Assets of CB Balance Sheet

Changes in the asset items lead to changes in reserves

and consequently to changes in the money supply.
Because these assets (government securities and
discount loans) earn interest while the liabilities
(currency in circulation and reserves) do not, the CB
makes billions of dollars every year.
Although it returns most of its earnings to the federal
government, CBs spend some of it on “worthy causes,”
such as supporting economic research.
 Cont.
• Government securities. the CB’s holdings of securities
issued by the Government. The CB provides reserves to
the banking system by purchasing securities. An
increase in government securities held by the CB leads
to an increase in the money supply.
• Discount loans. The CB can provide reserves to the
banking system by making discount loans to banks. An
increase in discount loans can also be the source of an
increase in the money supply. The interest rate charged
banks for these loans is called the discount rate.
 Monetary Base (MB)
• The monetary base or high-powered money equals
currency in circulation (C ) plus the total reserves in
banking system (R ).
• The MB can be expressed as
• MB = C + R
• The Federal Reserve exercises control over the
monetary base through its purchases or sale of
government securities in the open market, called
open market operations, and through its extension
of discount loans to banks.
 Open Market Operations by CB
• open market purchase, or an open market sale.

Open Market Purchase from a Bank.

• the CB purchases $100 of bonds from a bank and

pays for them with a $100 check.
• The bank will either deposit the check in its
account with the Fed or cash it in for currency,
which will be counted as vault cash.
 Cont.

BANKING SYSTEM
Assets Liabilities
Securities - $100
Reserves + $100
 Cont.
Central Bank
Assets Liabilities
Securities +$100 Reserves +$100
 Cont.
• Open Market Purchase from the Nonbank Public
the person or corporation that sells the $100 of bonds
to the CB deposits the CB’s check in a local bank.
NONBANK PUBLIC
Assets Liabilities
Securities -$100
Checkable deposits +$100
 Cont.
BANKING SYSTEM
Assets Liabilities
Réserves +$100 Checkable deposits +$100

Central Bank
Assets Liabilities
Securities +$100 Reserves +$100
 Cont.
• If the person or corporation selling the bonds
to CB cashes the check issued by the CB at a
local bank for currency, the effect on reserves
is different.
• The seller will receive currency of $100 while
reducing holdings of securities by $100.
 Cont.
• The bond seller’s T-account will be

• NONBANK PUBLIC
• Assets Liabilities
• Securities - $100
• Currency + $100

• Central Bank
• Assets Liabilities
• Securities +$100 Currency in circulation +$100
 Cont.
• The net effect is that reserves are unchanged, while
currency in circulation increases by the $100 of the open
market purchase.
• Thus the monetary base increases by the $100 amount of
the open market purchase, while reserves do not. This
contrasts with the case in which the seller of the bonds
deposits the Fed’s check in a bank; in that case, reserves
increase by $100, and so does the monetary base.
• 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.
 Open Market Sale
• the monetary base will decline by $100. For example, if the Fed sells the bonds
to an individual who pays for them with currency, the buyer exchanges $100 of
currency for $100 of bonds, and the resulting T-account is:
• NONBANK PUBLIC
• Assets Liabilities
• Securities + $100
• Currency - $100

• Central Bank
• Assets Liabilities
• Securities -$100 Currency in circulation -$100

Because deposits at banks are by far the largest component of the money supply,
understanding how these deposits are created is the first step in understanding
the money supply process.
 Cont.
• The effect of open market operations on the
monetary base is much more certain than the
effect on reserves.
 Discount Loans
• The CB makes a $100 discount loan to HNB. The bank is
credited with $100 of reserves from the proceeds of the loan.
• The BANK
• Assets Liabilities
• Reserves +$100 Discount L +$100
• Central Bank
• Assets Liabilities
• Discount L +$100 Reserves + $100
 Cont.
• The monetary liabilities of the Fed have increased by $100, and the
monetary base, too, has increased by this amount.
• if a bank pays off a loan from the CB, thereby reducing its borrowings from
the CB by $100.
• BANKING SYSTEM
• Assets Liabilities
• Reserves -$100 Discount L -$100
• Central Bank
• Assets Liabilities
• Discount L -$100 Reserves - $100
 Cont.
• The net effect on the monetary liabilities of
the CB, and hence on the monetary base, is
then a reduction of $100. We see that the
monetary base changes one-for-one with the
change in the borrowings from the Fed.
 Multiple Deposit Creation
• A $100 loan by Bank 1 is deposited at Bank A. We assume that Bank
A and all other banks hold no excess reserves.
• BANK A
• Assets Liabilities
• Reserves +$100 Checkable deposits +$100

• If the required reserve ratio is 10%, this bank will now find
itself with a $10 increase in required reserves, leaving it $90
of excess reserves. Because Bank A does not want to hold
on to excess reserves, it will make loans for the entire
amount. Its loans and checkable deposits will then increase
by $90.
 Cont.
BANK A
• Assets Liabilities
Reserves $10 Checkable deposits $100
Loans $90
Suppose the lent amount is deposited in Bank B
BANK B
• Assets Liabilities
• Reserves $90 Checkable deposits $90
 Cont.
• The checkable deposits in the banking system have
increased by another $90, for a total increase of $190
($100 at Bank A plus $90 at Bank B).
• Bank B will keep 10% of $90 ($9) as required reserves
and has 90% of $90 ($81) in excess reserves. Bank B
will make an $81 loan to a borrower.
BANK B
• Assets Liabilities
Reserves $ 9 Checkable deposits $90
Loans $81
 Cont.
The $81 spent by the borrower from Bank B will be deposited
in Bank C. Consequently, from the initial $100 increase of
reserves in the banking system, the total increase of
checkable deposits in the system so far is $271 ( $100+ $90+
$81).
• Following the same reasoning, if all banks make loans for
the full amount of their excess reserves, further increments
in checkable deposits will continue (at Banks C, D, E, and so
on). Therefore, the total increase in deposits from the initial
$100 increase in reserves will be $1,000: The increase is
tenfold, the reciprocal of the 0.10 reserve requirement.
 Cont.
• Increase in Increase in Increase in
• Bank Deposits ($) Loans ($) Reserves ($)
• A 100.00 90.00 10.00
• B 90.00 81.00 9.00
• C 81.00 72.90 8.10
• D 72.90 65.61 7.29
• E 65.61 59.05 6.56
• F 59.05 53.14 5.91
• ....
• ....
• ....
• Total for all banks
– 1,000.00 1,000.00 100.00
 Deposit Multiplier
• The multiple increase in deposits generated from an
increase in the banking system’s reserves is called the
simple deposit multiplier.6 In our example with a
10% required reserve ratio, the simple deposit

multiplier is 10.

 D  1 R
r
• 370
 Critique of the Simple Model

• The model seems to indicate that the CB is able to exercise

complete control over the level of checkable deposits by
setting the required reserve ratio and the level of reserves.
But if some proceeds from loans are used to raise the
holdings of currency, checkable deposits will not increase by
the amount given by the model.
• When banks do not make loans or buy securities in the full
amount of their excess reserves, the model does not work
the way it is predicted. For ex. if Bank A decides to hold on
to all $90 of its excess reserves, no deposits would be made
in Bank B, and this would also stop the deposit creation
process.
 Cont.
• Banks’ decisions regarding the amount of
excess reserves they wish to hold, depositors’
decisions regarding how much currency to
hold, and borrowers’ decisions on how much
to borrow from banks can cause the money
supply to change.
 The Money Supply Model and the Money Multiplier

• Since, the CB can control the monetary base

better than it can control reserves, it makes
sense to link the money supply (M) to the
monetary base (MB).
M = m * MB
The variable m is the money multiplier, which
indicates how much the money supply
changes for a given change in the monetary
base MB.
 Factors that affect m
• Depositors’ decisions about their holdings of
currency and checkable deposits
c {C/D} currency ratio
• The reserve requirements imposed by the CB
on the banking system.
• Banks’ decisions about excess reserves
e {ER/D} excess reserves ratio
 Derivation of the model
R = RR + ER
which states that the total amount of reserves in the banking
system R equals the sum of required reserves RR and excess
reserves ER.
RR = r * D
The total amount of required reserves equals the required
reserve ratio r times the amount of checkable deposits D.
Substituting r * D into RR,
R = (r * D) + ER
A key point here is that the CB sets the required reserve ratio r
to less than 1. Thus $1 of reserves can support more than $1 of
deposits, and the multiple expansion of deposits can occur.
 Cont.

MB = R + C = (r * D) + ER + C
An important feature of this equation
an increase in the monetary base that goes into
currency is not multiplied, whereas an increase that goes
into supporting deposits is multiplied.
an additional dollar of MB that goes into excess
reserves (ER) does not support any additional deposits or
currency. The reason for this is that when a bank decides to
hold excess reserves, it does not make additional loans, so
these excess reserves do not lead to the creation of deposits.
 Cont.

• To derive the money multiplier formula in terms of the currency ratio c {C/D}
and the excess reserves ratio e {ER/D}, we can rewrite the last equation,
specifying C as c * D and ER as e * D

MB = (r * D) + (e * D) + (c * D) = (r+ e+ c) D

And can rearrange the equation as

1
D MB
r ec
Using the definition of the money supply as
currency plus checkable deposits (M = D + C)
and again specifying C as c * D
M = D + (c * D) = (1 + c) * D
Substituting this for D

1 c
M * MB
r ec
 Cont.
The ratio that multiplies MB is the money multiplier that tells
how much the money supply changes in response to a given
change in the monetary base (high-powered money). The
money multiplier m is thus:

1 c
m 
r ec
and it is a function of the currency ratio set by depositors
c, the excess reserves ratio set by banks e, and the
required reserve ratio set by the CB r.
 Workings of the model
r= required reserve ratio = 0.10
C = currency in circulation = $400 billion
D = checkable deposits = $800 billion
ER = excess reserves = $0.8 billion
M = money supply (M1) = C+ D= $1,200 billion
 Cont.

The money multiplier of 2.5 tells us that, given

the required reserve ratio of 10% on
checkable deposits and the behavior of
depositors as represented by c = 0.5 and
banks as represented by e = 0.001, a $1
increase in the monetary base leads to a $2.50
increase in the money supply (M1).
 Cont.
An important characteristic of the money
multiplier is that it is less than the simple deposit
multiplier of 10. The key to understanding this
result is to realize that although there is multiple
expansion of deposits, there is no such
expansion for currency. Thus if some portion of
the increase in high-powered money finds its
way into currency, this portion does not undergo
multiple deposit expansion.
 Factors That Determine the Money Multiplier

1. Changes in the Required Reserve Ratio r

If the required reserve ratio on
checkable deposits increases while all the
other variables stay the same, the same level
of reserves cannot support a large amount of
checkable deposits. In that case more reserves
are needed and that means banks must
contract their loans, causing a decline in
deposits and hence in the money supply.
 Cont.
• For example when r increases from 10% to
15% (leaving all the other variables
unchanged). The money multiplier becomes:
1  0.5 1.5
m  2.3
0.15  0.001  0.5 0.651

The money multiplier and the money supply are

negatively related to the required reserve ratio r.

2.3 is less than 2.5.

2. Changes in the Currency Ratio c
An increase in c means that depositors are
converting some of their checkable deposits
into currency. As we have seen, checkable
deposits undergo multiple expansion while
currency does not. Hence when checkable
deposits are being converted into currency,
the overall level of multiple expansion
declines, and so must the multiplier.
 Cont.
• For example, when c rises from 0.50 to 0.75.
The money multiplier then falls from 2.5 to:
1  0.75 1.75
m   2.06
0.1  0.001  0.75 0.851
The money multiplier and the money supply are
negatively related to the currency ratio c.
 Cont.
3. Changes in the Excess Reserves Ratio e
When banks increase their holdings of excess
reserves relative to checkable deposits, the
banking system in effect has fewer reserves to
support checkable deposits. This means that
given the same level of MB, banks will contract
their loans, causing a decline in the level of
checkable deposits and a decline in the money
supply, and the money multiplier will fall.
 Cont.
• For example when e rises from 0.001 to 0.005.
The money multiplier declines from 2.5 to:
1  0.5 1.5
m  2.48
0.1  0.005  0.5 0.605

The money multiplier and the money supply are

negatively related to the excess reserves ratio e.
 Cont.
4. Market Interest Rates.
The cost to a bank of holding excess reserves is its
opportunity cost, the interest that could have been
earned on loans or securities if they had been held
instead of excess reserves.
If i increases, the opportunity cost of holding excess
reserves rises, and the desired ratio of excess reserves
to deposits falls. A decrease in i, conversely, will reduce
the opportunity cost of excess reserves, and e will rise.
The banking system’s excess reserves ratio e is
negatively related to the market interest rate i.
 Cont.
5. Expected Deposit Outflows
If banks fear that deposit outflows are likely to
increase (that is, if expected deposit outflows
increase), they increase the excess reserves ratio.
In other words, If expected deposit outflows
rise, the expected benefits, and hence the
expected returns for holding excess reserves,
increase. Therefore the excess reserves ratio e is
positively related to expected deposit outflows.