Money Supply and Its Determinants

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Questions and Answers

How do the actions of depositors influence the money supply?

Depositors can increase the money supply by depositing more currency. (correct)

Depositors' choice to hold currency does not affect the money supply.

Holding excess reserves by banks decreases the money supply.

The money supply is solely controlled by the Federal Reserve's policies.

What occurs when the Federal Reserve conducts open market purchases?

Banks' reserves are negatively impacted.

The nonborrowed monetary base decreases.

The money supply increases due to the creation of deposits. (correct)

The required reserve ratio is adjusted downwards.

What effect does an increase in the required reserve ratio have on the money supply?

It has no impact on the money supply.

It increases the money supply as banks lend more.

It forces banks to borrow more from the Federal Reserve.

It decreases the money supply as banks have to hold more reserves. (correct)

How does a decrease in borrowed reserves from the Federal Reserve affect the money supply?

It reduces reserves, which decreases deposit creation. Signup and view all the answers

Which best describes the relationship between the nonborrowed monetary base and the money supply?

The money supply is positively related to the nonborrowed monetary base. Signup and view all the answers

What is the result of a bank increasing its borrowing from the Federal Reserve?

It will create an opportunity for multiple deposit creation. Signup and view all the answers

Which of the following statements is NOT true regarding the factors that determine the money supply?

Only the Federal Reserve's actions directly influence the money supply. Signup and view all the answers

Which factor negatively influences the money supply?

Increased required reserve ratio. Signup and view all the answers

What effect do Open Market Purchases have on the money supply?

They increase the money supply. Signup and view all the answers

How does an increase in excess reserves affect the money supply?

It decreases the money supply. Signup and view all the answers

What is the relationship between currency holdings and the money supply?

They are negatively correlated when excess reserves are constant. Signup and view all the answers

What happens to the money supply if banks decide to hold fewer excess reserves?

The money supply increases. Signup and view all the answers

What is a consequence of increased currency holdings by individuals?

It reduces the overall money supply. Signup and view all the answers

What can lead to a decrease in the money supply according to the theorem relating to excess reserves?

Banks making fewer loans. Signup and view all the answers

How does the money multiplier relate to changes in the monetary base?

It shows how the money supply changes in response to the monetary base. Signup and view all the answers

What effect do reductions in borrowing from the Fed have on the money supply?

They decrease the money supply. Signup and view all the answers

What happens to Bank A's assets after the Fed's open market purchase of $100 million in bonds?

Assets increase by $100 million Signup and view all the answers

What is the excess reserve available for lending after Bank A makes its initial loan?

$90 million Signup and view all the answers

How much in total checkable deposits exists after the transactions through Bank A and Bank B?

$190 million Signup and view all the answers

What is the reserve requirement for Bank B based on its deposits of $90 million?

$9 million Signup and view all the answers

After Bank B makes a loan of $81 million, how much must it retain in reserves?

$9 million Signup and view all the answers

What is the total increase in deposits after the initial reserve increase leads through banks A, B, and C?

$271 million Signup and view all the answers

What will happen to Bank A's reserves and checkable deposits after borrowers spend the $90 million loan?

Both reserves and checkable deposits will decrease by $90 million. Signup and view all the answers

How much of Bank B's total deposits can it lend out after adhering to the reserve requirement?

$81 million Signup and view all the answers

What happens to the monetary base when the Fed lends money to a bank?

It increases by the loan amount. Signup and view all the answers

What effect does repaying the loan to the Fed have on the bank's reserves?

Reserves decrease by the repayment amount. Signup and view all the answers

How does the public's desire to hold more cash affect the monetary base?

It has no effect on the total monetary base. Signup and view all the answers

What is 'float' in the context of the banking system?

A temporary rise in reserves due to check processing. Signup and view all the answers

What happens when the U.S. Treasury transfers money to its account at the Fed?

It decreases banking system reserves. Signup and view all the answers

What is the effect of a change in reserves due to shifts between deposits and cash?

It has no impact on the monetary base. Signup and view all the answers

Which aspect of the monetary base is considered more stable and controllable by the Fed?

Currency in circulation. Signup and view all the answers

When a bank receives an increase in its reserves due to the processing of a check, this is known as what?

Float. Signup and view all the answers

What is the primary purpose of Quantitative Easing?

To inject money into the economy Signup and view all the answers

What effect did Quantitative Easing have on the U.S. monetary base from 2007 to 2017?

It increased by 350% Signup and view all the answers

How did the money multiplier change as a result of the excess reserves held by banks during QE?

It fell by 50% Signup and view all the answers

Why did banks prefer to hold onto their excess reserves during the period of QE?

Because the Fed paid interest on excess reserves Signup and view all the answers

What was the actual increase in the money supply (M1) from 2007 to 2017, despite the growth in the monetary base?

150% Signup and view all the answers

What limitation was imposed by the rising excess reserves ratio during the QE period?

It restricted the expansion of the money supply Signup and view all the answers

In response to what situation was Quantitative Easing primarily implemented by the U.S. Federal Reserve?

2007 financial crisis Signup and view all the answers

What was one major consequence of banks holding excess reserves during the QE period?

Decreased lending activity Signup and view all the answers

Study Notes

The Money Supply and its Determinants

The money supply's level is influenced by various factors, including the actions of depositors and banks, not just the Federal Reserve's actions.
Factors that determine the money supply include: changes in the nonborrowed monetary base, changes in borrowed reserves, changes in the required reserve ratio, changes in excess reserves, and changes in currency holdings.

Changes in Nonborrowed Monetary Base (MBn)

Theorem: The money supply is directly proportional to the nonborrowed monetary base.
Open Market Purchases: When the Fed buys securities, it increases the nonborrowed monetary base by adding reserves to banks. This results in a multiple deposit creation process leading to an increase in the money supply.
Open Market Sales: When the Fed sells securities, it reduces the monetary base and bank reserves, leading to a contraction of deposits and a decrease in the money supply.

Changes in Borrowed Reserves (BR)

Theorem: The money supply is directly related to the level of borrowed reserves from the Federal Reserve.
Increased Borrowing: When banks borrow more from the Fed (e.g., through discount loans), it increases their reserves, supporting multiple deposit creation and enhancing the money supply.
Decreased Borrowing: A reduction in bank borrowing from the Fed leads to a decline in reserves, reducing deposit creation and the money supply.

Changes in Required Reserve Ratio (rr)

Theorem: The money supply is inversely proportional to the required reserve ratio.
Increased Reserve Requirement: A higher reserve ratio necessitates banks to hold more reserves, reducing the amount available for lending and decreasing the money supply.
Decreased Reserve Requirement: A lower reserve ratio allows banks to lend a larger portion of their deposits, thereby increasing the money supply.

Impact of Open Market Purchase

An example of an open market purchase is when the Fed buys $100 million in bonds from a bank, increasing the bank's reserves by $100 million.
If the required reserve ratio is 10%, the bank must keep $10 million in required reserves, leaving $90 million in excess reserves that can be lent out.
The bank loans out $90 million, which is then deposited in another bank, further expanding the money supply.
The initial increase in reserves of $100 million leads to a total deposit increase of $271 million due to the multiplier effect.

Changes in Excess Reserves

Theorem: The money supply is inversely related to the amount of excess reserves held by banks.
Increased Holding of Excess Reserves: When banks hold more excess reserves, they reduce lending, hindering deposit creation and decreasing the money supply.
Decreased Holding of Excess Reserves: A reduction in excess reserves leads to increased lending, fostering deposit creation and boosting the money supply.
Benefit of Holding Excess Reserves: Banks keep excess reserves as a precaution against potential deposit withdrawals, which could lead to losses. If they anticipate more withdrawals, banks will retain higher excess reserves, resulting in a decrease in the money supply.

Changes in Currency Holdings

Theorem: The money supply is inversely related to currency holdings when excess reserves are constant.
Increased Currency Holding: When people convert deposits into currency, it moves money from a component of the money supply that undergoes multiple expansion (deposits) to one that does not (currency). This reduces the overall money supply.
Decreased Currency Holding: When people deposit more of their currency into banks, it increases checkable deposits, facilitating multiple deposit creation and raising the money supply.

The Money Multiplier

The money multiplier reflects the amount of change in the money supply in response to a change in the monetary base. The monetary base encompasses currency (C) and reserves (R) held by banks.
The money multiplier is inversely related to the excess reserves ratio (e).

Impact of Changes in the Monetary Base

Fed Loans to Banks: When the Fed lends money to a bank, the bank's reserves increase by the loan amount, leading to an increase in the monetary base.
Bank Pays Off Loan: When the bank repays the loan to the Fed, the bank's reserves decrease by the repayment amount, resulting in a decrease in the monetary base.

Other Factors Affecting the Monetary Base

Float: Temporary fluctuations in the monetary base can occur due to the Fed processing checks, known as "float."
Treasury Deposits at the Fed: When the U.S. Treasury moves money from commercial banks to its account at the Fed, it reduces reserves in the banking system.

Quantitative Easing (QE)

Definition: QE involves central banks buying financial assets like government bonds to inject money into the economy and reduce long-term interest rates. It is used when traditional tools, like lowering interest rates, are no longer effective.
Example (2007-2017): Following the 2007 financial crisis, the U.S. Federal Reserve implemented QE programs, resulting in a 350% expansion of the monetary base but only a 150% increase in the money supply (M1).
Reason: Despite a larger monetary base, the money multiplier fell by 50%, diminishing the potential rise in the money supply. This reduction occurred because banks retained significant excess reserves due to the Fed paying interest on them, making it more appealing for banks to hold reserves rather than lend them out. This phenomenon led to a dramatic increase in the excess reserves ratio, restricting the expansion of the money supply despite QE.
Conclusion: While QE effectively expanded the monetary base significantly, it didn't translate to a proportional increase in the money supply due to banks' preference for holding excess reserves, resulting in a lower money multiplier.

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Description

This quiz explores the factors influencing the money supply, including the roles of banks, depositors, and the Federal Reserve. Understand the dynamics of the nonborrowed monetary base and how open market operations impact money supply changes.