise to
equal the discount rate
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Should the Fed
Pay Interest on Reserves?
• Why pay interest on reserves?
– Required reserves are higher than banks need, so
they avoid them by sweep accounts, which are costly
– Interest on reserves could increase efficiency; banks
would price their services more in line with their
economic costs
– Because bank reserves are an asset, their return
should be determined by the market
– The Fed would gain an additional policy tool
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Should the Fed
Pay Interest on Reserves? (cont’d)
• Disadvantages of interest on reserves
– Would be costly to the Fed: $700 million to $5
billion per year, depending on the interest rate
paid, at current reserve levels
– Payment of interest would lead to more
reserves being held, so the amount would be
even higher
– The system of required clearing balances
implicitly pays interest
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