Money and Banking Chapter 14 The Money Supply Process

Chapter 14 The Money Supply Process CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe who determines the money supply . Explain how the central bank balance sheet differs from the balance sheets of commercial banks and other depository institutions . Define the monetary base and explain its importance . Define open market operations and explain how they affect the monetary base . Describe the multiple deposit creation process . Define the simple deposit multiplier and explain its information content . List and explain the two major limitations or assumptions of the simple deposit multiplier . URL books 310

The Central Bank Balance Sheet LEARNING OBJECTIVES Who determines the money supply ?

How does the central bank balance sheet differ from the balance sheets of other banks ?

What is the monetary base ?

Ultimately the money supply is determined by the interaction groups commercial banks and other , depositors , borrowers , and the central bank . Like any bank , the central banks balance sheet is composed of assets and liabilities . Its assets are similar to those of common banks and include government securities and discount loans . The former provide the central bank with income and a liquid asset that it can easily and cheaply buy and sell to alter its balance sheet . The latter are generally loans made to commercial banks . So far , so good . The central bank liabilities , however , fundamentally from those of common banks . Its most important liabilities are currency in circulation and reserves . Yes , currency and reserves . You may recall from Chapter Bank Management those are the assets of commercial banks . In fact , for everyone but the central bank , the central bank notes , Federal Reserve notes ( in the United States , are assets , things owned . the central bank , its notes are things owed ( liabilities ) just like your promissory note ( would be your liability , but it would be an asset for the note holder or owner . Similarly , commercial banks own their deposits in the Fed ( reserves ) which the Fed , of course , owes to the commercial banks . So reserves are commercial bank assets but central bank liabilities . Currency in circulation ( and reserves ( compose the monetary base ( aka money ) the most basic building blocks ofthe money supply . Basically , an equation you want to internalize . In the United States , includes and coins issued by the Treasury . We can ignore the latter because it is a relatively small percentage of the , and the Treasury can not legally manage the volume of coinage in circulation in an active fashion , but rather only meets the demand for each denomination , and coins . The Fed also supplies the unit , and for some reason Americans prefer notes to coins . In most countries , coins URL books 311

demand for the single currency unit denomination . includes only and coins in the hands of . Any in banks is called vault cash and is included in , which also includes bank deposits with the Fed . Reserves are of two types those required or mandated by the central bank ( and any additional or excess reserves ( ER ) that banks wish to hold . The latter are usually small , but they can grow substantially during panics like that of 2008 . Central banks , of course , are highly institutions because their assets earn interest but their liabilities are costless , or nearly so . Therefore , they have no gap problems , and liquidity management is a snap because they can always print more notes or create more reserves . Central banks anachronistically own prodigious quantities of gold , but some have begun to sell off their holdings because they no longer convert their notes into gold or anything else for that matter . Gold is no longer part of the but is rather just a commodity with an unusually high ratio . KEY TAKEAWAYS The central bank , depository institutions of every stripe , borrowers , and depositors all help to determine the money supply . The central bank helps to determine the money supply by controlling the monetary base ( aka powered money or its monetary liabilities . The central bank balance sheet differs from those of other banks because its monetary liabilities , currency in circulation ( and reserves ( are everyone assets . The monetary base or ME , where currency in circulation ( not in the central bank or any bank ) reserves bank vault cash and deposits with the central bank . is important because an increase ( decrease ) in it will increase ( decrease ) the money supply ( currency plus checkable deposits , plus time deposits and retail money market deposit accounts , etc . by some multiple ( hence the nickname ) Students sometimes become confused about this because they think the central bank is the government . At must , it is part of the government , and not the part that issues the bonds . Sometimes , as in the case of the BUS and , it is not part of the government at all . URL books 312

Open Market Operations LEARNING OBJECTIVE . What are open market operations and how do they affect the monetary base ?

We are now ready to understand how the central bank the money supply ( with the aid of the we encountered in Chapter Bank Management . Central banks like the Fed the via the . They control their monetary liabilities , by buying and selling securities , a process called open market operations . If a central bank wants to increase the , it need only buy a security . Any asset will do , but securities , especially government bonds , are generally best because there is little default risk , liquidity is high , and they pay interest . If a central bank bought a bond from a bank , the following would occur Assets Liabilities Securities Reserves The banking system would lose worth of securities but gain of reserves ( probably a credit in its account with the central bank but , as noted above , or other forms of cash also count as reserves ) Bank Assets Liabilities Securities Reserves The central bank would gain of securities essentially by creating of reserves . Notice that the item transferred , securities , has opposite signs , negative for the banking system and positive for the central bank . That makes good sense if you think about it because one party is selling ( giving up ) and the other is buying ( receiving ) Note also that the central bank liability has the same sign as the banking system asset . That too makes sense because , as noted above , the central bank URL books 313

liabilities are everyone else assets . So if the central bank liabilities increase or decrease , everyone else assets should do likewise . Ifthe central bank happens to buy a the public ( any ) and that entity deposits the proceeds in its bank , precisely the same outcome would occur , though via a slightly more circuitous route Assets Liabilities Securities Checkable deposits Assets Liabilities Reserves Checkable deposits Assets Liabilities Securities Reserves slightly different Assets Liabilities Securities Currency Assets Liabilities Securities Currency in circulation If the seller of the security keeps the proceeds as cash ( however , the outcome is Note that in either case , however , the increases by the amount ofthe purchase because either or increases by the amount of the purchase . Keep in mind that currency in circulation means cash ( like ) no longer in the central bank . An in the hands of its maker is no liability cash in the hands of its issuer is not a liability . So although the money existed physically before Some Dude sold his bond , it did not exist economically as money until it left its papa ( mama ?

the central bank . If the books 314 transaction were reversed and Some Dude bought a bond from the central bank with currency , the notes he paid would cease to be money , and currency in circulation would decrease by . In fact , whenever the central bank sells an asset , the exact opposite of the above occurs the shrinks because ( decreases along with the central bank securities holdings , and banks or the public own more securities but less or The public can the relative share and but not the . Say that you had in your bank account but wanted 30 in cash to take your other to the carnival . Your account would look like the following because you turned 30 of deposits into 30 of Your ' Assets Liabilities Checkable deposits ( Currency Your bank would look like the following because it lost 30 of deposits and 30 of reserves , the 30 you walked off with our Bank Assets Liabilities Reserves Checkable deposits ( The central bank would look like the following because the public ( you ! would hold 30 and your bank reserves would decrease accordingly ( as noted above ) Assets Liabilities Currency in circulation Reserves ( The central bank can also control the monetary base by making loans to banks and receiving their loan repayments . A loan increases the and a repayment decreases it . A million loan and repayment a week later looks like this URL books 315

Bank Assets Liabilities Date Loans Reserves January , 2010 Loans Reserves January , 2010 Assets Liabilities Date Reserves January , 2010 Reserves ( January , 2010 Take time now to practice deciphering the effects of open market operations and central bank loans and repayments via in Exercise . You 11 be glad you did . EXERCISES Use to describe what happens in the following instances The Bank of Japan sells billion of securities to banks . The Bank of England buys million of securities from banks . Banks borrow million from the . Banks repay million of loans to the Bank of Canada . The Fed buys 75 billion of securities from the public , which deposits 70 billion and keeps billion in cash . KEY TAKEAWAYS Open market operations occur whenever a central bank buys or sells assets , usually government bonds . By purchasing bonds ( or anything else for that matter ) the central bank increases the monetary base and hence , by some multiple , the money supply . Picture the central bank giving up some money to acquire the bond , thereby putting or reserves into circulation . By selling bonds , the central bank decreases the monetary base and hence the money supply by some multiple . Picture the central bank giving up a bond and receiving money for it , removing or reserves from circulation . Similarly , the and increase whenever the Fed makes a loan , and they decrease whenever a borrower repays the Fed . URL books 079 ?

316 A Simple Model of Multiple Deposit Creation LEARNING OBJECTIVES . What is the multiple deposit creation process ?

What is the money multiplier ?

What are the major limitations of the simple deposit multiplier ?

As shown above , the central bank pretty much controls the size of the monetary base . The check clearing process and the government banking activities can cause some , but generally the central bank can anticipate such and respond accordingly . That does not mean , however , that the central bank controls the money supply , which , ifyou Chapter Money consists of more than . for example , also includes checkable deposits . The reason is that each ( or , etc . of additional creates some multiple of new deposits in a process called multiple deposit creation . Suppose the central bank buys million of securities from Some Bank . We know that the following will occur Sonic Ban Liabilities Securities million Reserves million Assets Liabilities Securities million Reserves million Some Bank suddenly has million in excess reserves . Its deposits are unchanged , but it has million more in cash . What will the bank do ?

Likely what banks do best make loans . So its account will be the following Sonic Bunk Assets Liabilities Loans million Deposits million URL books 317 Recall from Chapter Bank Management that deposits are created in the process of making the loan . The bank has effectively increased by million . The borrower will not leave the proceeds of the loan in the bank for long but instead will use it , within the guidelines set by the loan covenants , to make payments . As the deposits out of Some Bank , its excess reserves decline until Some Bank has essentially swapped securities for loans Sonic Bank Assets Liabilities Securities million Loans million But now there is another mil ion of checkable deposits out there and they rarely rest . Suppose , for simplicity sake , they all end up at Another Bank . Its would be the following Bank Assets Bank Liabilities Reserves million Checkable deposits million If the required reserve ratio ( is 10 percent , Another Bank can , and likely will , use those deposits to fund a loan , making its Assets Liabilities Reserves million Checkable Deposits million Loans million That loan will also eventually be paid out to others and deposited into other banks , which in turn will lend 90 percent of them ( to other borrowers . Even if a bank decides to invest in securities instead of loans , as long as it buys the bonds from anyone but the central bank , the multiple deposit creation expansion will continue , as in Figure Multiple deposit creation , with an increase in of million , if . Figure Multiply ( 11 ' I US ( I ' million . URL books 318

Notice that the increase in deposits is the same as the increase in loans from the previous bank . The increase in reserves is the increase in deposits times the required reserve ratio of , and the increase in loans is the increase in deposits times the remainder , Rather than working through this rather clunky process every time , you can calculate the effects of increasing reserves with the called simple deposit multiplier formula AD ( AR where AD change in deposits AR change in reserves required reserve ratio million 10 million , just as in Figure Multiple deposit creation , with an increase in reserves of million , if Practice calculating the simple deposit multiplier in Exercise . EXERCISE books 319

. Use the simple deposit multiplier AD ( AR to calculate the change in deposits given the following conditions ' in ' or ( in ) 10 100 10 20 10 10 10 100 can not divide by Stop and Think Box Suppose the Federal Reserve wants to increase the amount of checkable deposits by by conducting open market operations . Using the simple model of multiple deposit creation , determine what value of securities the Fed should purchase , assuming a required reserve ratio of percent . What two major assumptions does the simple model of multiple deposit creation make ?

Show the appropriate equation and work . The Fed should purchase worth of securities . The simple model of multiple deposit creation is AD ( which of course is the same as AR ( So for this problem ( worth of securities should be purchased . This model assumes that money is not held as cash and that banks do not hold excess reserves . Pretty easy , eh ?

Too bad the simple deposit multiplier isn very accurate . It provides an upper bound to the deposit creation process . The model simply isn very realistic . Sometimes banks hold excess reserves , and people sometimes prefer to hold cash instead of deposits , thereby stopping the multiple deposit creation process cold . That is why , at the beginning of the chapter , we said that depositors , borrowers , and banks were also important players in the money supply determination process . In the next chapter , we take their decisions into account . KEY TAKEAWAYS The multiple deposit creation process works like this say that the central bank buys 100 of securities from Bank , which lends the 100 in cash it receives to some borrower . Said borrower writes checks URL books 320

against the 100 in deposits created by the loan until all the money rests in Bank . Its deposits and reserves increased by 100 , Bank lends as much as it can , say ( or 90 , to another borrower , who writes checks against it until it winds up in Bank , which also lends 90 percent of it . Bank lends 90 percent of that , Bank lends 90 percent of that , and so on , until a 100 initial increase in reserves has led to a increase in deposits ( and loans ) The simple deposit multiplier is AD ( AR , where AD change in deposits AR change in reserves required reserve ratio . The simple deposit multiplier assumes that banks hold no excess reserves and that the public holds no currency . We all know what happens when we assume or . These assumptions mean that the simple deposit multiplier overestimates the multiple deposit creation process , providing us with an estimate . URL books , 321

Suggested Reading Hummel , William . Money Is , How It Works ed . IN , 2006 . David , and Jan . Open Market Operations and Financial Markets . New York , 2007 . URL books 322