1. Chapter 17
The Money Supply Process

2. Players in the Money Supply Process
Central bank (Federal Reserve)
Banks (depository institutions)
Depositors (individuals and institutions)
Borrowers

3. Fed’s Balance Sheet (important items)
Federal Reserve System
Assets
Liabilities
Government Securities and Mortgage Backed Securities
Currency in circulation
Discount loans
Reserves
Monetary Liabilities
Currency in circulation(in the hands of the public)
Reserves: bank deposits at the Fed
Assets
Government securities: holdings by the Fed that affect money supply and earn interest.
Fed now holding MBS.
Discount loans: provide reserves to banks and earn the discount rate

4. The Federal Reserve Balance Sheet: June 2003
Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars)
ASSETS
LIABILITIES
Gold $
11,045
$593,031
Federal Reserve notes (outstanding)
Loans to banks
36,538
U.S. Treasury securities
550,314
20,359
Bank reserves (from depository institutions)
6,219
U.S. Treasury Deposits
All other assets
46,268
24,556
All other liabilities and net worth
Total
644,165
$644,165
Source: Federal Reserve Bulletin, August 2003, Table 1.18.

5. Federal Reserve Balance Sheet August, 2007
The Beginning of the Financial Crisis
(Millions of Dollars)
ASSETS
LIABILITIES
Gold $
11,037
$777,769
Federal Reserve notes (outstanding)
Loans to banks
1,342
Deposits:
U.S. Treasury securities
779,642
12,771
Bank reserves (from depository institutions)
4,572
U.S. Treasury deposit
All other assets
82,451
79,360
All other liabilities and net worth
Total
874,472
$874,472
Source: Board of Governors of the Federal Reserve System.

6. THE FEDERAL RESERVE BALANCE SHEET: August 2009
ASSETS
LIABILITIES
Gold $
11,037
$872,150
Federal Reserve notes (outstanding)
Loans to banks
339,335
Deposits:
U.S. Treasury securities
705,331
724,650
Bank reserves (from depository institutions)
261,487
U.S. Treasury
All other assets
936,031
133,447
All other liabilities and net worth
Total
1,991,734
$1,991,734
Source: Board of Governors of the Federal Reserve System.

7. THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS
LIABILITIES
Gold $
11,037
$1122,000
Federal Reserve notes (outstanding)
Loans to banks
449
Deposits:
U.S. Treasury securities
1730,000
1,795,000
Bank reserves (from depository institutions)
Mortgages
1,083,000
42,000
U.S. Treasury
All other assets
234,000
116,000
All other liabilities and net worth
Total
3,075,000
$3,075,000
Source: Board of Governors of the Federal Reserve System.

8. THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS
LIABILITIES
Gold $
11,037
$1,315,000
Federal Reserve notes (outstanding)
Loans to banks 59
Deposits:
U.S. Treasury securities
2,450,000
2,748,000
Bank reserves (from depository institutions)
Mortgages
1,731,000
65,000
U.S. Treasury
All other assets
290,000
353,000
All other liabilities (reverse Repo) and net worth
Total
4,481,000
$4,481,000
Source: Board of Governors of the Federal Reserve System.

9. Monetary Base (High Powered Money)
Note: Vault cash is included in reserves.
Recall: M1 = C + DD

10. The Money Supply Process: Open Market Purchase From a Commercial Bank (Assume a 10% reserve requirement)
Reserves have increased by $100.
What about excess reserves?
No change in currency
Monetary base (C + R) has increased by $100
Has the money supply changed?

11. Fed Open Market Purchase from Nonbank Public
Reserves have increased by $100.
What about excess reserves?
No change in currency
Monetary base (C + R) has increased by $100
Has the money supply changed?

12. 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 (C+R) increases by the amount of the open market purchase

13. Open Market Purchase: Summary
The effect on reserves in the banking system depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits
Always increases the monetary base by the amount of the purchase:
MB = C + R

14. Fed Open Market Sale to non-bank public
Federal Reserve System
Assets
Liabilities
Securities
+$100
-$100
Currency in circulation
Currency
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

15. Public withdraws $100 from Commercial Bank
+$100

16. Fed Discount Loan to a Bank
$100

17. Paying Off a Discount Loan from the Fed
Banking System
Federal Reserve System
Assets
Liabilities
Reserves
-$100
Discount loans
Net effect is to reduce the monetary base
Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System

18. Deposit Creation (Single Bank): Fed Open Market Purchase from First National Bank
Step 1
Step 2
First National Bank
Assets
Liabilities
Securities
-$100
Checkable deposits
+$100
Reserves
Loans
Step 3
First National Bank
Assets
Liabilities
Securities
-$100
Loans
+$100

19. Deposit Creation: The Banking System (10% Reserve Requirement)
Bank A
Assets
Liabilities
Reserves
+$100
Checkable deposits
+$10
Loans
+$90
Bank B
+$9
+$81

20. Creation of Deposits (assuming 10% reserve requirement and the initial $100 increase in reserves)

21. The Formula for the Simple Deposit Multiplier

22. Critique of the Deposit Multiplier
Currency removes funds from the banking system and stops the deposit creation process
Holding excess reserves stops the deposit creation process. Banks may not use all of their excess reserves to buy securities or make loans.
Depositor decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) affect the money supply and the Fed’s ability to control the money supply.

23. M1 = m x MB The M1 Money Multiplier
M1 =currency + checkable deposits = C + D
Link the money supply (M1) to the monetary base (MB) and let m be the money multiplier
Recall: MB = C + R
This is why the MB is called High Powered Money
M1 = m x MB

24. Deriving the M1 Money Multiplier
Let’s 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

25. Deriving the M1 Money Multiplier: m
M1 = m  MB
Reserves: R = RR + ER
Required Reserves: RR = r  D
R = (r  D) + ER

26. Deriving the M1 Money Multiplier
Math Trick:
MB = RR ER C
MB = (r  D) + (ER/D  D) + (C/D  D)
MB = (r + e + c)  D ;
Where e=(ER/D) and c =(C/D)
M1 = D + C = D + (C/D D)
M1 = (1+ c)  D ;

27. M1 Money Multiplier m < 1/r because of currency holding and ER.
m is the increase in the money supply resulting from a $1 increase in MB

28. Example

29. Case Study: The Great Depression Bank Panics, 1930 - 1933.
Bank failures (and no deposit insurance) caused:
Increase in deposit outflows and holding of currency (depositors)
An increase in the amount of excess reserves (banks)

30. Case Study: The Great Depression Bank Panic, 1930 - 1933
Case Study: The Great Depression Bank Panic, Deposits of Failed Commercial Banks
Bank failures (and no deposit insurance) caused:
Increase in deposit outflows and holding of currency (depositors)
An increase in the amount of excess reserves (banks)

31. Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?

32. Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933

34. Case Study: Money Supply 1980 -2005

35. Determinants of the Money Supply