Introduction to the Money Supply Process

1. Deposits and the Money Supply 2. Four Players in the Money Supply Process

1 Deposits and the Money Supply

Before we jump into the details of the money supply process, lets recall that weve already considered various measures of the money supply as part of our analysis of Mishkins Chapter 3, on What is Money? In Chapter 3, we learned about the Federal Reserves three monetary aggregates: M1, M2, and M3. These are the Feds official measures of the money supply. So lets begin on familiar ground, and think back to the definition of M1, which is the Feds narrowest measure of moneyand one that is most closely related to the theoretical concept of money as a medium of exchange. Mishkins Chapter 3, Table 1 (p.53) lists the value of M1 and its components as of December 2002. Component Value ($ billions) Percent of Total Currency 626.5 51.9 Travelers Checks 7.7 0.6 Demand Deposits 290.7 24.1 Other Checkable Deposits 281.2 23.3 Total M1 1206.1 100 Bank deposits account for 47.4%or almost one-halfof total M1! Evidently, to understand the money supply process, we need to begin by understanding how bank deposits are created.

2 Four Players in the Money Supply Process

There are four types of individuals and institutions that are involved in the process of creating deposits and hence in the money supply process more generally. 1. Central Bank = The government agency that oversees the banking system and is responsible for the conduct of monetary policy. The central bank in the US is the Federal Reserve System. 2. Banks (depository institutions) = The financial institutions that accept deposits from individuals and corporations and make loans. In the US, these include commercial

banks, savings and loan associations, mutual savings banks, and credit unions. 3. Depositors = The individuals and corporations that hold deposits in banks. 4. Borrowers from banks = Individuals and corporations that borrow from banks, along with Federal, State, and Local governments that issue bonds that are purchased by banks. Of these four players, the central bankthe Federal Reserve Systemis themost important. And since its also the one that we really havent considered yet, it will be helpful to turn next to a description of the Fed and its balance sheet.

The Money Supply Process

and Interest Rate Determination
Money can be narrowly defined as anything that may be used for purchasing goods and services or more broadly to include anything of value that may be used for trade. Changes to the the money stock in an aggregate economy can occur for any of several reasons:

changes in behavior (i.e., a desire to hold more cash 'C' relative to demand deposits 'DD' or time deposits 'TD'), changes in expectations (optimism or pessimism on behalf of the non-bank public or perhaps among bank managers), or changes in monetary policy (reserve requirements and open market operations).

To best understand how these changes occur, it is useful to look at the basic components of the balance sheets of the non-bank public, the commercial banks, and the central bank (i.e., the Federal Reserve): Non-Bank Public Assets Liabilities C = $2000 DD = $5000 TD = $0 Commercial Banking System Assets Liabilities rR = $500 xR = $500 L = $3000 S = $1000 DD = $5000 TD=$0 S = $2000 The Federal Reserve Assets Liabilities C = $2000 R = $1000

L = $3000

In the above example, C represents currency in circulation -- an asset of the non-bank public and a liability of the central bank. DD refers to demand deposits, TD to time deposits -- assets of the non-bank public and an liabilities of commercial banks. rR (required reserves), xR (excess reserves), and their sum R represent reserves and are non-income producing assets of the commercial banks and a liability of the central bank respectively. L refers to loans outstanding --

a liability of the non-bank public a and an income-producing asset for the commercial banks. Finally S is a reference to securities, specifically government securities (treasuries), that are liabilities of the Federal Government. The M1 Money Multiplier If we focus on M1 = C + DD, we find that this measure represents the main liquid financial assets of the non-bank public. In a similar manner we can define the monetary base B (also known as high-powered money), as the main liabilities of central bank. If we relate these two measures to one-another, we can define a link between the two, known as the Money Multiplier. This is accomplished as follows: M1 = [1 + (C/DD)](DD) B=R+C = [rd + (xR/DD) + (C/DD)](DD) where rd represents the reserve requirement on demand deposits. Rearranging, we can write: DD = B / [rd + (xR/DD) + (C/DD)] thus M1 = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]}B or MS = M1 = mm (B) where mm = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]} This money multiplier represents the ability of a fractional-reserve banking system to create money within the economy, that is, for each dollar of reserves; the money supply is some multiple of that value. Increasing the reserve requirements (rd) will reduce the value of the money multiplier and thus when holding the monetary base constant, reduce the money supply. Increases to the excess reserve-demand deposit ratio 'xR/DD' (pessimism among bank management) will have a similar affect on the money supply. Finally, changes in the currency-demand deposit ratio 'C/DD' will directly affect the money multiplier -- holding more cash in relative terms will reduce the money supply. Open market operations, one policy tool available to central banks, will affect the monetary base. If the central bank chooses to pursue an expansionary monetary policy, they would begin to buy government securities from the commercial banks. Payment for these securities would be in the form of reserves credited to the commercial bank's account with the central bank. Thus there is a change in the composition of assets within the commercial bank's balance sheet -- a change that lead to fewer income producing assets (securities) and more non-income producing assets (excess Reserves). Banks will attempt to convert some or all of these excess reserves to new loans by lowering the interest rate that they charge on these loans.