© 2012 Pearson Education, Inc. Publishing as Prentice Hall 1 of 46 Our model of how the money supply is determined includes three actors: 1.The Federal Reserve, which is responsible for controlling the money supply and regulating the banking system. 2.The banking system, which creates the checking accounts that are the most important component of the M1 measure of the money supply. 3.The nonbank public, which refers to all households and firms. The nonbank public decides the form in which they wish to hold moneyfor instance, as currency or as checking account balances. Figure 14.1 The Money Supply Process Three actors determine the money supply: the central bank (the Fed), the nonbank public, and the banking system.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 2 of 46 The process starts with the monetary base, which is also called high- powered money. Monetary base (or high-powered money) The sum of bank reserves and currency in circulation. Monetary base = Currency in circulation + Reserves. The money multiplier links the monetary base to the money supply. As long as the value of the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. There is a close connection between the monetary base and the Feds balance sheet, which lists the Feds assets and liabilities.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 3 of 46 Table 14.1 The Federal Reserves Balance Sheet

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 46 Reserve deposits are assets for banks, but they are liabilities for the Fed because banks can request that the Fed repay the deposits on demand with Federal Reserve Notes. The Monetary Base Currency in circulation Paper money and coins held by the nonbank public. Vault cash Currency held by banks. Currency in circulation = Currency outstanding – Vault cash. Bank reserves Bank deposits with the Fed plus vault cash. Reserves = Bank deposits with the Fed + Vault cash.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 46 Required reserves Reserves that the Fed compels banks to hold. Excess reserves Reserves that banks hold over and above those the Fed requires them to hold. Required reserve ratio The percentage of checkable deposits that the Fed specifies that banks must hold as reserves. Reserves = Required reserves + Excess reserves.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 46 How the Fed Changes the Monetary Base Open market operations The Federal Reserves purchases and sales of securities, usually U.S. Treasury securities, in financial markets. Open market purchase The Federal Reserves purchase of securities, usually U.S. Treasury securities. Open market operations are carried out by the Feds trading desk, which buys and sells securities electronically with primary dealers. In 2010, there were 18 primary dealers, who are commercial banks, investment banks, and securities dealers. In an open market purchase, which raises the monetary base, the Fed buys Treasury securities. The Fed increases or decreases the monetary base by changing the levels of its assetsthat is, the Fed changes the monetary base by buying and selling Treasury securities or by making discount loans to banks.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 7 of 46 We use a T-account for the whole banking system to show the results of the Feds open market purchase: The Feds open market purchase from Bank of America increases reserves by $1 million and, therefore, the monetary base increases by $1 million. A key point is that the monetary base increases by the dollar amount of an open market purchase.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 46 Open market sale The Feds sale of securities, usually Treasury securities. Because reserves have fallen by $1 million, so has the monetary base. We can conclude that the monetary base decreases by the dollar amount of an open market sale.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 46 The publics preference for currency relative to checkable deposits does not affect the monetary base. To see this, consider what happens if households and firms decide to withdraw $1 million from their checking accounts. One component of the monetary base (reserves) has fallen while the other (currency in circulation) has risen.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 46 Discount Loans Discount loan A loan made by the Federal Reserve, typically to a commercial bank. Discount loans alter bank reserves and cause a change in the monetary base. An increase in discount loans affects both sides of the Feds balance sheet: As a result of the Feds making $1 million of discount loans, bank reserves and the monetary base increase by $1 million.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 46 If banks repay $1 million in discount loans to the Fed, reducing the total amount of discount loans, then the preceding transactions are reversed. Discount loans fall by $1 million, as do reserves and the monetary base:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 46 Comparing Open Market Operations and Discount Loans Discount rate The interest rate the Federal Reserve charges on discount loans. Both open market operations and discount loans change the monetary base, but the Fed has greater control over open market operations. The discount rate differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets. The monetary base has two components: the nonborrowed monetary base, B non, and borrowed reserves, BR, which is another name for discount loans. We can express the monetary base, B, as The Fed has control over the nonborrowed monetary base. B = B non + BR.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 46 Making the Connection Explaining the Explosion in the Monetary Base In the fall of 2008 when the Fed began to purchase hundreds of billions of dollars worth of mortgage-backed securities and other financial assets, it was inevitable that the monetary base would increase. The Federal Reserves Balance Sheet and the Monetary Base

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 46 We now turn to the money multiplier to further understand the factors that determine the money supply. The money multiplier is determined by the actions of three actors in the economy: the Fed, the nonbank public, and banks. The Simple Deposit Multiplier Multiple Deposit Expansion How a Single Bank Responds to an Increase in Reserves Suppose that the Fed purchases $100,000 in Treasury bills (or T-bills) from Bank of America, increasing its reserves that much. Here is how a T-account can reflect these transactions:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 46 Next, Bank of America extends a loan to Rosies Bakery by creating a checking account and depositing the $100,000 principal of the loan in it. Both the asset and liability sides of Bank of Americas balance sheet increase by $100,000: The Simple Deposit Multiplier If Rosies spends the loan proceeds by writing a check for $100,000 to buy ovens from Bobs Bakery Equipment and Bobs deposits the check in its account with PNC Bank, Bank of America will have lost $100,000 of reserves and checkable deposits:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 46 How the Banking System Responds to an Increase in Reserves After PNC has cleared the check and collected the funds from Bank of America, PNCs balance sheet changes as follows: The Simple Deposit Multiplier Suppose that PNC makes a $90,000 loan to Jeromes Printing who writes a check in that amount for equipment from Computer Universe who has an account at SunTrust Bank. The balance sheets change as follows:

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 46 Suppose that SunTrust lends its new excess reserves of $81,000 to Howards Barber Shop to use for remodeling. When Howards spends the loan proceeds and a check for $81,000 clears against it, the changes in SunTrusts balance sheet will be as follows: The Simple Deposit Multiplier If the proceeds of the loan to Howards Barber Shop are deposited in another bank, checkable deposits in the banking system will rise by another $81,000. To this point, the $100,000 increase in reserves supplied by the Fed has increased the level of checkable deposits by $100,000 + $90,000 + $81,000 = $271,000. This process is called multiple deposit creation. Multiple deposit creation Part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits and an increase in the money supply that is a multiple of the initial increase in reserves.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 18 of 46 The Simple Deposit Multiplier Calculating the Simple Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 46 The Simple Deposit Multiplier