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Chapter 17

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

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Chapter 17

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  1. Chapter 17 The Money Supply Process

  2. Players in the Money Supply Process • Central bank (Federal Reserve System) • Banks (depository institutions; financial intermediaries) • Depositors (individuals and institutions) • Borrowers

  3. Fed’s Balance Sheet • 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

  4. The Federal Reserve Balance Sheet: June 2003

  5. THE FEDERAL RESERVE BALANCE SHEET: August 2007

  6. THE FEDERAL RESERVE BALANCE SHEET: August 2009

  7. THE FEDERAL RESERVE BALANCE SHEET: Oct. 2010

  8. THE FEDERAL RESERVE BALANCE SHEET: February 2013 http://www.federalreserve.gov/releases/h41/Current/

  9. Monetary Base (High Powered Money) Note: Vault cash is included in reserves. M1 = C + DD

  10. The Money Supply Process: Fed 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?

  11. 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?

  12. 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

  13. 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

  14. 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

  15. Public withdraws $100 from Commercial Bank +$100

  16. Fed Discount Loan to a Bank $100

  17. 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

  18. 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 MB= MBn + 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

  19. Deposit Creation (Single Bank): Fed Open Market Purchase from First National Bank Step 1 Step 2 Step 3

  20. Deposit Creation: The Banking System (10% Reserve Requirement)

  21. Creation of Deposits (assuming 10% reserve requirement and the initial $100 increase in reserves)

  22. The Formula for the Deposit Multiplier

  23. Critique of the Deposit Multiplier • Holding cash stops the deposit creation process • Currency removes funds from the banking system and has no multiple deposit expansion • 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.

  24. 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

  25. 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 ratio e = (ER/D) = excess reserves ratio

  26. Deriving the M1 Money Multiplier M1 = m  MB Reserves: R = RR + ER Required Reserves: RR = r  D R = (r  D) + ER

  27. 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 ;

  28. Money Multiplier m < 1/r because of currency holding and because of ER. mis the increase in the money supply resulting from a $1 increase in MB

  29. Example

  30. 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)

  31. 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)

  32. Case Study: The Great Depression Bank Panic Deposits of Failed Commercial Banks What happened to e and c?

  33. Case Study: The Great Depression Bank Panic M1 Money Supply and the Monetary Base, 1929–1933

  34. Case Study: Money Supply 1980 -2005

  35. Determinants of the Money Supply

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