Four (4) Players in the Money Supply Process

The cast of characters in the money supply story is as follows: 1. Central Bank 2. Banks (Depository Institution) 3. Depositors 4. Borrowers from Banks

CENTRAL BANK
Central Bank is a the government agency that oversees the banking system and is responsible for the conduct of monetary policy.

BANKS
Banks are financial intermediaries that accept deposits from individuals and institutions and make loans.

DEPOSITORS
Depositors are individuals and institutions that holds deposit in banks.

BORROWERS
Borrowers are individuals and institutions that borrow from the depository institutions. Borrowers are institutions that also issue bonds that are purchased by the depository institutions.

The FEDs Balance Sheet Federal Reserve System

ASSETS -government securities -discount loans LIABILITIES -currency in circulation -reserves

LIABILITIES
1. 2. Currency in Circulation - is the amount of currency in the hands of the public Reserves - consists of deposits at the Fed plus currency that is physically held by banks -are assets of the bank -liabilities of the fed

2 Categories of Reserves
Required Reserves reserves that the Fed requires the bank to hold Excess Reserves any additional reserves the banks choose to hold

ASSETS
1. 2. Government Securities -this category of assets covers the Feds holding of securities issued by the US Treasury Discount Loans -Fed can provide reserves to the banking system by making discount loans to banks *Discount Rate interest rate charged banks for these loans

Control Of The Monetary Base

Monetary Base -also called high-powered money MB = CFR

The Federal Reserve exercises control over the monetary base through its purchases or sale of government securities in the open market, called open market operations, and through its extension of discount loans to banks.

Federal Reserve Open Market Operations

-primary way in which the Fed causes changes in the monetary base Open Market Purchase a purchase of bond by the Fed Open Market Sale - a sale of bonds by the Fed

Open Market Purchase from a Bank

Banking System Assets Securities -$100 Reserves +$100 Liabilities

Federal Reserve System Assets Securities +$100 Liabilities Reserves +$100

Open Market Purchase from the Non Bank Public

Non Bank Public Assets Securities -$100
Checkable Deposits +$100

Liabilities

Banking System Assets Reserves +$100 Liabilities

Checkable Deposits +$100

Federal Reserve System Assets Liabilities Securities +$100 Reserves +$100

Non Bank Public

Assets Securities -$100 Currency +$100 Liabilities

Federal Reserve System

Assets Securities +$100

Liabilities
Currency in Circulation +$100

 Analysis reveals that 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 in deposits.

The effects of an open market purchase on the monetary base, however is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency.

Open Market Sale

Non bank Public Assets Securities +$100 Currency -$100 Liabilities

Federal Reserve System Assets Securities -$100 Liabilities

Currency in Circulation -$100

 CONCLUSION : The effect of open market operations on the monetary base is much more certain than the effect on reserves.

Shifts from Deposits into Currency

A shift from deposits to currency will affect the reserves in the banking system

Non Bank Public

Assets
Checkable Deposits -$100

Liabilities

Currency

+$100
Banking System

Assets Reserves -$100

Liabilities
Checkable Deposits -$100

Federal Reserve System Assets Liabilities

Currency in Circulation +$100

Reserves

-$100

 Monetary Base is also affected when the Fed makes a discount loan to a bank.

Discount Loans
Banking System
Asset

Liabilities
+$100 Discount Loans (borrowings from Fed) +$100

Reserves

Federal Reserve System

Asset
Discount Loans (borrowings from Fed) +$100 Reserves

Liabilities
+$100

Banking System Asset

Reserves

Liabilities
-$100 Discount Loans (borrowings from Fed) -$100

Federal Reserve System Asset

Discount Loans (borrowings from Fed) -$100 Reserves

Liabilities
-$100

Other Factors that affect Monetary Base

Two important items that are not controlled by the Fed but affect Monetary Base are: 1. float 2. treasury deposits

1. float the resulting temporary net increase in the total amount of reserves in the banking system occurring from the Feds check-clearing process 2. treasury deposits when the US Treasury moves deposits from commercial banks to its account at the Fed, leading to an increase in Treasury deposits at the Fed, it causes a deposit outflow at these banks and thus causes reserves in the banking system and monetary base to decrease


Float and Treasury deposits at the Fed both affect Monetary Base but are not fully controlled by the Fed

 Although float and treasury deposits with the Fed

undergo substantial short-run fluctuations, which complicate control of monetary base, they do not prevent the Fed from accurately controlling it.

Overview of the Feds Ability to Control the Monetary Base

Multiple Deposit Creation : A Simple Model

When the Fed supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount a process called multiple deposit creation.

Deposit Creation : The Single Bank

First National Bank Asset Liabilities
Securities Reserves -$100 +$100

First National Bank Asset Liabilities

Securities Reserves Loans -$100 Checkable Deposits +$100 +$100 +$100

 A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes loan.

Final T-Account of First National Bank

First National Bank Asset Liabilities
Securities Loans -$100 +$100

Deposit Creation : The Banking System

Bank A Asset
Reserves

Liabilities
+$100 Checkable Deposits +$100

Bank A Asset
Reserves Loans +$10 +$90

Liabilities
Checkable Deposits +$100

Bank B Asset
Reserves +$90

Liabilities
Checkable Deposits +$90

Bank B
Asset
Reserves Loans +$9 +$81

Liabilities
Checkable Deposits +$90

Bank B

Asset
Reserves Securities +$10 +$90

Liabilities
Checkable Deposits +$100

Whether a bank chooses to use its excess reserves to make loans to purchase securities, the effect on deposit expansion is the same. FORMULA FOR MULTIPLE EXPANSION if deposits can be written as follows. 1 = Where = change in total checkable deposits in banking system = required reserve ratio = change in reserves for banking system

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creation of deposits can be derived directly using algebra. We obtain the same answer for the relationship between a change in deposits and a change in reserves, but more quickly.

 Total amount of required reserves for banking system RR will equal total reserves in banking system R: =

Total amount of required reserves:

= Substituting r x D for RR: =

Dividing both sides of the preceding equation by r gives: 1 =

Taking the change in both sides of this equation and using delta to indicate a change gives 1 =
Which is the same formula for deposit creation found in Equation 1.

Critique of the Simple Model

Our model of multiple deposit creation seems to indicate that the Federal Reserve is able to exercise complete control over level of checkable deposits by setting the reserve required ratio and level of reserves. Banks decisions regarding the amount of excess reserves to hold, depositors decisions regarding how much currency to hold, and borrowers decision on how much to borrow from banks can cause the money supply to change.