1. Money Supply Process Fundamentals of Finance – Lecture 6

2. Four Players in the Money Supply Process Central bank Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions) Borrowers

3. The Central Bank’s Balance Sheet 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 CB that affect money supply and earn interest – Discount loans: provide reserves to banks and earn the discount rate Central Bank AssetsLiabilities SecuritiesCurrency in circulation Loans to Financial Institutions Reserves

4. Control of the Monetary Base

5. Open Market Purchase from a Bank Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Securities- $100mSecurities+$100mReserves+$100m Reserves+$100m

6. Open Market Purchase from the Nonbank Public Person selling bonds to the CB deposits the CB’s check in the bank Identical result as the purchase from a bank Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100mCheckable deposits +$100mSecurities+$100mReserves+$100m

7. Open Market Purchase from the Nonbank Public (cont’d) The person selling the bonds cashes the CB’s check Reserves are unchanged Currency in circulation increases by the amount of the open market purchase Monetary base increases by the amount of the open market purchase Nonbank PublicCentral Bank AssetsLiabilitiesAssetsLiabilities Securities-$100mSecurities+$100mCurrency in circulation +$100m Currency+$100m

8. Open Market Purchase: Summary The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits. The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase.

9. Open Market Sale Reduces the monetary base by the amount of the sale Reserves remain unchanged The effect of open market operations on the monetary base is much more certain than the effect on reserves Nonbank PublicCentral Bank AssetsLiabilitiesAssetsLiabilities Securities+$100mSecurities-$100mCurrency in circulation -$100m Currency-$100m

10. Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Checkable deposits -$100mReserves-$100mCheckable deposits -$100m Currency+$100m Central Bank AssetsLiabilities Currency in circulation +$100m Reserves-$100m Net effect on monetary liabilities is zero; Reserves are changed by random fluctuations; Monetary base is a more stable variable

11. Loans to Financial Institutions Monetary liabilities of the Fed have increased by $100 Monetary base also increases by this amount Banking SystemCentral Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100mLoans+$100mLoans+$100mReserves+$100m (borrowing from CB)

12. Other Factors that Affect the Monetary Base Float Treasury deposits at the Central Bank Interventions in the foreign exchange market

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

14. Multiple Deposit Creation: A Simple Model Bank A AssetsLiabilitiesAssetsLiabilities Securities-$100mSecurities-$100mCheckable deposits +$100m Reserves+$100mReserves+$100m Loans+$100m Bank A AssetsLiabilities Securities-$100m Loans+$100m Deposit Creation: Single Bank Excess reserves increase; Bank loans out the excess reserves; Creates a checking account; Borrower makes purchases; The Money supply has increased

15. Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100mCheckable deposits +$100mReserves+$10Checkable deposits +$100m Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Checkable deposits +$90Reserves+$9Checkable deposits +$90 Loans+$81 Multiple Deposit Creation: A Simple Model (Cont’d) Deposit Creation: The Banking System

16. Creation of Deposits (assuming 10% reserve requirement and a $100 increase in reserves) Bank 1 Assets Liabilities Reserves+100 Deposits+100 Bank 1 Пасиви Reserves +10 Deposits +100 Loans +90 Reserves + 9 Deposits + 90 Loans + 81 Bank 2 Deposits + 81 Loans + 72.9 Bank 3 Reserves + 8.1 BankDepositsReservesLoans ∆D∆D∆R∆R∆L∆L 11001090 2 981 3 8.172.9....... Banking system 1000100900 - Required reserve ratio - Deposit multiplier Reserve requirement r d = 10% Assets

17. Multiple Deposit Contraction The multiple deposit creation process should also work in reverse. When the Central Bank withdraws reserves from the banking system, there should be a multiple contraction of deposits. In fact, the contraction in deposits will be  D = (1/ r )   R Example: If  R = -100 and (1/ r ) = 10 because r d =10%, then  D = -1000.

18. Critique of the Simple Model Holding cash stops the process – Currency has no multiple deposit expansion Banks may not use 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.

19. The Money Supply and Money Multiplier Define money as currency plus checkable deposits: M1 Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

20. Deriving the Money Multiplier Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D. Then, c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio

21. Deriving the Money Multiplier (cont’d)

22. The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + (r x D) + ER Equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves.

23. Deriving the Money Multiplier (cont’d)

24. Intuition Behind the Money Multiplier

25. Factors that Determine the Money Supply 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.

26. The Great Depression Bank Panics, 1930–1933, and the Money Supply Bank failures (and no deposit insurance) determined: – Increase in deposit outflows and holding of currency (depositors) – An increase in the amount of excess reserves (banks) For a relatively constant MB, the money supply decreased due to the fall of the money multiplier.

27. Deposits of Failed Commercial Banks, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309.

28. Excess Reserves Ratio and Currency Ratio, 1929–1933 Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

29. M1 and the Monetary Base, 1929–1933 Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

30. The 2007-2009 Financial Crisis and the Money Supply During the recent financial crisis, the monetary base more than tripled as a result of the Fed's purchase of assets and new lending facilities to stem the financial crisis. The currency ratio fell somewhat during this period, which the money supply model suggests would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion. However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e.

31. M1 and the Monetary Base, 2007-2009 Source: Federal Reserve; www.federalreserve.gov/releases.www.federalreserve.gov/releases

32. Excess Reserves Ratio and Currency Ratio, 2007-2009 Source: Federal Reserve; www.federalreserve.gov/releases.www.federalreserve.gov/releases