LEARNING OBJECTIVES

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain the relationship between the Fed’s balance sheet and the monetary base. 14.1 Derive the equation for the simple deposit multiplier and understand what it means. 14.2 Explain how the behavior of banks and the nonbank public affect the money multiplier. 14.3 Appendix: Describe the money supply process for M2. 14A

3. High Times for “Gold Bugs” • “Gold bugs” refer to investors who have always wanted to hold gold. • Beginning in 2008, demand for gold as an investment soared. As a result, the gold price reached a record high of $1,780 per ounce in late 2011. • The motives of investors differed, but many were concerned with the consequences of the government action during the financial crisis. • Despite low inflation through 2012, holding gold is a way for some investors to hedge the risk of inflation created by a rapid increase in the money supply.

4. Key Issue and Question Issue: Years after the end of the financial crisis, banks continued to hold record levels of reserves. Question: Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should policymakers be concerned about the increase?

5. 14.1 Learning Objective Explain the relationship between the Fed’s balance sheet and the monetary base.

6. The Federal Reserve’s Balance Sheet and the Monetary Base The Federal Reserve’s Balance Sheet and the Monetary Base The model of how the money supply is determined includes three actors: 1. The Federal Reserve:responsible for controlling the money supply and regulating the banking system. 2. The banking system: creates the checking accounts that are a major component of M1. 3. The nonbank public (all households and firms): decides the form in which they wish to hold money (e.g., currency vs. checking deposits).

7. The Federal Reserve’s Balance Sheet and the Monetary Base Figure 14.1 The Money Supply Process Three actors determine the money supply: the Fed, the nonbank public, and the banking system.

8. The Federal Reserve’s Balance Sheet and the Monetary Base The process starts with the monetary base. Monetary base (or high-powered money) is the sum of bank reserves and currency in circulation. Monetary base = Currency in circulation + Reserves. The money multiplier links the monetary base to the money supply. When the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. There is a close connection between the monetary base and the Fed’s balance sheet.

9. The Federal Reserve’s Balance Sheet and the Monetary Base

10. The Monetary Base Currency in circulation is paper money and coins held by the nonbank public. Vault cash is currency held by banks. Currency in circulation = Currency outstanding – Vault cash. Bank reserves are bank deposits with the Fed plus vault cash. Reserves = Bank deposits with the Fed + Vault cash. • Reserve deposits are assets for banks and liabilities for the Fed. Why? • Banks can request that the Fed repay the deposits on demand with Federal Reserve Notes. The Federal Reserve’s Balance Sheet and the Monetary Base

11. Reserves = Required reserves + Excess reserves. Required reserves are reserves that the Fed requires banks to hold. Excess reserves are reserves that banks hold above those the Fed requires to hold. Reserves = Required reserves + Excess reserves. Required reserve ratio is the percentage of checkable deposits that the Fed specifies that banks must hold as reserves. The Federal Reserve’s Balance Sheet and the Monetary Base

12. How the Fed Changes the Monetary Base The Fed changes the monetary base by changing the levels of its assets— through buying and selling Treasury securities or making discount loans to banks. • Open market operations are the Fed’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. • Open market purchase is the Fed’s purchase of securities. • Open market sale is the Fed’s sale of securities. Open market operations are carried out electronically with primary dealers by the Fed’s trading desk. In 2012, there were 21 primary dealers (commercial banks, investment banks, and securities dealers). The Federal Reserve’s Balance Sheet and the Monetary Base

13. Example: Open market purchase—the Fed buys $1 million worth of Treasury bills from Bank of America . T-account for the whole banking system and the Fed: Result: The monetary base increases by the dollar amount of an open market purchase. The Federal Reserve’s Balance Sheet and the Monetary Base

14. Example: Open market sale—the Fed sells $1 million worth of Treasury bills to Barclays Bank. T-account for the whole banking system and the Fed: Result: The monetary base decreases by the dollar amount of an open market sale. The Federal Reserve’s Balance Sheet and the Monetary Base

15. The public’s preference for currency relative to checkable deposits does not affect the monetary base. Example: Households and firms decide withdraw $1 million from their checking accounts. One component of the monetary base (reserves) has fallen while the other (currency in circulation) has risen. The Federal Reserve’s Balance Sheet and the Monetary Base

16. Discount Loans • Discount loan is a loan made by the Fed to a commercial bank. • Discount loans alter bank reserves. • An increase in discount loans affects both sides of the Fed’s balance sheet: • $1 million of discount loans increases bank reserves and the monetary base by $1 million The Federal Reserve’s Balance Sheet and the Monetary Base

17. If banks repay $1 million in discount loans to the Fed, the preceding transactions are reversed. The Federal Reserve’s Balance Sheet and the Monetary Base

18. Comparing Open Market Operations and Discount Loans Both open market operations and discount loans change the monetary base, but the Fed has greater control over open market operations. The discount rate differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets. The monetary base (B) includes: the nonborrowed monetary base (Bnon) and borrowed reserves (BR) (same as discount loans). The Fed has control over the nonborrowed monetary base. Discount rate is the interest rate the Fed charges on discount loans. B = Bnon + BR. The Federal Reserve’s Balance Sheet and the Monetary Base

19. Making the Connection Explaining the Explosion in the Monetary Base The monetary base increased sharply in the fall of 2008 and stayed at high levels through 2012. Most of the increase occurred because of an increase in the bank reserves component, not the currency in circulation component. The Fed’s holdings of Treasury securities actually fell while the base was exploding. As the Fed began to purchase assets connected with Bear Stearns and AIG, the asset side of its balance sheet expanded, and so did the monetary base. Key point: Whenever the Fed purchases assets of any kind, the monetary base increases. The Federal Reserve’s Balance Sheet and the Monetary Base

20. Making the Connection Explaining the Explosion in the Monetary Base The Federal Reserve’s Balance Sheet and the Monetary Base

21. 14.2 Learning Objective Derive the equation for the simple deposit multiplier and understand what it means.

22. The Simple Deposit Multiplier The money multiplier helps us understand the factors that determine the money supply. The money multiplier is determined by the actions of three actors in the economy: the Fed, the nonbank public, and banks. Multiple Deposit Expansion How a Single Bank Responds to an Increase in Reserves Example: The Fed purchases $100,000 in Treasury bills from Bank of America: The Simple Deposit Multiplier

23. Next, Bank of America extends a loan to Rosie’s Bakery: Rosie’s spends the loan proceeds by writing a check for $100,000 to buy ovens from Bob’s Bakery Equipment, so Bank of America loses $100,000 checkable deposits: The Simple Deposit Multiplier

24. How the Banking System Responds to an Increase in Reserves Suppose Bob’s deposits the check in its account with PNC Bank. After PNC has cleared the check and collected the funds from Bank of America: Suppose that PNC makes a $90,000 loan to Jerome’s Printing who writes a check in that amount for equipment from Computer Universe who has an account at SunTrust Bank: The Simple Deposit Multiplier

25. Suppose that SunTrust lends its new excess reserves of $81,000 to Howard’s Barber Shop to use for remodeling: If the proceeds of the loan to Howard’s Barber Shop are deposited in another bank, checkable deposits in the banking system will rise by another $81,000. So far, the level of checkable deposits has increased by $100,000 + $90,000 + $81,000 = $271,000. This process is called multiple deposit creation. • Multiple deposit creation is part of the money supply process in which an • increase in bank reserves results in rounds of bank loans and creation of checkable deposits. • As a result, an increase in the money supply is a multiple of the initial increase in reserves. The Simple Deposit Multiplier

26. Calculating the Simple Deposit Multiplier Simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. The Simple Deposit Multiplier

27. The Simple Deposit Multiplier

28. 14.3 Learning Objective Explain how the behavior of banks and the nonbank public affect themoney multiplier.

29. Banks, the Nonbank Public, and the Money Multiplier The Effect of Increases in Currency Holdings and Increases inExcess Reserves Key assumptions for deriving the money multiplier: 1. Banks hold no excess reserves. 2. The nonbank public does not increase its holdings of currency. Banks, the Nonbank Public, and the Money Multiplier

30. The Effect of Increases in Currency Holdings and Increases inExcess Reserves • In order to build a complete account of the money supply process, we change the simple deposit multiplier in three ways: • 1. Rather than a link between reserves and deposits, we need a link between the monetary base and the money supply. • 2. We need to include the effects of changes in the nonbank public’s desire to hold currency relative to checkable deposits. • The more currency the nonbank public holds relative to checkable deposits, the smaller the multiplier deposit creation process. • 3. We need to include the effects of changes in banks’ desire to hold excess reserves. • The more excess reserves banks hold relative to their checkable deposits, the smaller the multiplier deposit creation process. Banks, the Nonbank Public, and the Money Multiplier

31. Deriving a Realistic Money Multiplier Banks, the Nonbank Public, and the Money Multiplier

32. Currency-to-deposit ratio (C/D) is the ratio of currency held by the nonbank public, C, to checkable deposits, D. Banks, the Nonbank Public, and the Money Multiplier

33. A money multiplier of 2 means that every $1 billion increase in the monetary base will result in a $2 billion increase in the money supply. Banks, the Nonbank Public, and the Money Multiplier

34. Key points about the multiplier expression: 1. The money supply will change in the same direction of a change in the monetary base or the money multiplier. 2. An increase in C/D causes the value of the money multiplier and the money supply to decline. 3. An increase in rrD causes the value of the money multiplier and the money supply to decline. 4. An increase in ER/D causes the value of the money multiplier and the money supply to decline. Banks, the Nonbank Public, and the Money Multiplier

35. Solved Problem 14.3 Using the Expression for the Money Multiplier Bank reserves = $500 billion Currency = $400 billion a. If banks are holding $80 billion in required reserves, and the required reserve ratio = 0.10, what is the value of checkable deposits? b. Given this information, what is the value of the money supply (M1)? What is the value of the monetary base? What is the value of the money multiplier? Banks, the Nonbank Public, and the Money Multiplier

36. Solved Problem Solved Problem 14.3 Using the Expression for the Money Multiplier Solving the Problem Step 1Review the chapter material. Banks, the Nonbank Public, and the Money Multiplier

37. Solved Problem Solved Problem 14.3 Using the Expression for the Money Multiplier Solving the Problem Banks, the Nonbank Public, and the Money Multiplier

38. Banks, the Nonbank Public, and the Money Multiplier

39. The Money Supply, the Money Multiplier, and the Monetary Base During the 2007–2009 Financial Crisis Movements in the Monetary Base, M1, and the Money Multiplier, 1990–2010 Figure 14.2 Panel (a) shows that beginning in the fall of 2008, the size of the monetary base soared. M1 also increased, but not nearly as much. Panel (b) shows that the e value of the money multiplier declined sharply during the same period. Banks, the Nonbank Public, and the Money Multiplier

40. Why did the monetary base increase so much more than M1? Figure 14.3 Movements in (C/D) and (ER/D) The currency-to-deposit ratio (C/D) fell during the financial crisis of 2007–2009, while the excess reserves-to–deposits ratio (ER/D) soared. Banks, the Nonbank Public, and the Money Multiplier

41. Making the Connection Did the Fed’s Worry over Excess Reserves Cause the Recession of 1937–1938? Following the end of the bank panics in early 1933, excess reserves in the banking system soared. Many banks had suffered heavy losses and had a strong desire to remain liquid. Nominal interest rates had also fallen to very low levels, which reduced the opportunity cost of holding reserves. By late 1935, unemployment remained high and inflation low. Yet the Fed worried about a rapid increase in stock prices and higher inflation. The Board of Governors decided to reduce excess reserves by raising the required reserve ratio. But the Fed’s policy ignored the reasons banks were holding excess reserves. As bank loans contracted, so did the money supply. The economy fell into recession again in 1937. Banks, the Nonbank Public, and the Money Multiplier

42. Making the Connection Did the Fed’s Worry over Excess Reserves Cause the Recession of 1937–1938? The Fed reversed course in April 1938 by cutting the required reserve ratio. Banks, the Nonbank Public, and the Money Multiplier

43. In 2012, banks’ enormous holdings of excess reserves raise concerns about the implications for future inflation. If banks were to suddenly begin lending the nearly $1 trillion in excess reserves, the result would be a rapid increase in the money supply and inflation. Fear of this potential for a much higher rate of inflation in the future drove some investors in 2012 to buy gold. Banks, the Nonbank Public, and the Money Multiplier

44. In Your Interest Making the Connection In You Are Worried About Inflation, Should You Invest in Gold? Beginning in 2008, many investors bought gold for the fear of higher inflation in the future. But how good an investment is gold? Drawbacks of gold as an investment: Gold pays no interest or dividend; it has to be stored and safeguarded. Because gold pays no interest, it is difficult to determine its fundamental value as an investment. Gold’s value depends on how likely its price is to increase in the future. Many individual investors believe that gold is a good hedge against inflation because the price of gold can be relied on to rise if the general price level rises. But is this view correct? The record of the past 30 years does not support it. Banks, the Nonbank Public, and the Money Multiplier

45. In Your Interest Making the Connection In You Are Worried About Inflation, Should You Invest in Gold? In 2012, the real price of gold (the nominal price of gold divided by the consumer price index) was still below its September 1980 level. Banks, the Nonbank Public, and the Money Multiplier

46. Answering the Key Question At the beginning of this chapter, we asked the question: “Why did bank reserves increase rapidly during and after the financial crisis of 2007–2009, and should policymakers be concerned about the increase?” The rapid increase in bank reserves beginning in 2008 was a result of the Fed purchasing assets. Banks held large balances of excess reserves because the Fed was paying interest on them and the increased risk in alternative uses of the funds. Inflation remained very low through 2012, but some policymakers were concerned that if banks began to lend out their holdings of excess reserves, a future increase in the inflation rate was possible.

47. The Money Supply Process for M2 Describe the money supply process for M2. 14A M2 is a broader monetary aggregate than M1, including not only currency, C, and checkable deposits, D, but also nontransaction accounts. These nontransaction accounts consist of savings and small-time deposits, which we will call N, and money market deposit accounts and similar accounts, MM. So we can represent M2 as: M2 = C + D + N + MM. We can express M2 as the product of an M2 multiplier and the monetary base: M2 = (M2 multiplier) x Monetary base.