chapter 17
DESCRIPTION
Chapter 17. The Money Supply Process. Players in the Money Supply Process. Central bank (Federal Reserve System) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions) Borrowers. Fed’s Balance Sheet. Monetary Liabilities - PowerPoint PPT PresentationTRANSCRIPT
Chapter 17
The Money Supply Process
Players in the Money Supply Process
• Central bank (Federal Reserve)
• Banks (depository institutions)
• Depositors (individuals and institutions)
• Borrowers
Fed’s Balance Sheet (important items)
• Monetary Liabilities– Currency in circulation(in the hands of the public)– Reserves: bank deposits at the Fed
• Assets– Government securities: holdings by the Fed that affect
money supply and earn interest. – Fed now holding MBS.– Discount loans: provide reserves to banks and earn the
discount rate
Federal Reserve System
Assets Liabilities
Government Securities and Mortgage Backed Securities
Currency in circulation
Discount loans Reserves
The Federal Reserve Balance Sheet: June 2003
Assets and Liabilities of the Federal Reserve System, June 30, 2003(millions of dollars)
ASSETS LIABILITIES
Gold $ 11,045 $593,031 Federal Reserve notes (outstanding)
Loans to banks 36,538
U.S. Treasury securities
550,314 20,359 Bank reserves (from depository institutions)
6,219 U.S. Treasury Deposits
All other assets 46,268 24,556 All other liabilities and net worth
Total $644,165 $644,165 Total
Source: Federal Reserve Bulletin, August 2003, Table 1.18.
Federal Reserve Balance Sheet August, 2007 The Beginning of the Financial Crisis (Millions of Dollars)
ASSETS LIABILITIES
Gold $ 11,037 $777,769 Federal Reserve notes (outstanding)
Loans to banks 1,342Deposits:
U.S. Treasury securities
779,642 12,771 Bank reserves (from depository institutions)
4,572 U.S. Treasury deposit
All other assets 82,451 79,360 All other liabilities and net worth
Total $ 874,472 $874,472 Total
Source: Board of Governors of the Federal Reserve System.
THE FEDERAL RESERVE BALANCE SHEET: August 2009
ASSETS LIABILITIES
Gold $ 11,037 $872,150 Federal Reserve notes (outstanding)
Loans to banks 339,335Deposits:
U.S. Treasury securities
705,331 724,650 Bank reserves (from depository institutions)
261,487 U.S. Treasury
All other assets 936,031 133,447 All other liabilities and net worth
Total $ 1,991,734 $1,991,734 Total
Source: Board of Governors of the Federal Reserve System.
THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS LIABILITIES
Gold $ 11,037 $1122,000 Federal Reserve notes (outstanding)
Loans to banks 449 Deposits:
U.S. Treasury securities
1730,000 1,795,000 Bank reserves (from depository institutions)
Mortgages 1,083,000 42,000 U.S. Treasury
All other assets 234,000 116,000 All other liabilities and net worth
Total $ 3,075,000 $3,075,000 Total
Source: Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/releases/h41/Current/
THE FEDERAL RESERVE BALANCE SHEET: February 2013
ASSETS LIABILITIES
Gold $ 11,037 $1,315,000 Federal Reserve notes (outstanding)
Loans to banks 59 Deposits:
U.S. Treasury securities
2,450,000 2,748,000 Bank reserves (from depository institutions)
Mortgages 1,731,000 65,000 U.S. Treasury
All other assets 290,000 353,000 All other liabilities (reverse Repo) and net worth
Total $ 4,481,000 $4,481,000 Total
Source: Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/releases/h41/Current/
Monetary Base (High Powered Money)
High-powered money
= +
= currency in circulation
= total reserves in the banking system
MB C R
C
R
Note: Vault cash is included in reserves.Recall: M1 = C + DD
The Money Supply Process: Open Market Purchase From a Commercial Bank (Assume a 10% reserve requirement)
• Reserves have increased by $100. • What about excess reserves?• No change in currency• Monetary base (C + R) has increased by $100• Has the money supply changed?
Fed Open Market Purchase from Nonbank Public
• Reserves have increased by $100. • What about excess reserves?• No change in currency• Monetary base (C + R) has increased by $100• Has the money supply changed?
• 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 (C+R) increases by the amount of the open
market purchase
Open Market Purchase: Summary
• The effect on reserves in the banking system depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits
• Always increases the monetary base by the amount of the purchase:
MB = C + R
Fed Open Market Sale to non-bank public
• 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
Nonbank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in circulation
-$100
Currency -$100
Public withdraws $100 from Commercial Bank
+$100
$100
Fed Discount Loan to a Bank
Paying Off a Discount Loan from the Fed
• Net effect is to reduce the monetary base
• Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System
Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Reserves -$100 Discount loans
-$100 Discount loans
-$100 Reserves -$100
Deposit Creation (Single Bank): Fed Open Market Purchase from First National Bank
Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Securities -$100 Securities -$100 Checkable deposits
+$100
Reserves +$100 Reserves +$100
Loans +$100
First National Bank
Assets Liabilities
Securities -$100
Loans +$100
Step 1 Step 2
Step 3
Deposit Creation: The Banking System (10% Reserve Requirement)
Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable deposits
+$100 Reserves +$10 Checkable deposits
+$100
Loans +$90
Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90 Checkable deposits
+$90 Reserves +$9 Checkable deposits
+$90
Loans +$81
Creation of Deposits (assuming 10% reserve requirement and the initial $100 increase in reserves)
The Formula for the Simple Deposit Multiplier
Assuming banks do not hold excess reserves
Required Reserves ( ) = Total Reserves ( )
= Required Reserve Ratio ( ) times the total amount
of checkable deposits ( )
Substituting
=
Dividing both s
RR R
RR r
D
r D Rides by
1 =
Taking the change in both sides yields
1 =
r
D Rr
D Rr
Critique of the Deposit Multiplier
• Currency removes funds from the banking system and stops the deposit creation process
• Holding excess reserves stops the deposit creation process. Banks may not use all of their excess reserves to buy securities or make loans.
• Depositor decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) affect the money supply and the Fed’s ability to control the money supply.
The M1 Money Multiplier
• M1 =currency + checkable deposits = C + D
• Link the money supply (M1) to the monetary base (MB) and let m be the money multiplier
• Recall: MB = C + R
• This is why the MB is called High Powered Money
M1 = m x MB
Deriving the M1 Money Multiplier
Let’s assume that the desired holdings of currency (C) and excess reserves (ER) grow proportionally with checkable deposits D.
Then,
c = (C/D) = currency ratioe = (ER/D) = excess reserves ratio
Deriving the M1 Money Multiplier: m
M1 = m MB
Reserves: R = RR + ERRequired Reserves: RR = r D R = (r D) + ER
1Mm
MB
Deriving the M1 Money Multiplier
Math Trick: MB = RR + ER + C
MB = (r D) + (ER/D D) + (C/D D)
MB = (r + e + c) D ; Where e=(ER/D) and c =(C/D)
M1 = D + C = D + (C/D D) M1 = (1+ c) D ;
M1 Money Multiplier
m < 1/r
because of currency holding and ER.
m is the increase in the money supply resulting from a $1 increase in MB
1 (1 ) (1 )
( ) ( )
M c xD cm
MB r e c xD r c e
Example
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
c $400B
$800B0.5
e $0.8B
$800B0.001
m 10.5
0.10.0010.5 1.5
0.6012.5
This is less than the simple deposit multiplier
Although there is multiple expansion of deposits,
there is no such expansion for currency
Case Study: The Great Depression Bank Panics, 1930 - 1933.
• Bank failures (and no deposit insurance) caused:– Increase in deposit outflows and holding of
currency (depositors)– An increase in the amount of excess reserves
(banks)
Case Study: The Great Depression Bank Panic, 1930 - 1933. Deposits of Failed Commercial Banks
• Bank failures (and no deposit insurance) caused:– Increase in deposit
outflows and holding of currency (depositors)
– An increase in the amount of excess reserves (banks)
Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?
Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933
Case Study: Money Supply 1980 -2005
Determinants of the Money Supply