1. Money Supply

2. Learning Objectives Review the money supply expansion process.
Learn how to derive the M1 model.
Understand how the interaction of the money multiplier and base determine M1.
Understand the role of the Federal Reserve, the commercial banking system, and the non-bank public in the money creation process.

3. The Money Supply M1: Currency + travelers checks + checkable deposits
M2: M1 + small time deposits + overnight repurchase agreements + overnight Eurodollars + money market mutual fund balances
M3: M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money market fund balances

4. The Creators of Money
The three major players whose decisions and actions determine the rate of growth in the money supply are:
The Federal Reserve (Fed)
Sets reserve requirements
Operates the discount window
Engages in open market operations
The Commercial Banking System
Accepts deposits and makes loans
Sets excess reserves
The Non-Bank Public
Holds either deposits or cash

5. Money Creation
Banks create money in their normal, day-to-day profit seeking activities
Banks do not try to create money
Money creation occurs because we have a fractional reserve commercial banking system.
Banks must hold a fraction of their deposits idle as reserves. They may lend the remainder.
As they make loans, new deposits are created, causing the money supply to expand.

6. Bank Reserves Total Reserves = Required reserves plus excess reserves
Required reserves = Deposits times reserve requirement
Excess reserves = Total reserves minus required reserves

7. Money Creation: Summary
New Deposit Required Reserves Excess Reserves New Loan
$100
$100
$ $ $ $ 90
$ $ $ $ 81
$ $ $ $ 72.90
$ $ $ $
$ $ $ $
$1, $ $ $900

8. The M1 Model: Derivation
Definitions:
M1 = D + C
Base = R + C
Total Deposits = D
Assumptions:
r = R/D = required reserve ratio for deposits
e = E/D = the excess reserve ratio
c = C/D = the ratio of currency to deposits

9. The M1 Model: Derivation
B = R + C
R = rD + E
D = D
C = cD
E = eD
B = rD + eD + cD
B = D(r + e + c) 1
( r + e + c)
D = B

10. The M1 Model: Derivation
M1 = D + C
M1 = D + cD
M1 = D(1 + c) Factor out D
M1 = c r + e + c B
M1 = Multiplier x Base

11. Money Multiplier Terms
Changes in r
If r increases, the multiplier decreases
If r decreases, the multiplier increases
The money multiplier and M1 are negatively related.

12. Money Multiplier Terms
Changes in c
If c increases, reserves drain from the banking system.
Fewer reserves mean less expansion of deposits.
If c decreases, reserves in the banking system increase.
More reserves mean more expansion of deposits.
The money multiplier and M1 are negatively related.

13. Money Multiplier Terms
Changes in e
An increase in e means banks are holding more excess reserves and lending less.
A decrease in e means banks are holding fewer excess reserves and lending more.
The money multiplier and M1 are negatively related.

14. The Money Supply: Summary
The money supply equals the monetary base times the money multiplier
The monetary base (base) is defined as:
Base = Reserves + Currency
Base can be controlled by the Federal Reserve
The multiplier reflects the ability of the banking system to expand deposits
The multiplier = 1 + c/(r + e + c)
The value of the multiplier is determined by the Fed, banks, and the members of the non-bank public.
Definitions:
M1 = D + C
B = R + C
D = D M1 = D + C
R = rD M1 = D + cD
E = eD M1 = D(1 + c)
C = cD M1 = 1 + c/(r + e + c) * B
Model:
R = rD + eD
B = rD + eD + cD
B = D(r + e + c)
D = B/(r + e + c)

15. Open Market Operations
Fed Bank
Presidents
Securities
Dealers
Change in
Reserves
Change in
Money
Supply
Federal Open
Market Comm.
Federal Reserve
Bank of New York
Commercial
Banks
Fed Board of
Governors

16. Open Market Operations
When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves.
When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed

17. Discount Loans
When the Fed makes a discount loan to a bank, the bank is credited with an increase in reserves.
When a bank repays the Fed, the bank’s reserves are debited.

18. Reserve Requirements
If the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease.
If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.

19. Excess Reserves Banks determine the level of excess reserves
Increases in excess reserves diminish the expansion of deposits.
Decreases in excess reserves increase the expansion of deposits

20. Currency Drains
Members of the non-bank public determine currency in circulation
Increases in currency drains from the banking system, diminish the expansion of deposits
Decreases in currency drains from the banking system, increase the expansion of deposits

21. Central Bank Policy Channels
Cost & Availability
of Credit
Full
Employment
Growth
Price
Stability
Policy
Tools
Volume
and
Growth of
Borrowing
Spending
by the
Public
Size and Growth
Rate of Money
Supply
Level & Growth
Bank Reserves
Market Value
of Securities