Four Players in the Money Supply Process

1. Central bank: the Fed 2. Banks (depository institutions) 3. Depositors 4. Borrowers from banks and institutions that issue bonds Federal Reserve System
most important player conducts monetary policy

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

The Feds Balance Sheet

Federal Reserve System
Assets Government securities e.g. bonds issued by the U.S. Treasury Discount loans: Fed provides reserves to banking system at rate called the discount rate. Liabilities Currency in circulation Excludes coins from US Treasury, less than 10% of monetary base. Reserves: deposits at the Fed plus currency in bank vaults.

Monetary Base, MB = C + R
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 2

More on Reserves
Fed requires banks to hold a fraction (10%) of deposits as reserves.
This fraction is called the required reserve ratio

Additional holding of cash are called excess reserves. Total reserves = Required Reserves plus Excess Reserves Note: Fed does not pay interest on liabilities, but collects interest on its assets. Earnings (in billions) go to federal government and pay for the operation of the Fed.
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 3

Control of Monetary Base

MB = Currency in circulation + Reserves = highpowered money Open Market Operations Fed exercises control over monetary base through
1. Purchases or sales of government securities in open market 2. Extension of discount loans to banks A purchase of bonds by the Fed is called an open market purchase A sale of bonds by the Fed is called an open market sale

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Control of the Monetary Base

Open Market Purchase of $100 of bonds from Bank with a $100 check The Banking System The Fed Assets Liabilities Assets Liabilities Securities $100 Securities + $100 Reserves + $100 Reserves + $100 Open Market Purchase of $100 of bonds from person or corporation who deposits the Feds check in a local bank Public The Fed Assets Liabilities Assets Liabilities Securities $100 Deposits + $100 Banking System Assets Liabilities Reserves + $100 Checkable Deposits + $100 Securities + $100 Reserves + $100

Result: R $100, MB $100 in both cases!

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 5

If Person Cashes Check for Currency

Public Assets Securities $100 Currency + $100 Liabilities Assets Securities + $100 The Fed Liabilities Currency in circulation + $100

Note: At local bank vault cash falls by $100, deposits at Fed increase by same amount. I.e., the transaction is simply a switch from one type of reserves to another. Result: Reserves unchanged, MB $100 Conclusion: Effect on MB of OMP is certain, effect on Reserves depends on whether seller of bond keeps proceeds in currency or deposits.

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Open Market Sale

Open Market Sale of $100 of bonds from person who pays cash Public Assets Securities + $100 Currency $100 Liabilities Assets Securities $100 The Fed Liabilities Currency in circulation $100

Result: Reserves unchanged, MB $100 If instead, person uses a check written on a local bank reserves fall by $100. Conclusion: Effect on MB of OMS is certain, effect on Reserves depends on whether buyer of bond uses currency or checkable deposits.

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Overall Conclusion Fed can control MB using OMOs more effectively than it can control reserves.

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Affecting reserves without changing MB

Shifts From Deposits into Currency (Jane Brown permanently withdraws $100 from her checking account.) Public Assets Deposits $100 Currency + $100 Banking System Assets Liabilities Reserves $100 Deposits $100 Liabilities Assets The Fed Liabilities Currency + $100 Reserves $100

Result: R $100, MB unchanged

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Discount Loans
Also affect MB

Suppose Fed makes $100 loan to First National Bank

Banking System Assets Liabilities Reserves Discount + $100 loan + $100 Result: R $100, MB $100 Reverse happens when bank pays of a discount loan (I.e., all of the +s become s).
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 10

The Fed Assets Discount loan + $100

Liabilities Reserves + $100

Factors outside Feds control

Certain factors affect the MB that are outside the control of the Fed 1. Float - results from check clearing process that occurs at the Fed
first increase reserves of depositing bank second (later) decrease the reserves of bank on which check is drawn result is temporary increase in MB

2. Treasury deposits at Fed

whenever Treasury moves deposits from commercial banks to Fed the result is a decrease in MB
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 11

Deposit Creation: Single Bank

Assets Securities Reserves Assets Securities Reserves Loans Assets Securities Loans First National Bank Liabilities $100 + $100 First National Bank Liabilities $100 + $100 + $100 Deposits + $100

First National Bank Liabilities $100 + $100 Deposits + $100

12

Deposit Creation: Banking System

Assets Reserves Assets Reserves Loans Assets Reserves Assets Reserves Loans Bank A Liabilities Deposits Bank A Liabilities Deposits Bank B Liabilities Deposits Bank B Liabilities Deposits

+ $100

+ $100

+ $10 + $90

+ $100

+ $90

+ $90

+$9 + $81

+ $90
13

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

Deposit Creation

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

14

Deposit Creation
If Bank A buys securities with $90 check Bank A Assets Liabilities Reserves + $10 Deposits + $100 Securities + $90 Seller deposits $90 at Bank B and process is same Whether bank makes loans or buys securities, get same deposit expansion

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

15

Deposit Multiplier
Simple Deposit Multiplier 1 D = R r Deriving the formula R = RR = r D D= D = 1 r 1 r R R

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

16

Deposit Creation: Banking System as a Whole Banking System Assets Liabilities Securities $100 Deposits Reserves + $100 Loans + $1000 Critique of Simple Model Deposit creation stops if: 1. Proceeds from loan kept in cash 2. Bank holds excess reserves
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 17

+ $1000

Money Multiplier M = m MB Deriving Money Multiplier R = RR + ER RR = r D R = (r D) + ER Adding C to both sides R + C = MB = (r D) + ER + C 1. Tells us amount of MB needed support D, ER and C 2. Increase in C or ER is not multiplied MB = (r D) + (e D) + (c D) = (r + e + c) D
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 18

D=

1 r+e+c

MB

M = D + (c D ) = (1 + c) D M= m = 1+c r+e+c 1+c r+e+c MB

m < 1/r because no multiple expansion for currency and because as D ER (I.e., m is much less than 10 from simple model) r or c or e results in m and M.
Chapter 15 & 16-- The Money Supply Process -- Professor Garratt 19

Excess Reserves Ratio, e

Determinants of e 1. i , relative Re on ER (opportunity cost ), e 2. Expected deposit outflows, ER insurance worth more, e
20

Factors Determining Money Supply

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

21

Money Supply

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

22

Determinants of the Money Supply

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

23

Deposits at Failed Banks: 192933

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

24

e, c: 192933

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

25

Money Supply and Monetary Base: 192933

Chapter 15 & 16-- The Money Supply Process -- Professor Garratt

26