Chapter 17 The Money Supply Process

Players in the Money Supply Process Central bank (Federal Reserve) Banks (depository institutions) Depositors (individuals and institutions) Borrowers

Fed’s Balance Sheet (important items) Federal Reserve System Assets Liabilities Government Securities and Mortgage Backed Securities Currency in circulation Discount loans Reserves 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

The Federal Reserve Balance Sheet: June 2003 Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETS LIABILITIES Gold $ 11,045 $593,031 Federal Reserve notes (outstanding) Loans to banks 36,538 U.S. Treasury securities 550,314 20,359 Bank reserves (from depository institutions) 6,219 U.S. Treasury Deposits All other assets 46,268 24,556 All other liabilities and net worth Total 644,165 $644,165 Source: Federal Reserve Bulletin, August 2003, Table 1.18.

Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis (Millions of Dollars) ASSETS LIABILITIES Gold $ 11,037 $777,769 Federal Reserve notes (outstanding) Loans to banks 1,342 Deposits: U.S. Treasury securities 779,642 12,771 Bank reserves (from depository institutions) 4,572 U.S. Treasury deposit All other assets 82,451 79,360 All other liabilities and net worth Total 874,472 $874,472 Source: Board of Governors of the Federal Reserve System.

THE FEDERAL RESERVE BALANCE SHEET: August 2009 ASSETS LIABILITIES Gold $ 11,037 $872,150 Federal Reserve notes (outstanding) Loans to banks 339,335 Deposits: U.S. Treasury securities 705,331 724,650 Bank reserves (from depository institutions) 261,487 U.S. Treasury All other assets 936,031 133,447 All other liabilities and net worth Total 1,991,734 $1,991,734 Source: Board of Governors of the Federal Reserve System.

THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETS LIABILITIES Gold $ 11,037 $1122,000 Federal Reserve notes (outstanding) Loans to banks 449 Deposits: U.S. Treasury securities 1730,000 1,795,000 Bank reserves (from depository institutions) Mortgages 1,083,000 42,000 U.S. Treasury All other assets 234,000 116,000 All other liabilities and net worth Total 3,075,000 $3,075,000 Source: Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/h41/Current/

THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETS LIABILITIES Gold $ 11,037 $1,315,000 Federal Reserve notes (outstanding) Loans to banks 59 Deposits: U.S. Treasury securities 2,450,000 2,748,000 Bank reserves (from depository institutions) Mortgages 1,731,000 65,000 U.S. Treasury All other assets 290,000 353,000 All other liabilities (reverse Repo) and net worth Total 4,481,000 $4,481,000 Source: Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/releases/h41/Current/

Monetary Base (High Powered Money) Note: Vault cash is included in reserves. Recall: M1 = C + DD

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?

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?

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

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

Fed Open Market Sale to non-bank public Federal Reserve System Assets Liabilities Securities +$100 -$100 Currency in circulation Currency 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

Public withdraws $100 from Commercial Bank +$100

Fed Discount Loan to a Bank $100

Paying Off a Discount Loan from the Fed Banking System Federal Reserve System Assets Liabilities Reserves -$100 Discount loans 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

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

Deposit Creation: The Banking System (10% Reserve Requirement) Bank A Assets Liabilities Reserves +$100 Checkable deposits +$10 Loans +$90 Bank B +$9 +$81

Creation of Deposits (assuming 10% reserve requirement and the initial $100 increase in reserves)

The Formula for the Simple Deposit Multiplier

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.

M1 = m x MB 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 M1 = m x MB

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

Deriving the M1 Money Multiplier: m M1 = m  MB Reserves: R = RR + ER Required Reserves: RR = r  D R = (r  D) + ER

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 ;

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

Example

Case Study: The Great Depression Bank Panics, 1930 - 1933. 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)

Case Study: The Great Depression Bank Panic, 1930 - 1933 Case Study: The Great Depression Bank Panic, 1930 - 1933. 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)

Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?

Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933

Case Study: Money Supply 1980 -2005

Determinants of the Money Supply