1. Chapter 15
Money supply Process

2. Four players in the Money Supply Process
Functions of the central Bank
The central Bank Balance sheet
Monetary Policy
Control of the Monetary Base
Deposit Creation

3. Four players in the Money Supply Process
(1) The central Bank: The government agency that oversees the banking system , and is responsible for the conduct of monetary policy. (2) Banks (Depository Institutions): The financial Intermediaries that accept deposits from individuals & institutions and make loans : commercial banks , savings& loan associations & credit Unions

4. (3) Depositors: Individuals and institutions that hold deposits in banks. (4) Borrowers from banks: Individuals and institutions that borrow from the depository Institutions , and institutions that issue bonds that are purchased by the Depository Institutions.

5. Functions of the Central Bank:
Monopoly of Note Issuing:
Central bank concentrated on the Management of government accounts, and on the issuing of notes.
(2) Lender of the last Resort:
the central bank is the provider of reserves to financial institutions. When no else would provide them in order to prevent a financial crisis.

6. (3) Government Banker: A) The central bank keeps an account for the treasury, into which its revenues are deposits , and from which its expenses are met B) It acts as a government agent for the management of the National Debt (conducting short term & long term loans for the government) c) It is responsible for implementing government monetary policy , which aims at controlling the amount of money in circulation (to control the inflation rate) d) It has the important job of controlling foreign exchange

7. (4) A Banker’s Bank: The central bank holds deposits made by commercial banks, which appear in its balance sheet in the liability side( appear in the balance sheet of commercial banks in the asset side) 5) Control of credit and cash available to the public

8. The central Bank Balance sheet
Total assets = total liabilities + capital
The central banks assets are those things it owns and claims it has on outside entities
The central bank’s liabilities are debts it owes, or claims that outside entities have on the central bank
The central bank’s capital accounts are simply the difference between its total assets and total liabilities

9. The Central bank Assets liabilities Government securities Currency in circulation Discount Loans Reserves

10. Liabilities: Currency in circulation : is the amount of currency in the hands of the public Currency held by depository institutions is also a liability of the central bank Reserves: reserves are Assets for the banks, but liabilities for the central bank. This is because the banks can demand payment on them at any time, and the central bank is required to satisfy its obligation

11. Assets : Government Securities: these covers the central bank’s holdings of securities issued by the treasury. Discount loans: the central bank can provide reserves to the banking system by making discount loans to banks

12. Tools of Monetary Policy
Monetary policy is deliberate action taken to affect the size of the Economy’s Money supply for the purpose of promoting economic stability and maximum output and employment with a minimum of inflation

13. First: the three major tools of Monetary policy
Open market operations
Setting reserves requirements for commercial banks and other depository institutions
Setting the level of the discount rate

14. (1) Open market operations
The central bank can directly affect the amount of bank reserves by buying or selling government securities ( stock, bonds) , in the open market where these securities are traded. Such transactions are called open market operations
When the central bank conducts open market purchases, it buys government bonds and puts reserves into the banking system, causing an expansion of demand deposits and other checkable deposits, and hence an increase in the economy’s money supply

15. When the central bank conducts open market sales , it sells government bonds and takes reserves out of the banking system, causing a contraction of demand deposits and other checkable deposits, and hence a decrease in the economy’s money supply

16. A) Open market Purchases
Suppose that the central bank buy 1000 of government securities in open market, and that the seller is a commercial bank
The central bank pays the commercial bank by increasing the commercial bank’s reserves account by the amount of 1000

17. The changes in the central bank’s balance sheet Assets liabilities Gov securities 1000 commercial bank 1000 Reserves deposits

18. The changes in the commercial bank’s balance sheet Assets liabilities Deposits at the Central bank( Reserves) Gov securities – 1000

19. Suppose that the central bank buys 1000 of gov securities in the open market from an individual or a business (or corporation) other than a bank.
The central bank simply makes out a check for 1000 drawn against it and payable to the seller deposits the check in a commercial bank. The commercial bank for collection, and the commercial bank’s reserves account at the central bank is increased by 1000

20. The changes in the central bank’s balance sheet Assets liabilities Securities commercial bank Reserves deposits

21. The changes in the commercial bank’s balance sheet Assets liabilities Deposits at the Demand deposits Central bank

22. In general, we can say that commercial bank reserves are increased by the amount of central bank open market purchase no matter whether the seller of the securities is a bank or a nonbank

23. B) Open market Sales
Suppose that the central bank sells 1000 of government securitiesin open market, and that the buyer is a commercial bank
The central bank takes payment from the commercial bank by reducing the commercial bank’s reserves account by the amount of 1000

24. The changes in the central bank’s balance sheet Assets liabilities Gov securities – commercial bank Reserves deposits

25. The changes in the commercial bank’s balance sheet Assets liabilities Deposits at the Central bank Gov securities+1000

26. What if the buyer of the 1000 of gov securities sold by the central bank is an individual or business other than a bank?
Suppose that payment is made to the central bank with a check drawn against the buyer’s deposit at a commercial bank. When the central bank receives the check, it decreases the commercial bank’s reserves deposits at it by 1000

27. The changes in the central bank’s balance sheet Assets liabilities Securities commercial bank-1000 Reserves deposits

28. The changes in the commercial bank’s balance sheet Assets liabilities Deposits at the Demand deposits Central bank

29. In general , we can say that bank reserves are decreased by the amount of central bank open market sales, regardless of whether the buyer is a bank or a nonbank.

30. (2) Legal Reserves Requirements
The central bank has the authority to set the required reserve ratios within limits. The required reserves ratio establishes the minimum amount of reserves that banks must hold against demand deposits liabilities . How does the central bank affect the economy’s money supply by changing bank reserve requirements?

31. Suppose that all banks in the banking system are fully loaned up and that the required reserve ratio is 10% . The balance sheet of a commercial bank would look like
Assets liabilities
Reserves Demand
deposits

32. (A) Increase in the legal Reserves Requirement
Suppose that the central bank wants to tighten up the economy’s money supply, this means that the central bank wants to force the banks in the banking system to reduce their lending activity or their holdings of other earnings.
Suppose that the central bank increase the legal reserve requirement from 10% to 12%. Our bank is now required to hold 120,000 of reserves against its of demand deposits

33. Since it only has 100000 of reserves, it is 20000 short
Since it only has of reserves, it is short. In order to make up this deficiency, the bank must reduce its loans or sell off of its other earnings assets

34. (B) Decrease in the legal Reserves Requirement
If the central bank wants to increase the money supply, it can reduce the reserves requirement.
Suppose that the central bank reduce the required reserve ratio from 10% to 8%. Our bank is now required to hold of reserves against its of demand deposits
Therefore , it has of excess reserves.

35. In general, we can say that an increase in the required reserve ratio will force a money supply reduction. A decrease in the required reserve ratio increase the amount of excess reserves, encouraging banks to increase lending and deposit expansion, thereby increasing the money supply.

36. (3) Setting the Discount Rate
The depository institutions make loans to the public, and the central banks make loans to depository institutions.
Banks naturally find it attractive to borrow from the central bank, whenever the interest rates they can earn from making loans to business and consumers greater than the discount rate.

37. On the other hand, when the discount rate is higher than these interest rates, banks are discourage from borrowing at the central bank.
In general, we can say that if the central bank raises the discount rate, bank borrowing is reduced, and the amount of reserves in the banking system falls . this tends to deposit contraction, and a reduction in the size of the money supply
If the central bank lowers the discount rate, bank borrowing rises, causing an increase in reserves and deposit expansion and hence an increase in the money supply

38. Control of the Monetary Base
The monetary base consists of those liabilities of the Monetary authorities
MB = C+ R
MB is the monetary base
C currency in circulation
R total Reserves in Banking system

39. How will a central bank sale of 100 of government bonds to banks affect the monetary base & reserves?
Banking system
Assets liabilities
Securities +100
Reserves -100

40. The Central Bank Assets liabilities Gov securities-100 Reserves -100 change in monetary base = -100 change in reserves = -100

41. How will a central bank sale of 100 of government bonds to the nonbank public affect the monetary base & reserves if the nonbank public pays for the bonds with checks?
Nonpublic public
Assets liabilities
Securities +100
checkabledeposits-100

42. BANKING SYSTEM Assets Liabilities Reserves -100 checkable deposits central bank Government securities -100 Reserves -100 Change in monetary base =-100 Change in reserves = -100

43. How will a central bank sale of 100 of government bonds to the nonbank public affect the monetary base & reserves if the nonbank public pays for the bonds with currency?
Nonpublic public
Assets liabilities
Securities +100
Currency -100

44. central bank Government securities -100 currency in circulation -100 Change in monetary base =-100 Change in reserves = 0

45. Multiple Deposits creation: A simple Model
When the central bank supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount .this process is called multiple deposits creation

46. A- How the central bank provides Reserves to the banking system
The central bank provides reserves to the banking system by purchasing bonds or by making loans o the bank
Suppose that the central bank makes 100 discount loan to the first National bank

47. First National Bank Assets Liabilities Reserves 100 Discount loan 100

48. The central Bank Assets Liabilities Discount loan 100 Reserves 100

49. (2) Suppose that the central bank buy 100 worth of bonds from the first National Bank, and pays for them with a check written on itself.

50. First National Bank Assets Liabilities Reserves 100 securities - 100

51. The central Bank Assets Liabilities Securities 100 Reserves 100

52. B- Deposits creation : the single Bank
When a bank acquires additional excess reserves , either through the sale of securities or a discount loan from the central bank, it can lend the amount of its excess reserves, thereby expanding deposits by an amount = to the increase in reserves.

53. First National Bank Assets Liabilities securities - 100 loans +100

54. C- Deposit creation : the banking system
Although an individual bank can lend& create deposits of an amount equal to its excess reserves, the banking system can generate a multiple expansion of deposits, when reserves in the system increase.
When the central bank provides additional reserves to the banking system, checkable deposits, and therefore the money supply increase by an amount that exceeds the initial change in reserves.

55. The formula for the simple deposits Multiplier can be written as:
∆ D= ⅟r × ∆ R
Where
∆ D represents change in total checkable deposits in the banking system
r represents required reserve ratio
∆ R represents change in reserves for the banking system

56. Increase in reserves
Increase in loans
Increase in deposits
bank
100
First national 10 90 A 9 81 B
8.10
72.90 C
7.29
65.61 D
6.56
59.05 E
5.91
53.14 F
1000
Total for all banks

57. Also a decline in the banking system’s reserves will cause a multiple contraction of deposits, a process opposite that of multiple deposits creation.

58. Critique of the simple Model
If some proceeds from loans are used to raise the holdings of currency, checkable deposits will not increase by as much as our simple model of multiple deposit creation tells us