The Money Supply Process PDF

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Money And Banking: Supply process notes...

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The Money Supply Process: Summary, Outline, and Key Terms The amount of money available in the economy is determined by the actions of three groups: the central bank, depository institutions, and depositors. The Federal Reserve has certain tools it tries to use in order to affect the money supply. The other two groups affect the money supply through their decision to make loans (depository institutions) or how to hold their money (depositors). In order to understand how the Fed affects the money supply, we must understand its balance sheet. The Fed is a bank, which means it will have certain liabilities, such as currency in circulation and reserves held at the fed by banks, and assets, with securities and loans to financial institutions making up the largest asset categories. The size and composition of the Fed’s balance sheet helps us understand how the Fed affects the money supply. The Fed’s ability to control the money supply is through its ability to control the monetary base, also referred to as high-powered money. The monetary base is composed of currency in circulation and the total amount of reserves in the banking system. The Fed uses open market operations and discount lending to change the monetary base. The monetary base can also change because of factors outside the control of the Fed, however the effect that these factors can have is rather small and can be anticipated by policymakers at the Fed. When the Fed uses these policy tools, open market operations in particular, the effect on the money supply can be much larger than the effect on the monetary base. For example, the Fed increases the monetary base by buying Treasury bonds from primary dealers at commercial banks. This purchase will increase the amount of excess reserves a bank has. When the bank loans out these excess reserves, they create deposits at other banks. These banks can then loan out their excess reserves, which create more deposits. Ultimately, the amount of additional 1 deposits created in the banking system can be calculated with the formula ∆ D= × ∆ R , r 1 is known where D is deposits, r is the required reserve ratio, and R is reserves. The fraction r as the simple deposit multiplier. This formula shows not only how additional reserves can lead to additional deposits, but how the reserve ratio can affect the amount of deposits that are created. Thus, required reserve ratio is another monetary policy tool. This simple deposit creation model only works if banks make additional loans when deposits increase. If people decide to hold more of their wealth in cash, or if banks decide to only loan out a portion of the excess reserve, the amount of deposits created will be less than what is predicted by the model. Another tool, the money multiplier, tells us how much the money supply will increase for a given 1+c where c is the change in the monetary base. The money multiplier is the ratio m= r +e +c currency-to-deposit ratio, e is the excess reserves-to-deposit ratio, and r is the required reserve ratio. Thus, the money multiplier will rise or fall depending upon how currency holdings and excess reserves change. An increase in the money multiplier means increases in the monetary

base will lead to larger increases in the money supply, while a smaller money multiplier means increases in the monetary base will have a smaller effect on the money supply.

1. The Three Players in the Money Supply Process 2. The Fed’s Balance Sheet 3. Control of the Monetary Base a. Open Market Operations b. Shifts between Deposits and Currency c. Discount Lending d. Additional Factors 4. Open Market Purchases and Deposit Creation a. Deposit Creation Through the Banking System i. Simple Deposit Multiplier ii. Critiques of the Deposit Creation Model 5. Factors that Determine the Money Supply 6. The Money Multiplier

Key Terms Federal Reserve Depository Institutions Depositors High-Powered Money Monetary Base Open Market Operations Primary Dealer Discount Window Deposit Creation Model Simple Deposit Multiplier...