Money Supply

Money Supply

Learning Objectives

• Review the money supply expansion process.

• Learn how to derive the M1 model.

• Understand how the interaction of the money multiplier and base determine M1.

• Understand the role of the Federal Reserve, the commercial banking system, and the non-bank public in the money creation process.

The Money Supply• M1: Currency + travelers checks + checkable

deposits

• M2: M1 + small time deposits + overnight repurchase agreements + overnight Eurodollars + money market mutual fund

balances

• M3: M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money market fund balances

The Creators of Money• The three major players whose decisions and

actions determine the rate of growth in the money supply are:– The Federal Reserve (Fed)

• Sets reserve requirements

• Operates the discount window

• Engages in open market operations

– The Commercial Banking System• Accepts deposits and makes loans

• Sets excess reserves

– The Non-Bank Public• Holds either deposits or cash

Money Creation• Banks create money in their normal, day-to-day

profit seeking activities

• Banks do not try to create money

• Money creation occurs because we have a fractional reserve commercial banking system.– Banks must hold a fraction of their deposits idle as

reserves. They may lend the remainder.• As they make loans, new deposits are created, causing the

money supply to expand.

Bank Reserves

• Total Reserves = Required reserves plus excess reserves– Required reserves = Deposits times reserve

requirement– Excess reserves = Total reserves minus

required reserves

Money Creation: SummaryNew Deposit Required Reserves Excess Reserves New Loan

$100 $100$100 $10.00 $ 90 $ 90$ 90 $ 9.00 $ 81 $ 81$ 81 $ 8.10 $ 72.90 $ 72.90$ 72.90 $ 7.29 $ 65.61 $ 65.61$ 65.61 $ 6.51 $ 59.05 $ 59.05

$1,000 $100 $900 $900

The M1 Model: Derivation

• Definitions:– M1 = D + C– Base = R + C– Total Deposits = D

• Assumptions:– r = R/D = required reserve ratio for deposits– e = E/D = the excess reserve ratio– c = C/D = the ratio of currency to deposits

The M1 Model: Derivation

• Model:B = R + C

• R = rD + E

• D = D

• C = cD

• E = eD

B = rD + eD + cD

B = D(r + e + c) 1 ( r + e + c)

BD =

The M1 Model: Derivation

• Model:M1 = D + C

M1 = D + cD

M1 = D(1 + c) Factor out D

• M1 = 1 + c r + e + c

B

• M1 = Multiplier x Base

Money Multiplier Terms

• Changes in r– If r increases, the multiplier decreases– If r decreases, the multiplier increases

• The money multiplier and M1 are negatively related.

Money Multiplier Terms

• Changes in c– If c increases, reserves drain from the banking

system.• Fewer reserves mean less expansion of deposits.

– If c decreases, reserves in the banking system increase.

• More reserves mean more expansion of deposits.

• The money multiplier and M1 are negatively related.

Money Multiplier Terms

• Changes in e– An increase in e means banks are holding more

excess reserves and lending less.– A decrease in e means banks are holding fewer

excess reserves and lending more.

• The money multiplier and M1 are negatively related.

The Money Supply: Summary

• The money supply equals the monetary base times the money multiplier– The monetary base (base) is defined as:

• Base = Reserves + Currency– Base can be controlled by the Federal Reserve

– The multiplier reflects the ability of the banking system to expand deposits

• The multiplier = 1 + c/(r + e + c)– The value of the multiplier is determined by the Fed, banks,

and the members of the non-bank public.

Open Market Operations Fed BankPresidents

Federal OpenMarket Comm.

Fed Board of Governors

Securities Dealers

Federal Reserve Bank of New York

Commercial Banks

Change inReserves

Change in Money Supply

Open Market Operations

• When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves.

• When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed

Discount Loans

• When the Fed makes a discount loan to a bank, the bank is credited with an increase in reserves.

• When a bank repays the Fed, the bank’s reserves are debited.

Reserve Requirements

• If the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease.

• If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.

Excess Reserves

• Banks determine the level of excess reserves– Increases in excess reserves diminish the

expansion of deposits.– Decreases in excess reserves increase the

expansion of deposits

Currency Drains

• Members of the non-bank public determine currency in circulation– Increases in currency drains from the banking

system, diminish the expansion of deposits– Decreases in currency drains from the banking

system, increase the expansion of deposits

Central Bank Policy Channels

PolicyTools

Level & GrowthBank Reserves

Cost & Availability of Credit

Size and Growth Rate of Money Supply

Market Value of Securities

Volume and Growth of Borrowing andSpending by the Public

FullEmployment

Growth

PriceStability