Transcript Chapter 14
Chapter 14
The Money
Supply Process
Three Players in the Money
Supply Process
• Central bank (Federal Reserve System)
• Banks (depository institutions; financial
intermediaries)
• Depositors (individuals and institutions)
14-2
© 2013 Pearson Education, Inc. All rights reserved.
The Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Securities
Currency in circulation
Loans to Financial
Institutions
Reserves
• 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
14-3
© 2013 Pearson Education, Inc. All rights reserved.
Control of the Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
14-4
© 2013 Pearson Education, Inc. All rights reserved.
Open Market Purchase from a
Bank
Banking System
Assets
Federal Reserve System
Liabilities
Securities
$100m
Reserves
+$100m
Assets
Securities
Liabilities
+$100m Reserves
+$100m
• Net result is that reserves have increased by $100
• No change in currency
• Monetary base has risen by $100
14-5
© 2013 Pearson Education, Inc. All rights reserved.
Open Market Purchase from the
Nonbank Public
Banking System
Assets
Reserve
s
Federal Reserve System
Liabilities
+$100m Checkable
deposits
+$100m
Assets
Securities
Liabilities
+$100m Reserves
+$100m
• Person selling bonds to the Fed deposits the Fed’s
check in the bank
• Identical result as the purchase from a bank
14-6
© 2013 Pearson Education, Inc. All rights reserved.
Open Market Purchase from
the Nonbank Public (cont’d)
Nonbank Public
Assets
Liabilities
Securities
-$100m
Currency
+$100m
Federal Reserve System
Assets
Securities
Liabilities
+$100m Currency in
circulation
+$100m
• 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
14-7
© 2013 Pearson Education, Inc. All rights reserved.
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
14-8
© 2013 Pearson Education, Inc. All rights reserved.
Open Market Sale
Nonbank Public
Assets
Liabilities
Securities
+$100m
Currency
-$100m
Federal Reserve System
Assets
Securities
Liabilities
-$100m Currency in
circulation
-$100m
• 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
14-9
© 2013 Pearson Education, Inc. All rights reserved.
Shifts from Deposits into
Currency
Nonbank Public
Assets
Banking System
Liabilities
Checkable
deposits
-$100m
Currency
+$100m
Assets
Reserves
Liabilities
-$100m Checkable
deposits
-$100m
Federal Reserve System
Assets
Liabilities
Currency in
circulation
+$100m
Reserves
-$100m
•Net effect on monetary liabilities is zero; Reserves are
changed by random fluctuations; Monetary base is a more
stable variable
14-10
© 2013 Pearson Education, Inc. All rights reserved.
Loans to Financial Institutions
Banking System
Assets
Reserve
s
Federal Reserve System
Liabilities
+$100m Loans
+$100m
(borrowing from Fed)
Assets
Loans
Liabilities
+$100m Reserves
+$100m
(borrowing from
Fed)
• Monetary liabilities of the Fed have increased by
$100
• Monetary base also increases by this amount
14-11
© 2013 Pearson Education, Inc. All rights reserved.
Other Factors that Affect the
Monetary Base
• Float
• Treasury deposits at the Federal Reserve
• Interventions in the foreign exchange
market
14-12
© 2013 Pearson Education, Inc. All rights reserved.
Overview of The 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
MBn= 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
14-13
© 2013 Pearson Education, Inc. All rights reserved.
Multiple Deposit Creation: A
Simple Model
Deposit Creation: Single Bank
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-$100m
Securities
-$100m Checkable
deposits
Reserves
+$100m
Reserves
+$100m
Loans
+$100m
+$100m
First National Bank
Assets
Liabilities
Securities
-$100m
Loans
+$100m
•Excess reserves increase; Bank loans out the excess reserves; Creates
a checking account; Borrower makes purchases; The Money supply has
increased
14-14
© 2013 Pearson Education, Inc. All rights reserved.
Multiple Deposit Creation: A
Simple Model (Cont’d)
Deposit Creation: The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Checkable
m deposits
Assets
+$100 Reserves
m
Loans
Reserves
+$100
m
Bank B
Liabilities
+$90 Checkable
deposits
Assets
+$90 Reserves
Loans
14-15
+$10 Checkable
deposits
+$90
Bank B
Assets
Liabilities
© 2013 Pearson Education, Inc. All rights reserved.
Liabilities
+$9 Checkable
deposits
+$81
+$90
Table 1 Creation of Deposits (assuming
10% reserve requirement and a $100
increase in reserves)
14-16
© 2013 Pearson Education, Inc. All rights reserved.
Deriving 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
D =
14-17
© 2013 Pearson Education, Inc. All rights reserved.
1
R
r
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.
14-18
© 2013 Pearson Education, Inc. All rights reserved.
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
14-19
© 2013 Pearson Education, Inc. All rights reserved.
Factors that Determine the
Money Supply (cont’d)
• 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.
14-20
© 2013 Pearson Education, Inc. All rights reserved.
Overview of the Money Supply
Process
Summary Table 1 Money Supply Response
14-21
© 2013 Pearson Education, Inc. All rights reserved.
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
14-22
© 2013 Pearson Education, Inc. All rights reserved.
Deriving the Money Multiplier
• 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
14-23
© 2013 Pearson Education, Inc. All rights reserved.
Deriving the
Money Multiplier (cont’d)
The total amount of reserves (R) equals the sum of
required reserves (RR) and excess reserves (ER).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = r × D
Subsituting for RR in the first equation
R = (r × D) + ER
The Fed sets r to less than 1
14-24
© 2013 Pearson Education, Inc. All rights reserved.
Deriving the
Money Multiplier (cont’d)
• The monetary base MB equals currency (C)
plus reserves (R):
MB = C + R = C + (r x D) + ER
• Equation reveals the amount of the
monetary base needed to support the
existing amounts of checkable deposits,
currency and excess reserves.
14-25
© 2013 Pearson Education, Inc. All rights reserved.
Deriving the
Money Multiplier (cont’d)
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 ec
M D C and C c D
M D (c D) (1 c) D
Substituting again
1 c
M
MB
r ec
The money multiplier is then
1 c
m
r ec
14-26
© 2013 Pearson Education, Inc. All rights reserved.
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
0.5
$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
c
Although there is multiple expansion of deposits,
there is no such expansion for currency
14-27
© 2013 Pearson Education, Inc. All rights reserved.
Application: The Great Depression Bank
Panics, 1930–1933, and the Money Supply
• 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.
14-28
© 2013 Pearson Education, Inc. All rights reserved.
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.
14-29
© 2013 Pearson Education, Inc. All rights reserved.
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.
14-30
© 2013 Pearson Education, Inc. All rights reserved.
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.
14-31
© 2013 Pearson Education, Inc. All rights reserved.
APPLICATION The 2007-2009
Financial Crisis and the Money Supply
• During the recent financial crisis, as shown in
Figure 4, the monetary base more than tripled as a
result of the Fed's purchase of assets and new
lending facilities to stem the financial crisis
• Figure 5 shows the currency ratio c and the excess
reserves ratio e for the 2007-2009 period. We see
that the currency ratio fell somewhat during this
period, which our money supply model suggests
would raise the money multiplier and the money
supply because it would increase the overall level of
deposit expansion. However, the effects of the
decline in c were entirely offset by the
extraordinary rise in the excess reserves ratio e
14-32
© 2013 Pearson Education, Inc. All rights reserved.
Figure 4 M1 and the Monetary Base,
2007-2009
Source: Federal Reserve; www.federalreserve.gov/releases.
14-33
© 2013 Pearson Education, Inc. All rights reserved.
Figure 5 Excess Reserves Ratio and
Currency Ratio, 2007-2009
Source: Federal Reserve; www.federalreserve.gov/releases.
14-34
© 2013 Pearson Education, Inc. All rights reserved.