Transcript The Money Supply Model

Money Supply
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-bank
public in the money creation process.
The Money Supply
• M1:
• M2:
• M3:
Currency + travelers checks + checkable
deposits
M1 + small time deposits + overnight
repurchase agreements + overnight
Eurodollars + money market mutual fund
balances
M2 + large denomination time deposits +
term repurchase agreements + term
Eurodollars + institutions only money
market fund balances
The Creators of Money
• The three major players whose decisions and
actions 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
Money Creation
• Banks create money in their normal, day-today 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.
Bank Reserves
• Total Reserves = Required reserves plus
excess reserves
– Required reserves = Deposits times reserve
requirement
– Excess reserves = Total reserves minus required
reserves
Money Creation: Summary
New Deposit
Required Reserves
Excess Reserves
$100
$ 90
$ 81
$ 72.90
$ 65.61
$10.00
$ 9.00
$ 8.10
$ 7.29
$ 6.51
$100
$ 90
$ 81
$ 72.90
$ 65.61
$ 59.05
$1,000
$100
$900
New Loan
$100
$ 90
$ 81
$ 72.90
$ 65.61
$ 59.05
$900
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
The M1 Model: Derivation
• Model:
B=R+C
•
•
•
•
R = rD + E
D=D
C = cD
E = eD
B = rD + eD + cD
B = D(r + e + c)
D=
1
B
( r + e + c)
The M1 Model: Derivation
• Model:
M1 = D + C
M1 = D + cD
M1 = D(1 + c)
Factor out D
• M1 = 1 + c
B
r+e+c
• M1 = Multiplier x Base
Money Multiplier Terms
• Changes in r
– If r increases, the multiplier decreases
– If r decreases, the multiplier increases
• The money multiplier and M1 are
negatively related.
Money Multiplier Terms
• 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.
Money Multiplier Terms
• 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 are
negatively related.
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
– The multiplier reflects the ability of the banking
system 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.
Open Market Operations
Fed 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
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 bank’s reserve position at the
Fed
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 bank’s
reserves are debited.
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 excess
reserves to lend, permitting the expansion of
deposits to increase.
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
Currency Drains
• Members of the non-bank public determine
currency in circulation
– Increases in currency drains from the banking
system, diminish the expansion of deposits
– Decreases in currency drains from the banking
system, increase the expansion of deposits
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