Monetary Theory and Policy

Chapter 14：The Money Supply Process

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Players in the Money Supply Process

Central bank (Federal Reserve System)

Banks (depository institutions; financial intermediaries)

Depositors (individuals and institutions)

Chapter 14 2 / 33
Fed’s Balance Sheet

Federal Reserve System

Assets Liabilities
Government securities Currency in circulation

Discount loans Reserves

Monetary 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 Fed that affect money
supply and earn interest
Discount loans: provide reserves to banks and earn the
discount rate
Chapter 14 3 / 33
Monetary Base

High-powered money
MB=C+R
C=currency in circulation
R=total reseres in the banking system

Chapter 14 4 / 33
Open Market Purchase from a Bank

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Reserves +$100
Reserves +$100

Net result is that reserves have increased by $100

No change in currency
Monetary base has risen by $100

Chapter 14 5 / 33
Open Market Purchase from Nonbank Public I

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Securities +$100 Reserves +$100
deposits

Person selling bonds to the Fed deposits the Fed’s check

in the bank
Identical result as the purchase from a bank

Chapter 14 6 / 33
Open Market Purchase from Nonbank Public II

Nonbank Public Federal Reserve System

Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Currency in +$100
circulation
Currency +$100

The person selling the bonds cashes the Fed’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
Chapter 14 7 / 33
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

Chapter 14 8 / 33
Open Market Sale

Nonbank Public Federal Reserve System

Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in -$100
circulation
Currency -$100

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

Chapter 14 9 / 33
Shifts from Deposits into Currency

Nonbank Public Banking System

Assets Liabilities Assets Liabilities
Checkable -$100 Reserves -$100 Checkable -$100
deposits deposits
Currency +$100

Net effect
Federal Reserve System on monetary liabilities
Assets Liabilities
is zero
Currency in +$100 Reserves are changed
circulation by random fluctuations
Reserves -$100
Monetary base
is a more stable variable

Chapter 14 10 / 33
Making a Discount Loan to a Bank

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves +$100 Discount +$100 Discount +$100 Reserves +$100
loans loan
(borrowing from Fed) (borrowing from
Fed)

Monetary liabilities of the Fed have increased by $100

Monetary base also increases by this amount

Chapter 14 11 / 33
Paying Off a Discount Loan from the Fed

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves -$100 Discount -$100 Discount -$100 Reserves -$100
loans loans
(borrowing from Fed) (borrowing from
Fed)

Net effect on monetary base is a reduction

Monetary base changes one-for-one with a change in the
borrowings from the Federal Reserve System

Chapter 14 12 / 33
Fed’s Ability to Control the Monetary Base

Open market operations are controlled by the Fed

The Fed cannot determine the amount of borrowing by
banks from the Fed
Split the monetary base into two components
MB
=n MB − BR
The money supply is positively related to both the non-
borrowed monetary base MBn and
to the level of borrowed reserves, BR, from the Fed

Chapter 14 13 / 33
Deposit Creation: Single Bank

First National Bank First National Bank

Assets Liabilities Assets Liabilities
Securities -$100 Securities -$100 Checkable +$100
deposits
Reserves +$100 Reserves +$100
Loans +$100

Excess reserves increase

First National Bank
Bank loans out the excess reserves
Assets Liabilities
Creates a checking account
Securities -$100
Borrower makes purchases
Loans +$100
The money supply has increased

Chapter 14 14 / 33
Deposit Creation: The Banking System

Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Reserves +$10 Checkable +$100
deposits deposits
Loans +$90

Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90 Checkable +$90 Reserves +$9 Checkable +$90
deposits deposits
Loans +$81

Chapter 14 15 / 33
Table 1 Creation of Deposits (assuming 10% reserve
requirement and a $100 increase in reserves)

Chapter 14 16 / 33
The Formula for Multiple Deposit Creation

Assuming banks do not hold excess reserves

Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r )
times the total amount of checkable deposits (D)
Substituting
r ×D =
R

Dividing both sides by r

1
D= ×R
r
Taking the change in both sides yields
1
∆D = × ∆R
r
Chapter 14 17 / 33
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.

Chapter 14 18 / 33
Factors that Determine the Money Supply

Changes in the nonborrowed monetary base MBn

The money supply is positively related to the non-
borrowed monetary base MBn
Changes in borrowed reserves from the Fed
The money supply is positively related to the level of
borrowed reserves, BR, from the Fed

Chapter 14 19 / 33
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.

Chapter 14 20 / 33
Summary Table 1 Money Supply Response

Chapter 14 21 / 33
The 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
M= m × MB

Chapter 14 22 / 33
Deriving the Money Multiplier I

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

Chapter 14 23 / 33
Deriving the Money Multiplier II

c = {C / D} ⇒ C = c × D and
e = {ER / D} ⇒ ER = e × D
Substituting in the previous equation
MB = (r × D) + (e × D) + (c × D) = (r + e + c) × D
Divide both sides by the term in parentheses
1
D= × MB
r +e+c
M = D + C and C = c × D
M = D + (c × D) = (1+ c) × D
Substituting again
1+ c
M= × MB
r +e+c
The money multiplier is then
1+ c
m=
r +e+c
Chapter 14 24 / 33
Intuition Behind the Money Multiplier

r = required reserve ratio = 0.10

C = currency in circulation = $400B
D = checkable deposits = $800B
ER = excess reserves = $0.8B
M money supply (M1) = C + D = $1,200B
$400B $0.8B
=c = 0.5 = e = 0.001
$800B $800B
1 + 0.5 1.5
m= = = 2.5
0.1 + 0.001 + 0.5 0.601
This is less than the simple deposit multiplier
Although there is multiple expansion of deposits, there is no
such expansion for currency
Chapter 14 25 / 33
Application: The Great Depression Bank Panics, 1930 - 1933.

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.

Chapter 14 26 / 33
 FIGURE 1 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.
Chapter 14 27 / 33
FIGURE 2 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.

Chapter 14 28 / 33
FIGURE 3 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.

Chapter 14 29 / 33
Quantitative Easing and the Money Supply,
2007-2014

When the global financial crisis began in the fall of

2007, the Fed initiated lending programs and large-
scale asset-purchase programs in an attempt to
bolster the economy.
By June 2014, these purchases of securities had led
to a quintupling of the Fed’s balance sheet and a
377% increase in the monetary base.

Chapter 14 30 / 33
Quantitative Easing and the Money Supply,
2007-2014

These lending and asset-purchase programs resulted

in a huge expansion of the monetary base and have
been given the name “quantitative easing.”
This increase in the monetary base did not lead to an
equivalent change in the money supply because
excess reserves rose dramatically.

Chapter 14 31 / 33
 Figure 4 M1 and the Monetary Base, 2007-
2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Chapter 14 32 / 33
 Figure 5 Excess Reserves Ratio and Currency
Ratio, 2007-2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Chapter 14 33 / 33