Chapter 18 The Fed, Depository Institutions, and the Money Supply Process ©2000 South-Western College Publishing

2 Open market operations The buying and selling of government securities by the Fed

3 Effect of Open Market Operations on Reserves When the Fed buys securities, reserves of depository institutions RISE When the Fed sells securities, reserves of depository institutions fall

4 Open Market Operations Interest Rates Deposit Creation Money Supply Credit Availability Reserves Lending Exhibit The Money Supply Process

5 Effect of Open Market Operations on Reserves Exhibit Fed Assets Liabilities (1) + $1,000 securities (3) + $1,000 deposit purchased from the due HLT public

6 Effect of Open Market Operations on Reserves Exhibit cont. Public Assets Liabilities (1) - $1,000 securities sold to the Fed public (2) + $1,000 deposits in the form of checks received from Fed and deposited in HLT

7 Effect of Open Market Operations on Reserves Exhibit cont. HLT National Bank Assets Liabilities (3) + $1,000 reserves (2) + $1,000 deposit in the form of deposits by the public by the Fed

8 Effect of Discount Loans on Monetary Base Exhibit Fed Assets Liabilities + $1,000 discount loans + $1,000 deposits due HLT

9 Effect of Discount Loans on Monetary Base Exhibit cont. HLT National Bank Assets Liabilities + $1,000 reserves + $1,000 discount loans

10 Factors that Affect the Reserves of Depository Institutions Exhibit Open Market Purchases Increases in discount loans Open Market Sales Decrease in discount loans Factors that increase reserves Factors that decrease reserves

11 Offsetting Open Market Operations Open market purchases or sales to offset changes in the monetary base from other factors

12 Federal Reserve Float The excess in reserves that results from a check being credited to one bank (or other depository institution) before it is debited from another

13 Total Reserves Required reserves plus excess reserves Required Reserves The amount of reserve assets that the Fed requires a depository institution to hold

14 Excess Reserves Reserves over and above those required by the Fed

15 Loan and Deposit Expansion at HLT National Bank Exhibit Assets Liabilities Total reserves $1,000 Checkable deposits $1,000 Assets Liabilities Required reserves $100 Checkable deposits $1,000 Excess reserves $900 New checkable Loan $900 deposits $900 Total $1,900 Total $1,900

16 What is loaned up? When a bank has no excess reserves left to serve as a basis for lending

17 Transactions between HLT National and Second National Bank Exhibit HLT National Bank Assets Liabilities Total Reserves Checkable Deposits $100 $1,000 Loan $900 Total $1,000 $1,000

18 Transactions between HLT National and Second National Bank Exhibit cont. Second National Bank Assets Liabilities Total Reserves Checkable Deposits $900 $900 Total $900 $900

19 Transactions of Second National and Third National Bank Exhibit Second National Bank Assets Liabilities Total Reserves Checkable Deposits $90 $900 Loans $810 Total $900 $900

20 Transactions of Second National and Third National Bank Exhibit cont. Third National Bank Assets Liabilities Total Reserves Checkable Deposits $810 $810 Total $810 $810

21 Required Reserve Ratio ( r D ) The fraction of deposits that depository institutions are required to hold as required reserve assets

22 Simple Money Multiplier The reciprocal of the required reserve ration, I/r D

23 (18-1) RR = r D  D (18-2) ER = TR  RR (18-3) TR = RR = r D  D (18-4) D = TR / r D (or) D = 1 / r D  TR (18-5) L = D = 1 / r D  TR RR = Required Reserve Assets r D = Required Reserve Ratio D = Deposit Liabilities ER = Excess Reserves TR = Total Reserves

24 Fractional Reserve Banking System A banking system in which individual banks hold reserve assets equal to a fraction of deposit liabilities

25 The Required Reserve Ratio and the Simple Money Multiplier Exhibit r D Simple Money Multiplier.05 1 /.05 = /.10 = /.20 = /.25 = /.50 = 2

26 The Money Supply and the Monetary Base = $487.3 = Monetary Base $470.4 Exhibit March 1999, billions * Travelers’ Checks included $ Currency in the Public’s hands* $44.9 $470.4* Reserves + Currency in the Public’s hands* Checkable Deposits = $1,090.7 = M1 +

27 Monetary Base Reserves plus currency in the hands of the public, denoted as MB

28 Money Multiplier The multiple of the change in the monetary base by which the money supply will change

29 Factors that Affect the Money Multiplier An Increase in... c (the desired ratio of currency to checkable deposits) e (the ratio of excess reserves held to checkable deposits) r D (the required reserve ratio) Caused by... The decision by the public to increase their holdings of currency relative to deposits The decision by the depository institutions to hold more excess reserves The decision by the Fed to increase the required reserve ratio Results in... A decrease in the money multiplier and a decrease in the money supply Exhibit

30 Factors that Affect the Money Multiplier A Decrease in... c (the desired ratio of currency to checkable deposits) e (the ratio of excess reserves held to checkable deposits) r D (the required reserve ratio) Caused by... The decision by the public to decrease their holdings of currency relative to deposits The decision by the depository institutions to hold fewer excess reserves The decision by the Fed to decrease the required reserve ratio Results in... An increase in the money multiplier and a increase in the money supply Exhibit cont.

31 Major Assets of the Fed * 1.Gold and SDRs Certificate Accounts and other Assets in Foreign Currencies 2.Loans 3.Securities 4.Floats *See Figure for detailed list.

32 Repurchase Agreement An arrangement whereby the New York Fed agrees to buy securities from the securities dealers with whom it does business regularly and the dealers agree to repurchase the securities on a specific day in the near future

33 Reverse Repurchase Agreement An arrangement whereby the New York Fed agrees to sell securities with dealers with whom it regularly does business and the Fed agrees to repurchase the securities on a specific day in the near future

34 Major Liabilities of the Fed 1.Federal Reserve Notes 2.Bank Deposits