Chapter 15: The Money Supply Process and the Money Multipliers

1. The Central Bank’s Balance Sheet Chapter Objectives Who determines the money supply? How does the central bank’s balance sheet differ from the balance sheets of other banks? What is the monetary base?

1. The Central Bank’s Balance Sheet Assets Government securities – Provides income – Liquidity Discount loans – Loans made to commercial banks Assets earn interest Liabilities Currency Reserves – Commercial bank reserves held at Fed Liabilities are costless

1. The Central Bank’s Balance Sheet Money supply is determined by the interaction of four groups: commercial banks and other depositories, depositors, borrowers, and the central bank. MB = C + R Monetary Base = Currency + Reserves

1. The Central Bank’s Balance Sheet MB = C + R Monetary Base = Currency + Reserves C = Currency = Notes + Coins (non-bank) R = Reserves = Vault cash + Reserves on deposit at Fed R = Reserves = Required reserves + Excess reserves Monetary Base = Currency + Vault cash + Reserves on deposit at Fed Monetary Base = Currency + Required reserves + Excess reserves

2. Open Market Operations Central bank increases monetary base: buys a security Note, however, that in any case the MB increases by the amount of the purchase because either C or R increases by the amount of the purchase. Keep in mind that currency in circulation means cash no longer in the central bank.

2. Open Market Operations Central bank decreases monetary base: sells a security When the central bank sells an asset, the MB shrinks because C (and/or R) decreases along with the central bank’s securities holdings and banks or the nonbank public own more securities but less C or R.

2. Open Market Operations Central bank increases monetary base: loans to a bank Central bank decreases monetary base: bank repays loan

3. A Simple Model of Multiple Deposit Creation Simple Deposit Multiplier Formula ∆D = (1/rr) x ∆R ∆D: change in deposits ∆R: change in reserves rr: required reserve ratio

3. A Simple Model of Multiple Deposit Creation Simple Deposit Multiplier Formula ∆D = (1/rr) x ∆R The central bank can control the multiplier by changing the reserve requirement (rr): As rr increases, ∆R has less effect on ∆D As rr decreases, ∆R has more effect on ∆D

3. A Simple Model of Multiple Deposit Creation Simple Deposit Multiplier Formula ∆D = (1/rr) x ∆R Weakness of the model: banks hold excess reserves and people prefer to hold cash