2 Players in the Money Supply Process Central bank (Federal Reserve)Banks (depository institutions)Depositors (individuals and institutions)Borrowers
3 Fed’s Balance Sheet (important items) Federal Reserve SystemAssetsLiabilitiesGovernment Securities and Mortgage Backed SecuritiesCurrency in circulationDiscount loansReservesMonetary LiabilitiesCurrency in circulation(in the hands of the public)Reserves: bank deposits at the FedAssetsGovernment 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
4 The Federal Reserve Balance Sheet: June 2003 Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars)ASSETSLIABILITIESGold$11,045$593,031Federal Reserve notes (outstanding)Loans to banks36,538U.S. Treasury securities550,31420,359Bank reserves (from depository institutions)6,219U.S. Treasury DepositsAll other assets46,26824,556All other liabilities and net worthTotal644,165$644,165Source: Federal Reserve Bulletin, August 2003, Table 1.18.
5 Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis(Millions of Dollars)ASSETSLIABILITIESGold$11,037$777,769Federal Reserve notes (outstanding)Loans to banks1,342Deposits:U.S. Treasury securities779,64212,771Bank reserves (from depository institutions)4,572U.S. Treasury depositAll other assets82,45179,360All other liabilities and net worthTotal874,472$874,472Source: Board of Governors of the Federal Reserve System.
6 THE FEDERAL RESERVE BALANCE SHEET: August 2009 ASSETSLIABILITIESGold$11,037$872,150Federal Reserve notes (outstanding)Loans to banks339,335Deposits:U.S. Treasury securities705,331724,650Bank reserves (from depository institutions)261,487U.S. TreasuryAll other assets936,031133,447All other liabilities and net worthTotal1,991,734$1,991,734Source: Board of Governors of the Federal Reserve System.
7 THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETSLIABILITIESGold$11,037$1122,000Federal Reserve notes (outstanding)Loans to banks449Deposits:U.S. Treasury securities1730,0001,795,000Bank reserves (from depository institutions)Mortgages1,083,00042,000U.S. TreasuryAll other assets234,000116,000All other liabilities and net worthTotal3,075,000$3,075,000Source: Board of Governors of the Federal Reserve System.
8 THE FEDERAL RESERVE BALANCE SHEET: February 2013 ASSETSLIABILITIESGold$11,037$1,315,000Federal Reserve notes (outstanding)Loans to banks59Deposits:U.S. Treasury securities2,450,0002,748,000Bank reserves (from depository institutions)Mortgages1,731,00065,000U.S. TreasuryAll other assets290,000353,000All other liabilities (reverse Repo) and net worthTotal4,481,000$4,481,000Source: Board of Governors of the Federal Reserve System.
9 Monetary Base (High Powered Money) Note: Vault cash is included in reserves.Recall: M1 = C + DD
10 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 currencyMonetary base (C + R) has increased by $100Has the money supply changed?
11 Fed Open Market Purchase from Nonbank Public Reserves have increased by $100.What about excess reserves?No change in currencyMonetary base (C + R) has increased by $100Has the money supply changed?
12 The person selling the bonds cashes the Fed’s check Reserves are unchangedCurrency in circulation increases by the amount of the open market purchaseMonetary base (C+R) increases by the amount of the open market purchase
13 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 depositsAlways increases the monetary base by the amount of the purchase:MB = C + R
14 Fed Open Market Sale to non-bank public Federal Reserve SystemAssetsLiabilitiesSecurities+$100-$100Currency in circulationCurrencyReduces the monetary base by the amount of the saleReserves remain unchangedThe effect of open market operations on the monetary base is much more certain than the effect on reserves
15 Public withdraws $100 from Commercial Bank +$100
17 Paying Off a Discount Loan from the Fed Banking SystemFederal Reserve SystemAssetsLiabilitiesReserves-$100Discount loansNet effect is to reduce the monetary baseMonetary base changes one-for-one with a change in the borrowings from the Federal Reserve System
18 Deposit Creation (Single Bank): Fed Open Market Purchase from First National Bank Step 1Step 2First National BankAssetsLiabilitiesSecurities-$100Checkable deposits+$100ReservesLoansStep 3First National BankAssetsLiabilitiesSecurities-$100Loans+$100
19 Deposit Creation: The Banking System (10% Reserve Requirement) Bank AAssetsLiabilitiesReserves+$100Checkable deposits+$10Loans+$90Bank B+$9+$81
20 Creation of Deposits (assuming 10% reserve requirement and the initial $100 increase in reserves)
22 Critique of the Deposit Multiplier Currency removes funds from the banking system and stops the deposit creation processHolding 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.
23 M1 = m x MB The M1 Money Multiplier M1 =currency + checkable deposits = C + DLink the money supply (M1) to the monetary base (MB) and let m be the money multiplierRecall: MB = C + RThis is why the MB is called High Powered MoneyM1 = m x MB
24 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 ratioe = (ER/D) = excess reserves ratio
25 Deriving the M1 Money Multiplier: m M1 = m MBReserves: R = RR + ERRequired Reserves: RR = r DR = (r D) + ER
26 Deriving the M1 Money Multiplier Math Trick:MB = RR ER CMB = (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 ;
27 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
29 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)
30 Case Study: The Great Depression Bank Panic, 1930 - 1933 Case Study: The Great Depression Bank Panic, Deposits of Failed Commercial BanksBank failures (and no deposit insurance) caused:Increase in deposit outflows and holding of currency (depositors)An increase in the amount of excess reserves (banks)
31 Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?
32 Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933