Chapter 8 -- The Money Supply Process

Chapter 8 — The Money Supply Process

Players in the Money Supply Process

  • Central bank (Federal Reserve System)
  • Banks (depository institutions; financial intermediaries)
  • Depositors (individuals and institutions)

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

Other Factors Affecting the Monetary Base

  • Float
  • Treasury deposits at the Federal Reserve
  • Interventions in the foreign exchange market

Fed’s Ability to Control the Monetary Base

  • Open market operations are controlled by the Fed
  • The Fed cannot determine the amount of borrowing by banks from the Fed
  • Split the monetary base into two components

 MBn= MB – BR

  • 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

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 bank’s decisions (amount of excess reserves to hold) also cause the money supply to change.

Chapter 8 -- The Money Supply Process

Fed’s Balance Sheet

Federal Reserve System
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves
  • Monetary Liabilities

–Currency in circulation: in the hands of the public

–Reserves: bank deposits at the Fed and vault cash

  • 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

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

Factors that Determine the Money Supply

  • 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.

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 x MB

Deriving the Money Multiplier III

  • 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 check able deposits, currency and excess reserves.

Application: The Great Depression Bank Panics, 1930 – 1933.

  • 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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