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7/31/2019 Lecture 8 Money Supply
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 1
Four Players
in the Money Supply Process
1. Central bank: the Fed
2. Banks (depository institutions)3. Depositors
4. Borrowers from banks and institutions that issue
bonds
Federal Reserve System
most important player
conducts monetary policy
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 2
The Feds Balance SheetFederal Reserve System
Government securitiese.g. bonds issued by the
U.S. Treasury
Discount loans: Fedprovides reserves to
banking system at ratecalled the discount rate.
Currency in circulationExcludes coins from US
Treasury, less than 10%of monetary base.
Reserves: deposits at
the Fed plus currency inbank vaults.
Assets Liabilities
Monetary Base, MB = C + R
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 3
More on Reserves Fed requires banks to hold a fraction (10%) of
deposits as reserves.
This fraction is called the required reserve ratio Additional holding of cash are called excess
reserves.
Total reserves = Required Reservesplus ExcessReserves
Note: Fed does not pay interest on liabilities, but
collects interest on its assets.Earnings (in billions) go to federal government
and pay for the operation of the Fed.
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 4
Control of Monetary Base
MB = Currency in circulation + Reserves = high-
powered moneyOpen Market Operations
Fed exercises control over monetary base through
1. Purchases or sales of government securities in open market
2. Extension of discount loans to banks
A purchase of bonds by the Fed is called an open market
purchase A sale of bonds by the Fed is called an open market sale
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Control of the Monetary BaseOpen Market Purchase of $100 of bonds from Bank with a $100 check The Banking System The Fed
Assets Liabilities Assets Liabilities
Securities $100 Securities + $100 Reserves + $100Reserves + $100
Open Market Purchase of $100 of bonds from person or corporation who deposits the
Feds check in a local bank
Public The Fed
Assets Liabilities Assets LiabilitiesSecurities $100 Securities + $100 Reserves + $100
Deposits + $100
Banking System
Assets Liabilities
Reserves Checkable Deposits
+ $100 + $100
Result:R $100,MB $100 in both cases!
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 6
If Person Cashes Check for Currency Public The Fed
Assets Liabilities Assets Liabilities
Securities $100 Securities + $100 Currency in circulation
Currency + $100 + $100
Note: At local bank vault cash falls by $100, deposits at Fed increase by same
amount. I.e., the transaction is simply a switch from one type of reserves to another.
Result: Reserves unchanged, MB $100
Conclusion: Effect on MB of OMP is certain, effect on Reserves depends on whether
seller of bond keeps proceeds in currency or deposits.
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 7
Open Market SaleOpen Market Sale of $100 of bonds from person who pays cash
Public The Fed
Assets Liabilities Assets LiabilitiesSecurities + $100 Securities $100 Currency in circulation
Currency $100 $100
Result: Reserves unchanged,MB $100
If instead, person uses a check written on a local bank reserves fall by $100.
Conclusion: Effect on MB of OMS is certain, effect on Reserves depends on whether
buyer of bond uses currency or checkable deposits.
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Overall Conclusion
Fed can control MB using OMOs more effectivelythan it can control reserves.
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 9
Affecting reserves without changing MBShifts From Deposits into Currency (Jane Brown permanently withdraws $100from her checking account.)
Public The Fed
Assets Liabilities Assets Liabilities
Deposits $100 Currency + $100
Currency + $100 Reserves $100
Banking System
Assets Liabilities
Reserves $100 Deposits $100
Result:R $100,MB unchanged
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 10
Discount Loans Also affect MB
Suppose Fed makes $100 loan to First National Bank
Banking System The Fed
Assets Liabilities Assets Liabilities
Reserves Discount Discount Reserves
+ $100 loan + $100 loan + $100 + $100
Result:R $100,MB $100
Reverse happens when bank pays of a discount loan (I.e., all of the
+s become s).
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Factors outside Feds control
Certain factors affect the MB that are outside the
control of the Fed1. Float - results from check clearing process that
occurs at the Fed
first increase reserves of depositing bank second (later) decrease the reserves of bank on which
check is drawn
result is temporary increase in MB2. Treasury deposits at Fed
whenever Treasury moves deposits from commercial
banks to Fed the result is a decrease in MB
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Deposit Creation: Single BankFirst National Bank
Assets Liabilities
Securities $100Reserves + $100
First National Bank
Assets LiabilitiesSecurities $100 Deposits + $100
Reserves + $100
Loans + $100
First National BankAssets Liabilities
Securities $100 Deposits + $100
Loans + $100
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Deposit Creation: Banking SystemBank A
Assets Liabilities
Reserves + $100 Deposits + $100
Bank A
Assets Liabilities
Reserves + $10 Deposits + $100
Loans + $90
Bank B
Assets Liabilities
Reserves + $90 Deposits + $90
Bank B
Assets Liabilities
Reserves + $ 9 Deposits + $90
Loans + $81
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Deposit Creation
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 15
Deposit Creation
If Bank A buys securities with $90 check
Bank AAssets Liabilities
Reserves + $10 Deposits + $100
Securities + $90Seller deposits $90 at Bank B and process is same
Whether bank makes loans or buys securities, get same
deposit expansion
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Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 16
Deposit Multiplier
Simple Deposit Multiplier
1D = Rr
Deriving the formula
R =RR = rD1
D = Rr
1D = R
r
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Deposit Creation: Banking System as a Whole
Banking System
Assets Liabilities
Securities $100 Deposits + $1000
Reserves + $100
Loans + $1000
Critique of Simple Model
Deposit creation stops if:
1. Proceeds from loan kept in cash
2. Bank holds excess reserves
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Money MultiplierM= mMB
Deriving Money Multiplier
R =RR +ERRR = rD
R = (rD) +ER
Adding Cto both sides
R + C=MB = (rD) +ER + C
1. Tells us amount ofMB needed supportD,ER and C
2. Increase in C or ER is not multipliedMB = (rD) + (e D) + (cD)
= (r+ e + c) D
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1D = MBr+ e + c
M=D + (cD ) = (1 + c) D
1 + cM= MB
r+ e + c
1 + cm = r+ e + c
m < 1/rbecause no multiple expansion for currency and because as
DER (I.e., m is much less than 10 from simple model)
ror c or e results in m and M.
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Excess Reserves Ratio, e
Determinants ofe
1. i, relativeRe onER (opportunity cost ), e
2. Expected deposit outflows,ER insurance worth more, e
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Factors Determining Money Supply
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Money Supply
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Determinants
of the MoneySupply
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Deposits at Failed Banks: 192933
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e
,c
: 192933
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Money Supply and Monetary Base: 192933
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