2 Learning Objectives Review the money supply expansion process. Learn how to derive the M1 model.Understand how the interaction of the money multiplier and base determine M1.Understand the role of the Federal Reserve, the commercial banking system, and the non-bank public in the money creation process.
3 The Money Supply M1: Currency + travelers checks + checkable deposits M2: M1 + small time deposits + overnight repurchase agreements + overnight Eurodollars + money market mutual fund balancesM3: M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money market fund balances
4 The Creators of MoneyThe three major players whose decisions and actions determine the rate of growth in the money supply are:The Federal Reserve (Fed)Sets reserve requirementsOperates the discount windowEngages in open market operationsThe Commercial Banking SystemAccepts deposits and makes loansSets excess reservesThe Non-Bank PublicHolds either deposits or cash
5 Money CreationBanks create money in their normal, day-to-day profit seeking activitiesBanks do not try to create moneyMoney creation occurs because we have a fractional reserve commercial banking system.Banks must hold a fraction of their deposits idle as reserves. They may lend the remainder.As they make loans, new deposits are created, causing the money supply to expand.
6 Bank Reserves Total Reserves = Required reserves plus excess reserves Required reserves = Deposits times reserve requirementExcess reserves = Total reserves minus required reserves
8 The M1 Model: Derivation Definitions:M1 = D + CBase = R + CTotal Deposits = DAssumptions:r = R/D = required reserve ratio for depositse = E/D = the excess reserve ratioc = C/D = the ratio of currency to deposits
9 The M1 Model: Derivation B = R + CR = rD + ED = DC = cDE = eDB = rD + eD + cDB = D(r + e + c)1( r + e + c)D =B
10 The M1 Model: Derivation M1 = D + CM1 = D + cDM1 = D(1 + c) Factor out DM1 = c r + e + cBM1 = Multiplier x Base
11 Money Multiplier Terms Changes in rIf r increases, the multiplier decreasesIf r decreases, the multiplier increasesThe money multiplier and M1 are negatively related.
12 Money Multiplier Terms Changes in cIf c increases, reserves drain from the banking system.Fewer reserves mean less expansion of deposits.If c decreases, reserves in the banking system increase.More reserves mean more expansion of deposits.The money multiplier and M1 are negatively related.
13 Money Multiplier Terms Changes in eAn increase in e means banks are holding more excess reserves and lending less.A decrease in e means banks are holding fewer excess reserves and lending more.The money multiplier and M1 are negatively related.
14 The Money Supply: Summary The money supply equals the monetary base times the money multiplierThe monetary base (base) is defined as:Base = Reserves + CurrencyBase can be controlled by the Federal ReserveThe multiplier reflects the ability of the banking system to expand depositsThe multiplier = 1 + c/(r + e + c)The value of the multiplier is determined by the Fed, banks, and the members of the non-bank public.Definitions:M1 = D + CB = R + CD = D M1 = D + CR = rD M1 = D + cDE = eD M1 = D(1 + c)C = cD M1 = 1 + c/(r + e + c) * BModel:R = rD + eDB = rD + eD + cDB = D(r + e + c)D = B/(r + e + c)
15 Open Market Operations Fed BankPresidentsSecuritiesDealersChangeinReservesChange inMoneySupplyFederal OpenMarket Comm.Federal ReserveBank of New YorkCommercialBanksFed Board ofGovernors
16 Open Market Operations When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves.When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed
17 Discount LoansWhen the Fed makes a discount loan to a bank, the bank is credited with an increase in reserves.When a bank repays the Fed, the bank’s reserves are debited.
18 Reserve RequirementsIf the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease.If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.
19 Excess Reserves Banks determine the level of excess reserves Increases in excess reserves diminish the expansion of deposits.Decreases in excess reserves increase the expansion of deposits
20 Currency DrainsMembers of the non-bank public determine currency in circulationIncreases in currency drains from the banking system, diminish the expansion of depositsDecreases in currency drains from the banking system, increase the expansion of deposits
21 Central Bank Policy Channels Cost & Availabilityof CreditFullEmploymentGrowthPriceStabilityPolicyToolsVolumeandGrowthofBorrowingSpendingby thePublicSize and GrowthRate of MoneySupplyLevel & GrowthBank ReservesMarket Valueof Securities