Chapter 14

The Money
Supply Process
 Preview

• This chapter provides an overview of how

commercial banks create deposits and
describes the basic principles of the money
supply creation process

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 Learning Objectives

• List and describe the “three players” that

influence the money supply.
• Classify the factors affecting the Federal
Reserve’s assets and liabilities.
• Identify the factors that affect the monetary
base and discuss their effects on the Federal
Reserve’s balance sheet.
• Explain and illustrate the deposit creation
process using T-accounts.

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 Learning Objectives

• List the factors that affect the money

supply.
• Summarize how the “three players” can
influence the money supply.
• Calculate and interpret changes in the
money multiplier.

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 Three Players in the Money Supply
Process

1. The Central bank: Federal Reserve

System
2. Banks: depository institutions; financial
intermediaries
3. Depositors: individuals and institutions

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 The Fed’s Balance Sheet

Federal Reserve System

Assets Liabilities
Securities Currency in circulation

Loans to Financial Reserves

Institutions

• 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

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 Control of the Monetary Base

High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system

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 Open Market Purchase from a Bank

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Securities -$100m Securities +$100m Reserves +$100m
Reserves +$100m

• Net result is that reserves have increased

by $100
• No change in currency
• Monetary base has risen by $100

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 Open Market Purchase from the
Nonbank Public
Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Reserve +$100m Checkable +$100m Securities +$100m Reserves +$100m
s deposits

• Person selling bonds to the Fed deposits the

Fed’s check in the bank
• Identical result as the purchase from a bank

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 Open Market Purchase from the
Nonbank Public
Nonbank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities -$100m Securities +$100m Currency in +$100m
circulation
Currency +$100m

• 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 increases by the amount of the open
market purchase

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 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.

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 Open Market Sale
Nonbank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities +$100m Securities -$100m Currency in -$100m
circulation
Currency -$100m

• 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.

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 Shifts from Deposits into Currency
Nonbank Public Banking System
Assets Liabilities Assets Liabilities
Checkable -$100m Reserves -$100m Checkable -$100m
deposits deposits
Currency +$100m

Federal Reserve System

Assets Liabilities
Currency in +$100m
circulation
Reserves -$100m

• Net effect on monetary liabilities is zero

• Reserves are changed by random fluctuations
• Monetary base is a relatively stable variable
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 Loans to Financial Institutions
Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Reserve +$100m Loans +$100m Loans +$100m Reserves +$100m
s
(borrowing from Fed) (borrowing from
Fed)

• Monetary liabilities of the Fed have

increased by $100
• Monetary base also increases by this
amount

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 Other Factors that Affect the
Monetary Base

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

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 Overview of The 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.

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 Multiple Deposit Creation: A Simple
Model
Deposit Creation: Single Bank
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Securities -$100m Securities -$100m Checkable +$100m
deposits
Reserves +$100m Reserves +$100m
Loans +$100m

• Excess reserves increase First National Bank

• Bank loans out the excess Assets Liabilities

reserves Securities -$100m

• Creates a checking account Loans +$100m

• Borrower makes purchases

• The Money supply has increased

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 Multiple Deposit Creation: A Simple
Model
Deposit Creation: The Banking System

Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves + Checkable + Reserves +$10 Checkable +
$100m deposits $100m deposits $100m
Loans +$90

Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90 Checkable +$90 Reserves +$9 Checkable +$90
deposits deposits
Loans +$81

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 Table 1 Creation of Deposits (assuming 10%
reserve requirement and a $100 increase in
reserves)

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 Deriving The Formula for Multiple
Deposit Creation
Assuming banks do not hold excess reserves
Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r ) times the total amount
of checkable deposits (D)
Substituting
r  D=R
Dividing both sides by r
1
D=  R
r
Taking the change in both sides yields
1
D =  R
r

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 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.

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 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

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 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.

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 Overview of the Money Supply
Process

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 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  MB

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 Deriving the Money Multiplier

• 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

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 Deriving the Money Multiplier

The total amount of reserves (R) equals the sum of

required reserves (RR ) and excess reserves (ER).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = r × D
Subsituting for RR in the first equation
R = (r × D) + ER
The Fed sets r to less than 1

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 Deriving the Money Multiplier

• 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 checkable deposits,
currency and excess reserves.

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 Deriving the Money Multiplier
c = {C / D}  C = c  D and
e = {ER / D}  ER = e  D
Substituting in the previous equation
MB  (r  D)  (e  D)  (c  D)  (r  e  c)  D
Divide both sides by the term in parentheses
1
D  MB
r  ec
M  D  C and C  c  D
M  D  (c  D)  (1 c)  D
Substituting again
1 c
M  MB
r ec
The money multiplier is then
1 c
m
r ec
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 Intuition Behind the Money
Multiplier
r  required reserve ratio = 0.10
C  currency in circulation = $400B
D  checkable deposits = $800B
ER  excess reserves = $0.8B
M  money supply (M1) = C  D = $1,200B
$400B
c  0.5
$800B
$0.8B
e  0.001
$800B
1 0.5 1.5
m   2.5
0.1 0.001 0.5 0.601
This is less than the simple deposit multiplier
Although there is multiple expansion of deposits,
there is no such expansion for currency

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 Quantitative Easing and the Money
Supply, 2007-2014

• When the global financial crisis began in the

fall of 2007, the Fed initiated lending
programs and large-scale asset-purchase
programs in an attempt to bolster the
economy.
• By June 2014, these purchases of securities
had led to a quintupling of the Fed’s balance
sheet and a 377% increase in the monetary
base.

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 Quantitative Easing and the Money
Supply, 2007-2014

• These lending and asset-purchase programs

resulted in a huge expansion of the
monetary base and have been given the
name “quantitative easing.”
• This increase in the monetary base did not
lead to an equivalent change in the money
supply because excess reserves rose
dramatically.

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 Figure 1 M1 and the Monetary Base,
2007-2014

Source: Federal Reserve Bank of St. Louis, FRED database:

http://research.stlouisfed.org/fred2/.

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 Figure 2 Excess Reserves Ratio and
Currency Ratio, 2007-2014

Source: Federal Reserve Bank of St. Louis, FRED database:

http://research.stlouisfed.org/fred2/.

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