Lesson 12: The Money Supply Process

Upon completion of this lesson, you should be able to do the following:

  • Descirbe how the public, banks, and the Fed influence the money supply through multiple deposit expansion and multiple deposit contraction.
  • Identify how the monetary base is related to the money supply.
  • Explain the basic items on the Fed's balance sheet.
  • Explain why the Fed cannot precisely control the money supply.

Introduction

This lesson focuses on the money supply process. The money supply has a big impact on interest rates, exchange rates, inflation, and a country's production of goods and services. Money supply fluctuations affect the financial markets, the prices of goods and services, and general economic well being. The Fed cannot completely control the money supply. The behavior of the public and banks can influence the money supply. For this lesson, you will be using the narrowest definition of money, which is the M1 definition. The model will only examine currency and checkable deposits.

Influencing the Money Supply

The monetary base is the total of all currency in circulation and reserves held by banks. The Fed can directly influence the monetary base and the monetary base influences the money supply. To understand how the money supply process works, the Fed's balance sheet must be introduced. In this lesson, only several items are introduced. In lesson 13, you will learn all the major components of the Fed's balance sheet. The Fed's liabilities are the currency in circulation and bank reserves.

  1. Currency in circulation - the Federal Reserve Notes the public is holding, i.e. U.S. money. This does not include vault cash at banks, because vault cash is already counted as bank reserves. Let's keep this example and lesson simple.

  2. Bank reserves - reserves held at the Fed or in a bank vault. The required reserve ratio is the percentage of total deposits that banks must hold. If a bank bank holds reserves above this amount, then it is called excess reserves. The important thing to notice is bank reserves are assets to the bank, but liabilities to the Fed. The money the public is holding is an asset to them, but a liability to the Fed.

The two major assets the Fed has are government securities and discount loans.

  1. When the Fed increases its assets, the monetary base increases. When the Fed decreases its assets, the monetary base decreases. The first and direct method to change the monetary base is through open market operations. Open market operations occur, when the Fed buys and sells financial securities. Usually the Fed buys and sells U.S. government securities. When the Fed buys U.S. government securities, it is called an open market purchase. The Fed's assets increase, causing the monetary base to increase. The Fed can also sell U.S. government securities, which is called an open market sale. The Fed's assets decrease, causing the monetary base to decrease.

    For example, the Fed buys a $10,000 T-bill from your bank. The transaction is listed below:

Your Bank

Assets Liabilities
-$10,000 T-bill

+$10,000 Deposit at the Fed

 

The Fed

Assets Liabilities
+$10,000 T-bill +$10,000 Bank reserves
  • The Fed buys the T-bill by using a Fed check. When the bank sends the check to the Fed, the Fed increases the reserves at your bank. There is no money behind the Fed check; its more like adding more numbers in a bank's accounting books. The bank's reserves increase and your bank will make a loan to someone, so the bank can earn interest. The Fed's assets increase, the monetary base increases, and the money supply increases.

    The second example, the Fed buys one T-bill from you for $10,000, using a Fed check. You deposit the Fed check at your bank.

You
Assets Liabilities
-$10,000 Treasury Bill

+$10,000 Demand Deposit (Checking)

 

Your Bank

Assets Liabilities
+$10,000 Fed Reserve Deposit +$10,000 Demand Deposit

The Fed

Assets Liabilities
+$10,000 T-bill +$10,000 Bank reserves
  • The money supply increased, because you traded the T-bill for a demand deposit. It makes no difference if the Fed buys U.S. securities from the public or a bank. The Fed's assets increase, causing the monetary base to increase. Your bank's reserves increase and your bank can make loans to earn interest. Then the money supply increases. If the Fed sells U.S. government securities, the opposite occurs.

The Fed's second asset is loans. The Fed can extend loans to banks, which helps the banks survive liquidity problems. The Fed loans are called discount loans. The interest rate the Fed charges for these loans is called the discount rate. The Fed does not use loans to influence the monetary base. Instead, the Fed relies on open market operations, because the Fed has complete control over how much securities it wants to buy and sell. With discount loans, the banks determine if they want to borrow from the Fed or not. The Fed cannot force a bank to accept a loan. However, if the Fed makes more discount loans, the Fed's assets increase, causing the monetary base and money supply to increase. For example, a bank asks the Fed for a loan of $1 million.

The Bank
Assets Liabilities
Reserves at Fed +$1 million Loan from Fed +$1 million

The Fed

Assets Liabilities
Loan to institution +$1 million Bank reserves +$1 million
  • The bank's reserves increased by $1 million, and now the bank can make more loans, which will increase the money supply. When the bank repays the Fed loan, the Fed's assets decrease, the monetary base decreases, and the money supply decreases. The transaction is listed below:

The Bank
Assets Liabilities
Reserves at Fed -$1 million Loan from Fed -$1 million

The Fed

Assets Liabilities
Loan to institution -$1 million Bank deposit at Fed -$1 million
  • In this next example, the Fed increases the monetary base, which causes the money supply to increase. The money supply is created through multiple deposit expansion. This means when the Fed increases the monetary base by $1, then the amount of checkable deposits will increase by more than $1. Checkable deposits are one component of the M1 definition of money, so the money supply increases by more than $1. The Fed wants to increase the money supply, so the Fed buys a $10,000 U.S. T-bill from you. You take the Fed check and deposit it at your bank.

Your Bank
Assets Liabilities
Required Reserves $1,000

Excess Reserves $9,000

Deposits $10,000
  • The money supply immediately increases by $10,000. The bank is required to hold 10% of its deposits as required reserves. The bank holds $1,000 for your account either as a deposit at the Fed or as vault cash. However, the bank has $9,000 in excess reserves. These reserves earn no interest, so the bank loan them out. Let your bank make a $9,000 car loan to your friend. The transaction is listed below:

Your Bank
Assets Liabilities
Required Reserves $1,000 

Excess Reserves $0

Loans $9,000

Deposits $10,000
  • The bank will write a check to your friend for $9,000. Your friend takes this check to a car dealership and buys a car. The car dealer deposits this check at his bank. The transaction is listed below:

Car Dealer's Bank
Assets Liabilities
Required Reserves $900

Excess Reserves $8,100

Loans $0

Deposits $9,000
  • The first thing to notice is the change in the money supply. The money supply has increased by $19,000. The $10,000 is sitting in your account and the $9,000 is in the car dealer's account. The car dealer's bank is required to hold 10% of the deposit, which is $900. The remaining funds, $8,100, earns no interest, so the car dealer's bank can loan this out. The car dealer grants a $8,100 business loan. The transaction is below:

Car Dealer's Bank
Assets Liabilities
Required Reserves $900

Excess Reserves $0

Loans $8,100

Deposits $9,000
  • The small business contracts with a construction company to renovate the business. The construction company receives a check for $8,100 and deposits this check in its bank. The transaction is listed below:

Construction Company's Bank
Assets Liabilities
Required Reserves $810

Excess Reserves $7,290

Loans $0

Deposits $8,100
  • The construction company's bank is required to hold 10% of this deposit, which is $810. The remaining reserves, $7,290, earns no interest, so this bank will grant a loan. The important thing to notice is the change in the money supply. The money supply increases to $27,100, which includes $10,000 in your account, $9,000 in the car dealer's account, and $8,100 in the construction company's account. When the construction company's bank grants a loan, then the money supply will increase again and this multiple deposit expansion will occur indefinitely.

Monetary Base and Money Supply

A formula can be derived that shows the maximum change in the money supply when the monetary base changes. First we start with the formula for total reserves. Total bank reserves equal required reserves plus excess reserves.

Total Reserves = Required Reserves + Excess Reserves

In this case, excess reserves equal zero, because banks earn no interest. The banks use this to make loans. The second equation is required reserves. When a bank accepts a new checking account, the bank is required to hold a percent of the deposit. The formula is listed below:

Required Reserves = Deposits * Required Reserve Ratio (rr)

Substitute this equation into the total reserves equation. Remember, the excess reserves equal zero.

Total Reserves = Deposits * rr

The important thing is how the money supply changes when bank reserves change. The formula is modified below. The symbol means change.

D Reserves = D Deposits * rr

Rearranging the equation, the equation shows how the money supply changes when bank reserves change.

D Deposits = D Reserves * ( 1 / rr )

If the Fed increases the money base by buying $10,000 of T-bills, then bank reserves increase by $10,000. If the required reserve ratio is 10%, then substitute this into the equation. The total change in checkable deposits will be $100,000. This formula is called the simple deposit multiplier, which equals ( 1 / rr ). The simple deposit multiplier shows the maximum increase of the money supply for a change in bank reserves. The money multiplier will be smaller in the real world because of leakages. Some people withdraw cash, when they deposits checks at the bank and some banks may hold onto their excess reserves as a safety measure.

The Fed can decrease the monetary base by selling its assets, causing bank reserves to decrease and the money supply to contract. The result of the Fed's sell of securities is called the multiple deposit contraction. The transaction is very similar to multiple deposit expansion, except all the numbers are negative.

As you can see, the Fed can control the monetary base very easily, but less control over the money supply. For instance, a change in the public's behavior can have an impact on bank reserves. For example, you went to your bank to withdraw $200. The transaction is listed below:

Your Bank
Assets Liabilities
Required Reserves $1,000 - $200

Excess Reserves $0

Loan $9,000

Deposits $10,000

-$200

The bank pays you $200 out of required reserves. The bank does not have any excess reserves, because it loaned the excess reserves out. Your deposit is now $9,800 and the bank is required to hold $980 in required reserves. However, it only has $800, so the bank is short $180. The bank has to call in loans. When the bank calls in loans, this causes other banks to lose deposits, so the money supply decreases by:

-$1,800 = -$180 * (1 / 0.10)

Your $200 is not included, because you converted $200 from a checkable deposit into currency. Remember the M1 definition of money, which is listed below: The starting point is the $180.

M1 = checkable deposits + currency

Just by people desiring to hold more currency and less deposits can cause bank reserves to decrease, contracting the money supply. Economists examine the proportion of cash to checkable deposits in the measure called the currency-deposit ratio (C/D). This ratio changes over time and is affected by four factors.

  1. Wealth - when a country becomes wealthier, people have higher income. Holding large amounts of currency is risky, so people tend to deposit their money into banks. The currency-deposit ratio decreases.

  2. Interest rates - bank deposits pay interest rates, while currency does not. When interest rates increase, people will tend to deposit more money into banks to earn the higher interest rate. The currency-deposit ratio increases.

  3. Risk - during a bank panic, people convert their deposits into currency. This has a detrimental effect on an economy. When deposits are converted into currency, bank reserves decreases, the multiple deposit contracts, causing the money supply to decrease. A contracting money supply can cause a recession. The currency-deposit ratio increases.

  4. Underground activities - people participating in these activities do not want the government to know about it, so they tend to deal exclusively with currency. Bank accounts leave transaction records. The currency-deposit ratio will increase, if people avoid paying taxes or participate in other illegal activities.

What if the Fed bought a T-bill from you for $10,000 and you took the Fed check to a bank and wanted the money in cash. In this case, total bank reserves do not change, but currency in circulation increases by $10,000 and the monetary base still increases by $10,000. The effect of an open-market purchase on the monetary base is always the same, whether the proceeds from the sale are kept in deposits or currency. When the Fed sells a U.S. government securities, it decreases the monetary base by the amount of government securities sold. The Fed can effectively control the monetary base.

The Money Multiplier Formula

The money multiplier is the ratio that relates the change in the money supply to a given change in the monetary base. In the simple deposit multiplier, the multiplier equaled to 1 / rr. The equation below starts with the M1 definition of money defined as a ratio to the monetary base:

M1 = m * B

M1 : Money supply definition 1.

m: Money multiplier.

B: Monetary base.

The currency-deposit ratio and reserve-deposit ratio are fixed and are listed below. Now in this example, the public can hold a combination of currency and deposits.

C / D : Currency-deposit ratio.

R / D : Total reserves-deposits ratio.

The M1 definition of the money supply is defined below. The M1 is simply currency plus checkable deposits. The monetary base is simply total bank reserves plus currency.

M1 = C + D

B = C + R

There is a clever substitution. Start off with the equation below. As you can see, the monetary base cancels out and M1 = M1.

M1 = (M1 / B) * B

Now substitute M1 = C + D and B = C + R into the equation. Only substitute these equations into the M1 and B which are listed in parenthesis.

M1 = [(C + D) / (C + R)] * B

The term in brackets is the money multiplier. Times the numerator and denominator of this fraction by D. The result is below:

M1 = [(C/D + 1) / (C/D + R/D)] * B

If the currency in circulation equals $240 billion, checkable deposits equal $600 billion, and total bank reserves equal $60 billion, then substitute these numbers into the currency-deposit ratio and total reserves-deposit ratio.

C / D = $240 B / $600 B = 0.40

R / D = $60 B / $600 B = 0.10

If the banks hold no excess reserves, then R / D equals the required reserve ratio. Substitute this into the equation.

M1 = [(0.40 + 1) / (0.40 + 0.10)] B

M1 = 2.8 B

The money multiplier equals 2.8. If the Fed buys $100,000 in T-bills, the monetary base increases by $100,000 and the M1 money supply increases by $280,000. This multiplier assumes that banks lend out their excess reserves. The banks can weaken the ratio between the monetary base and money supply. For example, if the Fed increased the monetary base by buying $100,000 in T-bills and the banks end up holding this change in excess reserves, then there is no effect on the money supply. The banks do not lend out any reserves, therefore deposits are not created and the money supply does not increase.

If the money multipliers are unstable, the Fed can have problems implementing monetary policy. The Fed can control the monetary base precisely (B), but it can only influence the money supply. The Fed can set the required reserve ratio, but the public determines the currency-deposit ratio and the banks determine how much excess reserves to hold. The main conclusion is the Fed cannot precisely control the money supply.

 

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