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)

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Side Note: Where does the Fed

get its money?
Mostly earns money off of interest payments on loans and
securities
Also seigniorage revenue. Whenever the Fed increases the
amount of money in circulation, it purchases new currency
from the U.S. Treasury for cents on the dollar.
For example, if a member bank needs an extra million
dollars, it calls the Fed to order currency, and the Fed asks
the Treasury to print the amount.
The Fed gives the money to the bank, and debits the banks
reserve account.
The Fed then invests the reserves in government securities
as collateral, and profits from the interest that accrues to
its own account. In 2006, after accounting for expenses,
the Fed returned $29 billion in profits to the U.S. Treasury.
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The Feds Balance Sheet

Liabilities
Currency in circulation: in the hands of the public
Reserves: bank deposits at the Fed and vault cash (in
banks)
Sum of reserves and currency (all of Feds liabilities) is
known as the monetary base

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
These earn higher interest than liabilities, meaning the Fed
earns billions each year

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The Feds Balance Sheet

Federal Reserve System
Assets

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Liabilities

Securities

Currency in circulation

Loans to Financial
Institutions

Reserves

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Control of the Monetary Base

High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
Monetary base is also known as high-powered money
Fed controls monetary base through open market operations,
the buying and selling of securities on the open market.
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Open Market Operations

A purchase of bonds by the Fed is known as
an open markets purchase (increases money
supply)
Fed buys bonds, gives out cash

A sale of bonds by the Fed is known as an

open market sale (decreases money supply)
Fed sells bonds, takes out cash from circulation

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Open Market Purchase

Suppose the Fed purchases $100 million of
bonds from banks (gives them $100 million
cash)
To see the impact we look at a T-account
Only shows change in assets/liabilities not the
total amount
Net result is that bank reserves have increased by
$100
No change in currency
Monetary base has risen by $100 (Feds liabilities)
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Open Market Purchase from a

Bank
Banking System
Assets

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Federal Reserve System

Liabilities

Securities

-$100m

Reserves

+$100m

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Assets
Securities

Liabilities
+$100m Reserves

+$100m

Purchase From Non-Bank Public

CASE 1
What if a company or individual sells $100
million of bonds to the Fed and deposits the
Feds check in their local bank
What happens?

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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 Feds check

in the bank
Identical result as the purchase from a bank
Note: A banks reserves are equal to cash in vaults and
cash at Fed. So increase in checkable deposits (cash on
hand) increases reserves.
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Open Market Purchase from the

Nonbank Public
The Fed has $100 million in securities as
assets
However must since bank reserves
increased by $100 million the Fed must
count this as a liability
Net Effect: Monetary base increased by
$100 million

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Open Market Purchase from the

Nonbank Public
CASE 2
What if the party selling the bonds, cash the
checks instead of depositing them in a
bank?
Sellers lose $100 million in securities but
gain $100 million in cash

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Open Market Purchase from

the Nonbank Public (contd)
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 Feds check

Reserves are unchanged (Main difference from case
1)
Currency in circulation increases by the amount of the
open market purchase
Monetary base increases by the amount of the open
market purchase
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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

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Open Market Sale

EX: The Fed sells $100 million in bonds to
banks or nonbank public
Buyers exchange $100 million in cash for
$100 million in bonds

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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

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Open Market Sale

In the case in which buyers of the bonds are
banks (or pay for bonds from checkable
deposits at a bank), the same $100 million
reduction in the money supply will occur
However now reserves will fall by $100 million
since bank deposits would have fallen by $100
million
In General: The effect of open market
operations on the monetary base is much
more certain than the effect on reserves
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Shifts from Deposits into

Currency
Even if the Fed does not conduct open
market operations, a shift from deposits to
currency will effect reserves in the banking
system
EX: Suppose its the winter holiday season
and the public wants to hold more cash
Withdraws $100 million

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Shifts from Deposits into

Currency
Nonbank Public
Assets

Banking System
Liabilities

Checkable
deposits

-$100m

Currency

+$100m

Assets
Reserves

Liabilities

-$100m Checkable
deposits

-$100m

Public withdraws $100 million, thus banking system loses

$100 million in checkable deposits and thus reserves
What is the impact on the Fed?

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Shifts from Deposits into

Currency
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

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Loans to Financial Institutions

How is the monetary base affected when the
Fed makes a loan to a financial institution?

When the Fed makes a $100 million loan to

a bank, the bank is credited with $100
million in reserves.

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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 million
Monetary base also increases by this amount
Reserves increase by $100 million
Reverse happens if bank pays off a loan
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Other Factors that Affect the

Monetary Base
As weve seen the Fed has a lot of power in
controlling the money supply
But there are factors affecting the monetary
base that the Fed does not control
Floats
Treasury deposits at the Federal Reserve

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Other Factors that Affect the

Monetary Base
Float: Product of Check clearing process of
Fed
When the Fed clears a check for banks it credits
the amount of the check to a bank (inc.
reserves) before it debits (decreases reserves) of
the bank on which the check was drawn.
Results in a temporary net increase in reserves

Treasury Deposits at the Fed

Treasury pulls money out of banks and into Fed
reduces monetary base

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Overview of The Feds Ability to

Control the Monetary Base
Weve seen two primary features determine
the monetary base:
1)Open market operations
2)Lending to financial institutions

(1) the Fed has total control over, (2) the

Fed does not
Fed can set discount rate (rate at which banks
borrow money) but cant directly control lending

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Overview of The Feds Ability to

Control the Monetary Base
Thus we should split the monetary base into two
components, one controlled by the Fed and one not
controlled by the Fed:
MBn= MB BR
OR
MB = MBn + BR
MB = Monetary base
MBn = Non-borrowed monetary base
BR = Borrowed reserves from the Fed
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

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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
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Multiple Deposit Creation: A

Simple Model (Contd)
Deposit Creation: The Banking System
Bank A
Assets
Reserves

Bank A
Liabilities

+ Checkable
$100m deposits

Assets
+ Reserves
$100m
Loans

Reserves

+
$100m

Bank B
Liabilities

+$90 Checkable
deposits

Assets
+$90 Reserves
Loans

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+$10 Checkable
deposits
+$90

Bank B
Assets

Liabilities

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Liabilities
+$9 Checkable
deposits
+$81

+$90

Table 1 Creation of Deposits (assuming

10% reserve requirement and a $100
increase in reserves)

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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
1
D = R
r
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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 banks decisions (amount of
excess reserves to hold) also cause the
money supply to change.

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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

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Factors that Determine the

Money Supply (contd)
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.
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Overview of the Money Supply

Process
Summary Table 1 Money Supply Response

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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
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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

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Deriving the
Money Multiplier (contd)
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

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Deriving the
Money Multiplier (contd)
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.

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Deriving the
Money Multiplier (contd)
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 e c
M D C and C c D
M D (c D) (1 c) D
Substituting again
1 c
M
MB
r e c
The money multiplier is then
1 c
m
r e c
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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
Although there is multiple expansion of deposits,
there is no such expansion for currency
c

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Application: The Great Depression Bank

Panics, 19301933, 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.

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Figure 1 Deposits of Failed

Commercial Banks, 19291933

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States,
18671960 (Princeton, NJ: Princeton University Press, 1963), p. 309.
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Figure 2 Excess Reserves Ratio

and Currency Ratio, 19291933

Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of
the United States, 18671960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

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Figure 3 M1 and the Monetary

Base, 19291933

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United
States, 18671960 (Princeton, NJ: Princeton University Press, 1963), p. 333.

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APPLICATIONThe 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
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Figure 4 M1 and the Monetary Base,

2007-2009

Source: Federal Reserve; www.federalreserve.gov/releases.

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Figure 5 Excess Reserves Ratio and

Currency Ratio, 2007-2009

Source: Federal Reserve; www.federalreserve.gov/releases.

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