Transcript Chapter 17

Chapter 17
The Money Supply Process
Players in the Money Supply Process
• Central bank (Federal Reserve)
• Banks (depository institutions)
• Depositors (individuals and institutions)
• Borrowers
Fed’s Balance Sheet (important items)
Federal Reserve System
Assets
Liabilities
Government Securities and
Mortgage Backed Securities
Currency in circulation
Discount loans
Reserves
• Monetary Liabilities
– Currency in circulation(in the hands of the public)
– Reserves: bank deposits at the Fed
• Assets
– Government securities: holdings by the Fed that affect
money supply and earn interest.
– Fed now holding MBS.
– Discount loans: provide reserves to banks and earn
the discount rate
The Federal Reserve Balance Sheet: June 2003
Assets and Liabilities of the Federal Reserve System, June 30, 2003
(millions of dollars)
ASSETS
Gold
Loans to banks
U.S. Treasury
securities
LIABILITIES
$ 11,045
$593,031
36,538
550,314
20,359
6,219
All other assets
Total
Federal Reserve notes (outstanding)
46,268
24,556
$644,165
$644,165
Source: Federal Reserve Bulletin, August 2003, Table 1.18.
Bank reserves (from depository
institutions)
U.S. Treasury Deposits
All other liabilities and net worth
Total
Federal Reserve Balance Sheet August, 2007
The Beginning of the Financial Crisis
(Millions of Dollars)
ASSETS
Gold
Loans to banks
$
LIABILITIES
11,037
$777,769
Federal Reserve notes
(outstanding)
1,342
Deposits:
U.S. Treasury
securities
779,642
12,771
4,572
All other assets
Total
82,451
79,360
$ 874,472
$874,472
Source: Board of Governors of the Federal Reserve System.
Bank reserves (from depository
institutions)
U.S. Treasury deposit
All other liabilities and net worth
Total
THE FEDERAL RESERVE BALANCE SHEET: August 2009
ASSETS
Gold
$
Loans to banks
LIABILITIES
11,037
$872,150
Federal Reserve notes
(outstanding)
339,335
Deposits:
U.S. Treasury
securities
705,331
All other assets
Total
$
724,650
Bank reserves (from depository
institutions)
261,487
U.S. Treasury
936,031
133,447
1,991,734
$1,991,734
Source: Board of Governors of the Federal Reserve System.
All other liabilities and net worth
Total
THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS
Gold
LIABILITIES
$
Loans to banks
11,037
$1122,000
449
Deposits:
U.S. Treasury
securities
1730,000
1,795,000
Mortgages
1,083,000
42,000
All other assets
234,000
116,000
$ 3,075,000
$3,075,000
Total
Federal Reserve notes (outstanding)
Bank reserves (from depository
institutions)
U.S. Treasury
All other liabilities and net worth
Total
Source: Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/releases/h41/Current/
THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS
Gold
LIABILITIES
$
Loans to banks
11,037
$1,315,000
59
Deposits:
U.S. Treasury
securities
2,450,000
2,748,000
Mortgages
1,731,000
65,000
All other assets
290,000
353,000
$ 4,481,000
$4,481,000
Total
Federal Reserve notes (outstanding)
Bank reserves (from depository
institutions)
U.S. Treasury
All other liabilities (reverse Repo) and net
worth
Total
Source: Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/releases/h41/Current/
Monetary Base (High Powered Money)
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
Note: Vault cash is included in reserves.
Recall: M1 = C + DD
The Money Supply Process: Open Market Purchase From
a Commercial Bank (Assume a 10% reserve requirement)
•
•
•
•
•
Reserves have increased by $100.
What about excess reserves?
No change in currency
Monetary base (C + R) has increased by $100
Has the money supply changed?
Fed Open Market Purchase from Nonbank Public
•
•
•
•
•
Reserves have increased by $100.
What about excess reserves?
No change in currency
Monetary base (C + R) has increased by $100
Has the money supply changed?
• 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 (C+R) increases by the amount of the open
market purchase
Open Market Purchase: Summary
• The effect on reserves in the banking system
depends on whether the seller of the bonds keeps
the proceeds from the sale in currency or in
deposits
• Always increases the monetary base by the amount
of the purchase:
MB = C + R
Fed Open Market Sale to non-bank public
Nonbank Public
Assets
Liabilities
Securities
+$100
Currency
-$100
Federal Reserve System
Assets
Securities
Liabilities
-$100 Currency in
circulation
-$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
Public withdraws $100 from Commercial
Bank
+$100
Fed Discount Loan to a Bank
$100
Paying Off a Discount Loan from the Fed
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
-$100 Discount
loans
-$100
Assets
Discount
loans
Liabilities
-$100 Reserves
-$100
• Net effect is to reduce the monetary base
• Monetary base changes one-for-one with a change
in the borrowings from the Federal Reserve System
Deposit Creation (Single Bank):
Fed Open Market Purchase from First National Bank
Step 1
Step 2
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-$100
Securities
-$100 Checkable
deposits
Reserves
+$100
Reserves
+$100
Loans
+$100
Step 3
+$100
Excess reserves increase
First National Bank
Bank loans out the excess reserves
Securities
-$100
Creates a checking account
Borrower makes purchases
Loans
+$100
The money supply has increased
Assets
Liabilities
Deposit Creation: The Banking System
(10% Reserve Requirement)
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Checkable
deposits
Assets
+$100 Reserves
Loans
Reserves
+$10 Checkable
deposits
+$100
+$90
Bank B
Assets
Liabilities
Bank B
Liabilities
+$90 Checkable
deposits
Assets
+$90 Reserves
Loans
Liabilities
+$9 Checkable
deposits
+$81
+$90
Creation of Deposits (assuming 10% reserve
requirement and the initial $100 increase in
reserves)
The Formula for the Simple Deposit Multiplier
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
R
r
Taking the change in both sides yields
D=
1
D =  R
r
Critique of the Deposit Multiplier
• Currency removes funds from the banking
system and stops the deposit creation process
• Holding excess reserves stops the deposit
creation process. Banks may not use all of
their excess reserves to buy securities or
make loans.
• Depositor decisions (how much currency to
hold) and bank’s decisions (amount of excess
reserves to hold) affect the money supply and
the Fed’s ability to control the money supply.
The M1 Money Multiplier
• M1 =currency + checkable deposits = C + D
• Link the money supply (M1) to the monetary
base (MB) and let m be the money multiplier
• Recall:
MB = C + R
M1 = m x MB
• This is why the MB is called High Powered
Money
Deriving the M1 Money Multiplier
Let’s 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
Deriving the M1 Money Multiplier: m
M1 = m  MB
M1
m
MB
Reserves:
Required Reserves:
R = RR + ER
RR = r  D
R = (r  D) + ER
Deriving the M1 Money Multiplier
Math Trick:
MB = RR
+ ER
+ C
MB = (r  D) + (ER/D  D) + (C/D  D)
MB = (r + e + c)  D ;
Where e=(ER/D) and c =(C/D)
M1 = D + C = D + (C/D D)
M1 = (1+ c)  D ;
M1 Money Multiplier
M1
(1  c) xD
(1  c)
m


MB (r  e  c) xD (r  c  e)
m < 1/r
because of currency holding and ER.
m is the increase in the money supply resulting from
a $1 increase in MB
Example
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
 0.5
$800B
$0.8B
e
 0.001
$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
c
Case Study: The Great Depression Bank Panics,
1930 - 1933.
• Bank failures (and no deposit insurance)
caused:
– Increase in deposit outflows and holding of
currency (depositors)
– An increase in the amount of excess reserves
(banks)
Case Study: The Great Depression Bank Panic, 1930
- 1933. Deposits of Failed Commercial Banks
• Bank failures (and no
deposit insurance)
caused:
– Increase in deposit
outflows and holding of
currency (depositors)
– An increase in the
amount of excess
reserves (banks)
Case Study: The Great Depression Bank Panic
Deposits of Failed Commercial Banks
What happened to e and c?
Case Study: The Great Depression Bank Panic
M1 Money Supply and the Monetary Base, 1929–1933
Case Study: Money Supply 1980 -2005
Determinants of the Money Supply