The Money Supply Model

8/3/2019 The Money Supply Model

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Money Supply


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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-bankpublic in the money creation process.


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The Money Supply

M1: Currency + travelers checks + checkable

deposits

M2: M1 + small time deposits + overnightrepurchase 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


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The Creators of Money

The three major players whose decisions andactions 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


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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.


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Bank Reserves Total Reserves = Required reserves plus

excess reserves

Required reserves = Deposits times reserve

requirement

Excess reserves = Total reserves minus

required reserves


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Money Creation: SummaryNew Deposit Required Reserves Excess Reserves New Loan

$100 $100$100 $10.00 $ 90 $ 90

$ 90 $ 9.00 $ 81 $ 81

$ 81 $ 8.10 $ 72.90 $ 72.90

$ 72.90 $ 7.29 $ 65.61 $ 65.61

$ 65.61 $ 6.51 $ 59.05 $ 59.05

$1,000 $100 $900 $900


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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


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Model:

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)

BD =


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Model:

M1 = D + C

M1 = D + cD

M1 = D(1 + c) Factor out D

M1 = 1 + c

r + e + c B

M1 = Multiplier x Base


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Money MultiplierT

erms Changes in r

If r increases, the multiplier decreases

If r decreases, the multiplier increases

The money multiplier and M1 are

negatively related.


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Money MultiplierT

erms 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.


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Money MultiplierT

erms 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 arenegatively related.


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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

T

he multiplier reflects the ability of the bankingsystem 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.


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Open Market OperationsFed Bank

Presidents

Federal Open

Market Comm.

Fed Board of

Governors

Securities

Dealers

Federal Reserve

Bank of New York

Commercial

Banks

Change

in

Reserves

Change in

Money

Supply


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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 banks reserve position at theFed


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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 banks

reserves are debited.


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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 excessreserves to lend, permitting the expansion of

deposits to increase.


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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


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Central Bank Policy Channels

Policy

Tools

Level & Growth

Bank Reserves

Cost & Availability

of Credit

Size and Growth

Rate of Money

Supply

Market Value

of Securities

Volume

and

Growth

of

Borrowing

and

Spending

by the

Public

Full

Employment

Growth

Price

Stability

Documents

The Money Supply Model