Lecture 8 Money Supply

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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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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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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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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If Person Cashes Check for Currency Public The Fed


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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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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Affecting reserves without changing MBShifts From Deposits into Currency (Jane Brown permanently withdraws $100from her checking account.)

Public The Fed


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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Discount Loans Also affect MB

Suppose Fed makes $100 loan to First National Bank

Banking System The Fed


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


Loans + $90

Bank B

Assets Liabilities


Bank B

Assets Liabilities

Reserves + $ 9 Deposits + $90

Loans + $81


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Deposit Creation


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Deposit Creation

If Bank A buys securities with $90 check

Bank AAssets Liabilities


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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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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Lecture 8 Money Supply