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Introduction to the Money Supply Process zFundamental Property -- Money supply expands when banks make loans (or more generally, expand loans or buy bonds)

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Deposit Expansion: The Individual Bank Consider the following example. (r D = 0.10, r T = 0.05) Chase R $20000 D $70000 L $90000 T $80000 Bonds $50000 E $10000

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Computing Required and Excess Reserves Chase r D = 0.10 R $20000 D $70000 r T = 0.05 L $90000 T $80000 Bonds $50000 E $10000 RR = r D D + r T T = (0.10)($70000) + (0.05)($80000) = $11000 ER = R - RR = $20000 - $11000 = $9000

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Loan of $9000 Step #1 -- Loan is Approved Chase R $20000 D $79000 L $99000 T $80000 Bonds $50000 E $10000 Borrower signs loan contract, receives check from bank.

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Step #2 -- Loan is Spent Chase R $11000 D $70000 L $99000 T $80000 Bonds $50000 E $10000 Seller deposits check in her bank. HSBC R + $9000 D + $9000

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Bank Loaning and Money Supply Expansion Consider: M2 = C + D + T + MMMF M2 = C + D + T + MMMF Our example: M2 = $0 + $9000 + $0 + $0 = $9000 (Chases loan leads to new deposits for HSBC.)

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Key Concepts: Money Supply Expansion zKey is step #1, Chase expands its deposit commitments without changing its reserves. zNote -- Process is symmetric. Repayment or liquidation of loan leads to decrease in M2 (by the amount of the loan).

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Deposit Expansion: The Banking System zMultiple Expansion -- An initial change in bank reserves prompted by the Federal Reserve leads to an eventual increase in the money supply which is a multiple of that initial change.

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Developing a Formula for Multiple Expansion z Define -- The Monetary Base, or High Powered Money (H) H = C + R

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Key Properties: The Monetary Base zThe monetary base (H) is unaffected by changes in public asset holdings. zThe monetary base (H) is also unaffected by bank loaning. zImportant factors that change H: Open Market Operations and Discount Loans (DL).

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Discount Loans and the Monetary Base zExample 1 -- Chase borrows $100 from the Federal Reserve. Chase R + $100 DL + $100 H = C + R = $0 + $100 = $100

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Open Market Operations and the Monetary Base zExample 2 -- The Federal Reserve buys a $100 bond from Chase. Chase Bonds - $100 R + $100 H = C + R = $0 + $100 = $100

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The Nonborrowed Base zThe Nonborrowed Base (H NON ) H NON = H - DL zKey property -- The nonborrowed base is only affected by open market operations.

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A Formula for Money Supply Determination zDefine the following variables. k = C/D t = T/D e = ER/D

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Money Supply Determination: The Formula M2 = (1 + k + t) (H NON + DL) + MMMF (k + r D + r T t + e) The money multiplier (m 2 )

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Computing the Money Multiplier: An Example Suppose that: C = 550 r D = 0.10 D = 600 r T = 0.03 T = 3000 ER = 10. Compute the money multiplier (m 2 ).

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Computing the Ratios k = C/D = 550/600 = 0.917 t = T/D = 3000/600 = 5.000 e = ER/D = 10/600 = 0.0167

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Plugging Into The Multiplier Formula m 2 = 1 + k + t k + r D + r T t + e m 2 = 1 + 0.917 + 5.0 0.917 + 0.10 + (0.03)(5.0) + 0.0167 m 2 = 5.84

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Effects of H NON and DL on M2 Determination zSince M2 = (m 2 )(H NON + DL), M2 = (m 2 )( H NON ), M2 = (m 2 )( DL). zIn other words, H NON M2 DL M2 zChanges in H NON or DL give banks reserves, greater ability to loan.

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Effects of Reserve Ratios on M2 Determination zIncreases in reserve ratios hinder bank loaning, thereby decreasing the multiplier and M2. m 2 = 1 + k + t k + r D + r T t + e r D m 2 M2 r T m 2 M2

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Effects of k (C/D) and t (T/D) on M2 Determination zChanges in k and t (publics desire to reallocate assets) have different effects on bank loaning, the multiplier, and M2. m 2 = 1 + k + t k + r D + r T t + e k m 2 M2 t m 2 M2

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Effects of e (ER/D) on M2 zChanges in e (banks desire to hold more excess reserves) affect the multiplier, which affects M2. m 2 = 1 + k + t k + r D + r T t + e e m 2 M2

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M2 Determination: Summary First, the formula again. M2 = (1 + k + t) (H NON + DL) + MMMF (k + r D + r T t + e)

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A Summary Table H NON M2 DL M2 r D M2 r T M2 k M2 t M2 e M2

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The Multiplier -- Trying to Control the Money Supply M2 = (1 + k + t) (H NON + DL) + MMMF (k + r D + r T t + e) zFederal Reserve controls H NON, r D, and r T and uses them as policy tools. zBut M2 is also determined by public asset holding (k, t, MMMF) and bank behavior (e, DL).

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Can the Federal Reserve Control the Money Supply? zPractical Solution -- The Federal Reserve tries to control money supply growth within a given target range. If actual M2 growth falls within the range, M2 is considered controlled.

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The Multiplier Effect and Controlling M2 zConsider formula for M2 determination (apart from MMMF), written as follows (recall that H = H NON + DL). M2 = (m 2 )(H)

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M2 Determination in Growth Rates zSince the levels are multiplicative, the growth rates are additive zGrowth in M2 (Growth in m 2 ) + (Growth in H)

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Implications for M2 Control zGrowth in M2 (Growth in m 2 ) + (Growth in H) zIf the multiplier is roughly constant over time (growth in m 2 0), then the growth rate of M2 will approximate closely the growth rate of the monetary base.

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Difficulties in M2 Control zGrowth in M2 (Growth in m 2 ) + (Growth in H) zBut if the multiplier changes over time (growth rate either positive or negative), then the growth rate of M2 will deviate from the growth rate of the monetary base.

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Non-Federal Reserve Changes in M2 zBest solution: constant multiplier, zero DL. Unfortunately, not true. zSecond best solution: predictable multiplier and DL. zHow to predict non-Fed controlled changes in M2? What determines movements in the components (k, t, e, DL, MMMF)?

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