1. Chapter 17 The Money Supply Process

2. Preview
This chapter provides an overview of how the banking system create deposits and describes the basic principles of the money supply creation process

3. Learning Objectives
List and describe the “three players” that influence the money supply – actually four players.
Identify the factors that affect the monetary base and discuss their effects on the Federal Reserve’s balance sheet.
Explain and illustrate the deposit creation process using T-accounts.

4. Mishkin says “three players” in the Money Supply Process – actually four players
The Central bank: Federal Reserve System
Banks: depository institutions; financial intermediaries
Depositors: individuals and institutions
Borrowers: Banks create money when they make loans

5. How Banks Create Money M1 is currency + deposits.
By granting loans, banks create money.
The balance sheet on the left is an example of a ___________?

6. The Fed’s Balance Sheet Major Assets and Liabilities
Federal Reserve System
Assets
Liabilities
Securities
Currency in circulation
Loans to Banks
Reserves
Liabilities
Currency in circulation: in the hands of the public
Reserves: bank deposits at the Fed and vault cash
Assets
Government securities: holdings by the Fed that affect money supply and earn interest
Discount loans (loans to banks): provide reserves to banks and earn the discount rate

7. Control of the Monetary Base

8. Open Market Purchase (Fed Buys Securities) from a Bank
Banking System
Federal Reserve System
Assets
Liabilities
Securities
-$100m
+$100m
Reserves
Net result is that reserves have increased by $100
No change in currency
Monetary base has increased by $100

9. Open Market Purchase from the Nonbank Public
Banking System
Federal Reserve System
Assets
Liabilities
Reserves
+$100m
Checkable deposits
Securities
Person selling bonds to the Fed deposits the Fed’s check in the bank
Same result as the purchase from a bank
reserves have increased by $100
no change in currency
monetary base has increased by $100

10. Open Market Purchase from the Nonbank Public – seller holds cash
Federal Reserve System
Assets
Liabilities
Securities
-$100m
+$100m
Currency in circulation
Currency
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 increases by $100 - the amount of the open market purchase

11. Open Market Purchase: Summary
The effect on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits.
The effect on the monetary base always increases the monetary base by the amount of the purchase.
The effect of open market operations on the monetary base is much more certain than the effect on reserves.

12. Open Market Sale (Fed Sells Bonds) to the Public)
Nonbank Public
Federal Reserve System
Assets
Liabilities
Securities
+$100m
-$100m
Currency in circulation
Currency
Reduces the monetary base by the amount of the sale
Reserves remain unchanged

13. Shifts from Deposits into Currency
Nonbank Public
Banking System
Assets
Liabilities
Checkable deposits
-$100m
Reserves
Currency
+$100m
Federal Reserve System
Assets
Liabilities
Currency in circulation
+$100m
Reserves
-$100m
Net effect on monetary liabilities is zero
Monetary base is unchanged, it is a relatively stable variable

14. Loans to Financial Institutions
Banking System
Federal Reserve System
Assets
Liabilities
Reserves
+$100m
Loans
Monetary liabilities of the Fed have increased by $100
Monetary base also increases by $100.

15. The Fed’s Ability to Control the Monetary Base
Open market operations are controlled by the Fed.
The Fed cannot determine the amount of borrowing by banks from the Fed.
Split the monetary base into two components:
MB = MBn + BR
The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Fed.

16. Multiple Deposit Creation: Fed buys $100m in Bonds from First National Bank
Deposit creation by single bank - 10% reserve requirement
First National Bank
Assets
Liabilities
Securities
-$100m
Checkable deposits
+$100m
Reserves
Loans
Excess reserves increase buy $100
Bank lends the excess reserves
Creates a checking account
Borrower makes purchases
The Money supply has increased by $100.
First National Bank
Assets
Liabilities
Securities
-$100m
Loans
+$100m

17. Multiple Deposit Creation: Fed buys $100m in Bonds from First National Bank
Deposit creation by single bank - 10% reserve requirement
Second Bank
Assets
Liabilities
Reserves
+$100m
Checkable deposits
+$10
Loans
+$90
Third Bank
+$9
+$81

18. Table 1 Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves)

19. Deriving The Formula for the Simple Deposit Multiplier

20. Simple is Too Simple Holding cash stops the process
Currency has no multiple deposit expansion
Banks may not lend all of their excess reserves to buy securities or make loans.
Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change.

21. Factors that Determine the Money Supply
Changes in the monetary base
The money supply is positively related to the monetary base MB
Changes in the required reserves ratio
The money supply is negatively related to the required reserve ratio.
Changes in currency holdings
The money supply is negatively related to currency holdings.
Changes in excess reserves
The money supply is negatively related to the amount of excess reserves.

22. The Money Multiplier
Use M1 Definition: currency plus checkable deposits
Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

23. Deriving the Money Multiplier
Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D.
Define:
c = (C/D) = currency ratio
e = (ER/D) = excess reserves ratio

24. Deriving the Money Multiplier

25. Deriving the Money Multiplier
The monetary base MB equals currency (C) plus reserves (R):
MB = C + R
= C + (r x D) + ER
This equation shows the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.

26. Deriving the Money Multiplier

27. Example -

28. Quantitative Easing and the Money Supply, 2007-2014
When the global financial crisis began in 2007, the Fed initiated lending programs and large-scale asset-purchase programs in an attempt to bolster the economy.
By June 2014, purchases of securities had led to a quintupling of the Fed’s balance sheet.
The lending and asset-purchase programs resulted in a huge expansion of the monetary base and have been given the name “quantitative easing.”

29. 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.

30. 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.

31. Credit facilities set up during the financial crisis.
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.
Credit facilities set up during the financial crisis.

32. THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS
LIABILITIES
Gold $
11,037
$1,122,000
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.

33. THE FEDERAL RESERVE BALANCE SHEET: February 2015
Very much the same today
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.

34. The increase in the monetary base did not lead to an equivalent change in the money supply because excess reserves increased dramatically
Source: Federal Reserve Bank of St. Louis, FRED database:

35. Excess Reserves Ratio and Currency Ratio, 2007-2014
Source: Federal Reserve Bank of St. Louis, FRED database:

36. The Limits on the Central Bank’s Ability to Control the Quantity of Money

37. The various factors affecting the money supply change over time.
The Limits on the Central Bank’s Ability to Control the Quantity of Money
The various factors affecting the money supply change over time.
Market interest rates affect the cost of holding both excess reserves and currency.
As interest rates increase, we expect to see {ER/D} and {C/D} fall.
This increases the money multiplier and the quantity of money.
Uncertainty increases {ER/D} and {C/D}.

38. The Limits on the Central Bank’s Ability to Control the Quantity of Money
If these changes in the money multiplier were predictable, the central bank might choose to exploit this link in its policymaking.
But, the money multiplier is too variable.
The relationship between the monetary base and the quantity of money is not something that a central bank can exploit for short-run policy purposes.
For short-run policy, interest rates have become the monetary policy tool of choice.

39. 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)

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

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