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Chapter 17 The Money Supply Process. Players in the Money Supply Process Central bank (Federal Reserve) Banks (depository institutions) Depositors (individuals.

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Presentation on theme: "Chapter 17 The Money Supply Process. Players in the Money Supply Process Central bank (Federal Reserve) Banks (depository institutions) Depositors (individuals."— Presentation transcript:

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) 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 Federal Reserve System AssetsLiabilities Government Securities and Mortgage Backed Securities Currency in circulation Discount loansReserves

4 The Federal Reserve Balance Sheet: June 2003 Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETSLIABILITIES Gold$11,045$593,031Federal Reserve notes (outstanding) Loans to banks36,538 U.S. Treasury securities 550,31420,359Bank reserves (from depository institutions) 6,219U.S. Treasury Deposits All other assets46,26824,556All other liabilities and net worth Total$644,165$644,165Total 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) ASSETSLIABILITIES Gold$11,037$777,769Federal Reserve notes (outstanding) Loans to banks1,342 Deposits: U.S. Treasury securities 779,64212,771Bank reserves (from depository institutions) 4,572U.S. Treasury deposit All other assets 82,451 79,360All other liabilities and net worth Total$874,472$874,472Total Source: Board of Governors of the Federal Reserve System.

6 THE FEDERAL RESERVE BALANCE SHEET: August 2009 ASSETSLIABILITIES Gold$11,037$872,150Federal Reserve notes (outstanding) Loans to banks339,335 Deposits: U.S. Treasury securities 705,331724,650Bank reserves (from depository institutions) 261,487U.S. Treasury All other assets 936, ,447All other liabilities and net worth Total $ 1,991,734 $ 1,991,734 Total Source: Board of Governors of the Federal Reserve System.

7 THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETSLIABILITIES Gold$11,037$1122,000Federal Reserve notes (outstanding) Loans to banks449Deposits: U.S. Treasury securities 1730,000 1,795,000Bank reserves (from depository institutions) Mortgages 1,083,000 42,000U.S. Treasury All other assets 234, ,000All other liabilities and net worth Total $3,075,000$3,075,000 Total Source: Board of Governors of the Federal Reserve System.

8 THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETSLIABILITIES Gold$11,037$1,315,000Federal Reserve notes (outstanding) Loans to banks59Deposits: U.S. Treasury securities 2,450,000 2,748,000Bank reserves (from depository institutions) Mortgages 1,731,000 65,000U.S. Treasury All other assets 290, ,000All other liabilities (reverse Repo) and net worth Total $4,481,000$4,481,000 Total 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 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 Nonbank PublicFederal Reserve System AssetsLiabilitiesAssetsLiabilities Securities+$100Securities-$100Currency in circulation -$100 Currency-$100

15 Public withdraws $100 from Commercial Bank +$100

16 $100 Fed Discount Loan to a Bank

17 Paying Off a Discount Loan from the Fed 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 Banking SystemFederal Reserve System AssetsLiabilitiesAssetsLiabilities Reserves-$100Discount loans -$100Discount loans -$100Reserves-$100

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

19 Deposit Creation: The Banking System (10% Reserve Requirement) Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves+$10Checkable deposits +$100 Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Checkable deposits +$90Reserves+$9Checkable deposits +$90 Loans+$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 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 M 1 = 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, 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, 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

33

34 Case Study: Money Supply

35 Determinants of the Money Supply


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