Chapter 15 Economics 244 PDF

Economics 244-Chapter 15 ======================== THE MONEY SUPPLY PROCESS **[Three players in money supply process ]** - **Central Banks (CB):** The central bank-- the government agency that oversees the banking system and is responsible for the conduct of monetary policy; in the Unite...

Economics 244-Chapter 15 ======================== THE MONEY SUPPLY PROCESS **[Three players in money supply process ]** - **Central Banks (CB):** The central bank-- the government agency that oversees the banking system and is responsible for the conduct of monetary policy; in the United States, the Federal Reserve System (South Africa: SARB) - **Banks:** Banks (depository institutions)-- the financial intermediaries that accept deposits from individuals and institutions and make loans. Examples: Commercial banks, savings and loan associations, mutual savings banks, and credit unions. - **Depositors:** Individuals and institutions that hold deposits in banks - Of the three players, the central bank is the most important. The CBs conduct of monetary policy involves actions that affect its balance sheet (holdings of assets and liabilities) **[The Central Banks balance sheet]** **The Fed's Balance Sheet:** The balance sheet consists of **liabilities** and **assets** that influence the money supply. **Liabilities:** when either the currency in circulation or reserves increase the overall money supply increases.Together, the Fed\'s monetary liabilities and a small portion from the U.S. Treasury (mostly coins) make up the **monetary base**. However, since the Treasury's contribution is less than 10%, we usually focus on the Fed's part when discussing the monetary base. 1. **Currency in Circulation**: - **Currency in circulation** is the money (like cash) that people and businesses have in hand. - Money issued by the Fed that the public holds. - **Effect on Money Supply**: When the amount of currency in circulation increases, the money supply increases. 2. **Reserves**: - These are deposits that banks hold at the Fed, plus physical cash banks keep in vaults. - **Effect on Money Supply**: An increase in bank reserves leads to more deposits and increases the money supply. - Reserves are split into: - **Required Reserves**: Banks must hold a portion of their deposits as reserves, called the required reserve ratio. - **Excess Reserves**: Reserves held beyond what's required. **Assets:** - assets on the Federal Reserve's (Fed\'s) balance sheet are important for two reasons: - **Impact on Money Supply**: When the Fed changes its assets, such as by buying or selling **government securities** or making **loans to banks**, it affects the reserves held by banks and the **monetary base**. This, in turn, changes the **money supply**. - **Earning Income**: The assets, like government securities and loans, earn interest. This means the Fed makes money from them. In contrast, the Fed's liabilities don't cost much, because they don't pay interest. As a result, the Fed makes billions in profits, most of which it gives back to the U.S. government, though it also spends some on beneficial projects like economic research 1. **Securities**: - Government securities (like bonds) that the Fed holds. - **Effect on Money Supply**: When the Fed buys these securities, it provides more reserves to the banking system, which increases the money supply. 2. **Loans to Financial Institutions**: - Also known as discount loans, these are loans the Fed makes to banks. - **Effect on Money Supply**: When the Fed lends more to banks, it increases reserves, thus increasing the money supply. **The SARB's Balance Sheet:** Similar to the Fed, the South African Reserve Bank (SARB) also has **liabilities** (currency in circulation, bank reserves) and **assets** (securities, loans) that affect the money supply in South Africa. In summary: - **Increased liabilities** (more currency in circulation or more reserves) lead to an increase in the money supply. - **Increased assets** (buying securities or making loans) also lead to an increase in the money supply. **[Monetary Base (MB):]** The monetary base is the total amount of currency in circulation (C) plus the reserves (R) that banks hold. It's expressed as: - **MB = C + R** This formula shows that the monetary base consists of currency (C) and reserves (R). **How the Fed Controls the Monetary Base:** The Federal Reserve controls the monetary base mainly through **open market operations** (buying or selling securities) and **discount loans** to banks. ### **What are Open Market Transactions?** - - - - - - **Open market purchases from NON-bank public** - Outcome: Person selling bonds to the SARB, deposits the SARB's check in the bank - Identical result as the purchase from a bank. Reserves increase, monetary base increases ⇒ money supply increases. OR - The person selling the bonds cashes the SARB'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 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. Bottom of Form **2. Open Market Sale (Selling Bonds):** - **Definition**: When the Federal Reserve (Fed) sells bonds, it\'s called an open market sale. This takes money out of the banking system. - - - - - - - - Reserves decrease by \$100 million.(cr) - - **Effect on the SARB Balance Sheet**: - **Assets**: Securities decrease by \$100 million.(cr) - **Liabilities**: currencys in circulation decrease by \$100 million.(dr) - **Effect on the Banking System**: - **Assets**: Securities increase by \$100 million. (dr) - Currency decrease by \$100 million (cr) - - - - **[Shifts from deposits into currency]** When the public shifts money from deposits to cash, it affects the reserves in the banking system but does **not** affect the overall monetary base. Here\'s a simplified breakdown: 1. **Cash Withdrawals**: For example, if the public withdraws \$100 million in cash, the bank loses \$100 million in reserves and deposits. 1. **Effect on the NonBank Public Balance Sheet**: 1. **Assets**: Checkable deposits decrease by \$100 million.(cr) 1. currencys increases by \$100 million.(dr) 2. **Effect on the Banking System**: 2. **Assets**: reserves decrease by \$100 million. (cr) 3. **Liabilities**: checkable deposits decrease by \$100 million (dr) 3. Federal reserve system: 4. Liabilities: Reserves decreases by \$100 (dr) and currency in circulation increases by \$100 (cr) 2. **Effect on Monetary Base**: The key point is that while **reserves** decrease, **currency in circulation** increases by the same amount, so the **monetary base remains unchanged**. The Fed still controls the monetary base, but reserves fluctuate due to these shifts between deposits and cash. 3. **Outcome**: The public\'s desire to hold more cash does not affect the total monetary base but does affect the reserves in the banking system, making the monetary base a more stable and controllable variable for the Fed. 1. **Fed Loans to Banks**: - When the Fed lends money to a bank, like the First National Bank, the bank's reserves increase by the loan amount. - Example: If the Fed loans \$100 million to the bank, the bank gets an additional \$100 million in reserves, and the Fed's balance shows \$100 million lent. - **Effect**: The monetary base (total reserves and currency in circulation) increases by the loan amount (\$100 million in this case). - **Bank**: Assets: + \$100 million (reserves), Liabilities: + \$100 million (loan from Fed). - **Fed**: Assets: + \$100 million (loan to bank), Liabilities: + \$100 million (reserves). 2. **Bank Pays Off Loan**: - When the bank repays the loan to the Fed, the bank's reserves decrease by the repayment amount. - Example: If the bank repays \$100 million, its reserves decrease by \$100 million, and the Fed's balance reflects the repayment. - **Effect**: The monetary base decreases by the amount of the loan repayment (\$100 million in this case). - **Bank**: Assets: -- \$100 million (reserves), Liabilities: -- \$100 million (loan repaid). - **Fed**: Assets: -- \$100 million (loan repaid), Liabilities: -- \$100 million (reserves). 1. **Float**: - When the Fed processes checks, it sometimes credits the bank receiving the check (increasing its reserves) before debiting the bank that issued the check (decreasing its reserves). - This results in a temporary increase in reserves across the banking system, called \"float.\" - **Effect**: Float causes a temporary rise in the monetary base. 2. **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. - **Effect**: This lowers the monetary base since banks lose reserves when Treasury deposits increase at the Fed. 3. **Foreign Exchange Market Interventions**: - When the U.S. Treasury asks the Fed to intervene in the foreign exchange market, it can also affect the monetary base. - **Effect**: Interventions may either increase or decrease the monetary base, depending on the nature of the transactions. 1. **Components of the Monetary Base**: - **Controllable Components**: - **Open Market Operations**: The central bank can fully control the amount of money in the monetary base through buying or selling government bonds (open market transactions). This is the primary tool for influencing the monetary base. - **Uncontrollable Components**: - **Borrowings from the Central Bank**: The central bank (like the Fed or SARB) sets the discount rate (interest rate for loans to banks), but it cannot control how much banks choose to borrow. This means borrowing from the central bank influences the monetary base but isn't fully under the CB's control. 2. **Splitting the Monetary Base**: - The monetary base is split into two parts: - **Nonborrowed Monetary Base (MBn)**: This is the part the central bank can fully control, mainly through open market operations. - **Borrowed Reserves (BR)**: This is the part the CB has less control over because it depends on how much banks decide to borrow from the CB. - 𝑀𝐵𝑛 = 𝑀𝐵 -- 𝐵 - Nonborrowed Monetary Base (MBn) = Total Monetary Base (MB) - Borrowed Reserves (BR). 3. **Other Factors**: - Other factors like **float** (from check clearing) and **Treasury deposits** at the CB also affect the monetary base but are not controlled by the central bank. Although these factors fluctuate in the short term, the central bank can usually predict and offset their impact using open market operations. 4. **Money Supply**: - The money supply increases when the nonborrowed monetary base (MBn) or borrowed reserves (BR) increase. Therefore, both components influence the money supply, though the central bank has more control over MBn. - - 1. - 2. - - 3. - 4. - 5. - **Deposit Creation in the banking system** 1. **Open Market Purchase Impact**: - The Fed buys \$100 million in bonds from a bank, increasing the **reserves** of the banking system by \$100 million. For simplicity, let's say this amount is deposited in **Bank A**.. - T- account: 1. Assets: reserves increase by \$100m 2. Liabilities: checkable deposits increase by \$100m 2. **Reserve Requirement**: - If the required reserve ratio is 10%, Bank A must keep **\$10 million** in required reserves, leaving **\$90 million** in **excess reserves** that it can lend out. 3. **Bank A Makes Loans**: - Bank A doesn't want to hold excess reserves, so it loans out **\$90 million**. The loan increases Bank A's **checkable deposits** by the same amount, as borrowers use the money to pay for goods/services. - When the borrowers spend this money, the reserves and checkable deposits at Bank A decrease by \$90 million, bringing them back to zero. Reserves is now \$10m and loans are \$90m 4. **Deposits at Bank B**: - The money spent by borrowers from Bank A gets deposited at another bank (Bank B). Now, **Bank B** holds the \$90 million in deposits. The T-account for bank B shows: 3. Assets: reserves increase by \$90m 4. Liabilities: checkable deposits increase by \$90m 5. **Total Checkable Deposits So Far**: - Across both Bank A and Bank B, the total increase in checkable deposits is **\$190 million** (\$100 million at Bank A + \$90 million at Bank B). 6. **Bank B Reserve Requirement**: - Bank B must hold 10% of \$90 million (\$9 million) as reserves, leaving **\$81 million** in excess reserves. 7. **Bank B Makes Loans**: - Bank B can lend out **\$81 million**. When borrowers spend this, the money gets deposited in another bank (Bank C). The T-account for bank B shows: 5. Assets: reserves increase by \$9m and loans increase by \$81m 6. Liabilities: checkable deposits increase by \$90m - 8. **Continuation of the Cycle**: - The deposit creation process continues, with Bank C receiving the \$81 million, and so on. The initial \$100 million reserve increase leads to a total deposit increase of **\$271 million** (\$100m + \$90m + \$81m) so far. **Key takeaway**: This process shows how a single injection of reserves into the banking system can multiply through loans and deposits across multiple banks, greatly expanding the total amount of deposits. **Deposit Creation (Summary):** 1. **Total Deposit Creation**: - If all banks lend out the full amount of their **excess reserves**, the process of deposit creation continues across multiple banks (e.g., Banks C, D, E, etc.). - For example, with an initial **\$100 million** increase in reserves and a **10% reserve requirement**, the total increase in deposits will be **\$1,000 million**. This is a **tenfold increase**, due to the 10% reserve ratio (0.10). The total deposit expansion is the **reciprocal of the reserve requirement**. 2. **Single Bank vs. Banking System**: - **Single Bank**: A single bank can only create deposits equal to its **excess reserves**. When it lends out those reserves, the bank loses them to other banks as borrowers spend the loan money. - **Banking System**: As a whole, the banking system can generate a **multiple expansion of deposits** because the reserves stay within the system. When one bank loses excess reserves, those reserves are transferred to another bank, which uses them to make more loans and create additional deposits. This cycle continues until the **initial reserve increase results in a multiple increase in deposits**. 3. **Simple Deposit Multiplier**: - The **simple deposit multiplier** shows how much total deposits increase based on an increase in reserves. It's calculated as: -  : - **ΔD** = Change in total checkable deposits - **rr** = Required reserve ratio (10% in this example, or 0.10) - **ΔR** = Change in reserves (e.g., \$100 million) - The **simple deposit multiplier** is the reciprocal of the reserve ratio. In this example, the multiplier is **10** (1/0.10), meaning \$100 million in reserves leads to \$1,000 million in total deposits. **Deriving formula for multiple deposit creation** **Derivation Steps:** 1. **Assumption about Reserves**: - Banks do not hold excess reserves, meaning all reserves are required reserves. - Therefore, total reserves (R) = required reserves (RR). 2. **Reserve Requirement Formula**: - The total required reserves (RR) are the reserve requirement ratio (rr) multiplied by total checkable deposits (D). - Formula: RR=rr×D 3. **Substitution**: - rr xD substitute to get RR: - R=rr×DR = rr \\times DR=rr×D 4. **Rearranging for Deposits**: - Rearranging the formula to solve for deposits (D): - D= 1/rr x R 5. **Change in Reserves and Deposits**: - If reserves change, the change in deposits (∆D) is proportional to the change in reserves (∆R): - ΔD= 1/rr x ΔR **Explanation:** - **Banking System Equilibrium**: - This derivation shows that for the entire banking system, deposit creation stops when excess reserves are zero. The system reaches equilibrium when required reserves equal total reserves (RR = R). - **Level of Checkable Deposits**: - The equation rr xD is substituted for RR, resulting in the equation R= rr x D, shows the relationship between reserves and deposits. A given level of reserves determines the maximum amount of checkable deposits the system can support in equilibrium(when ER=0). **Example:** - If the reserve ratio is 10% (rr = 0.1) and reserves increase by \$100 million, checkable deposits can increase by \$1,000 million. - This process continues until all reserves are used, eliminating excess reserves and supporting the maximum possible deposits. In simple terms, when banks loan out their reserves, they create deposits. For every increase in reserves, there is a multiplied increase in deposits, up to a point where no excess reserves remain. **Critique of Simple model** **Key Criticisms:** 1. **Currency Holding**: - When people hold onto cash instead of depositing it, it stops the deposit creation process. Unlike deposits, currency does not multiply. - **Example**: If a bank loans \$90 million and the borrower keeps it as cash, no further deposits are made. This reduces the total money supply increase, contrary to what the simple model predicts. 2. **Not All Excess Reserves Utilized**: - Banks may choose not to lend all their excess reserves, which reduces the extent of deposit creation. - **Example**: If a bank holds onto all \$90 million of excess reserves, no new loans or deposits are created, limiting the overall increase in the money supply. **Explanation:** - **Reality vs. Simple Model**: - The Federal Reserve cannot fully control the level of deposits because currency holdings by people and banks\' choices to hold excess reserves disrupt the multiplication of deposits. - The money supply depends on both the actions of depositors (whether they hold currency) and banks (how much excess reserves they keep), not just on the Fed\'s policies. In simple terms, the real-world creation of money is more complex than the model suggests, as it depends on the behaviors of both banks and depositors. **[Factors that determine the money supply ]** **1. Changes in the Nonborrowed Monetary Base (MBn):** - **Theorem**: The money supply is positively related to the nonborrowed monetary base. - **Explanation**: - **Open Market Purchases**: When the Fed buys securities, it increases the nonborrowed monetary base, adding reserves to banks. This leads to multiple deposit creation and an increase in the money supply. - **Money supply increases**: ↑ - **Open Market Sales**: When the Fed sells securities, it reduces the monetary base and bank reserves, causing a contraction of deposits and a decrease in the money supply. - **Money supply decreases**: ↓ **2. Changes in Borrowed Reserves (BR):** - **Theorem**: The money supply is positively related to the level of borrowed reserves from the Federal Reserve. - **Explanation**: - **Increased Borrowing**: When banks borrow more from the Fed (e.g., discount loans), it raises reserves, which supports multiple deposit creation, increasing the money supply. - **Money supply increases**: ↑ - **Decreased Borrowing**: If banks borrow less from the Fed, reserves fall, which reduces deposit creation and decreases the money supply. - **Money supply decreases**: ↓ **3. Changes in the Required Reserve Ratio (rr):** - **Theorem**: The money supply is negatively related to the required reserve ratio. - **Explanation**: - **Increased Reserve Requirement**: When the reserve ratio increases, banks must hold more reserves, reducing the amount they can lend out, thus decreasing the money supply. - **Money supply decreases**: ↓ - **Decreased Reserve Requirement**: A lower reserve ratio allows banks to lend more, increasing the money supply. - **Money supply increases**: ↑ **Summary:** - **Open Market Purchases** and **Borrowing from the Fed** increase the money supply, while **Open Market Sales**, **reductions in borrowing**, and **higher reserve requirements** decrease it. The Fed controls these factors to influence the economy, but reserve requirements have become less significant recently. 4\. **Changes in Excess Reserves:** - **Theorem**: The money supply is negatively related to the amount of excess reserves. - **Explanation**: - **Increased Holding of Excess Reserves**: When banks hold more excess reserves, they are not using those reserves to make loans, halting deposit creation and reducing the money supply. - **Money supply decreases**: ↓ - **Decreased Holding of Excess Reserves**: If banks hold fewer excess reserves, they make more loans, leading to increased deposit creation and a higher money supply. - **Money supply increases**: ↑ - **Benefit of Holding Excess Reserves**: Banks keep excess reserves as a safeguard against potential losses from deposit outflows, such as customers withdrawing large amounts. If they expect more withdrawals, banks will hold more excess reserves, decreasing the money supply 5\. **Changes in Currency Holdings:** - **Theorem**: The money supply is negatively related to currency holdings when excess reserves are constant. - **Explanation**: - **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. - **Money supply decreases**: ↓ - **Decreased Currency Holding**: If people deposit more of their currency into banks, it increases checkable deposits, allowing multiple deposit creation and raising the money supply. - **Money supply increases**: ↑  **[Money multiplier ]** The money multiplier shows how much the money supply (M) changes in response to a change in the monetary base (MB), which includes currency (C) and reserves (R) held by banks. **Key Formula: 𝑀1 = 𝑀 = 𝐶 +** D - 𝑀1 ⇒M1moneysupply - 𝑀 ⇒Money supply - C ⇒Desired holdings of currency - 𝐷 ⇒Checkable deposits 𝑀 = 𝑚×𝑀𝐵-\> 𝑚= 𝑀/𝑀𝐵 - M=Money supply - 𝑚 ⇒Money multiplier - 𝑀𝐵 ⇒Monetary base - \*Link the M1 money supply (M) to the monetary base (MB) and let m be the money multiplier. **Intuition:** The money multiplier tells us how a change in the monetary base leads to a larger change in the overall money supply. For example, if the monetary base increases by \$1, the money supply increases by more than \$1 due to how banks lend and hold deposits. Deviations: ( see notes page 16-18) **Money supply response to changes in factors** **Key Formula:** Where: - **M** = money supply. - **m** = money multiplier. - **MBn** = nonborrowed monetary base. - **BR** = borrowed reserves from the central bank. **Key Factors That Affect Money Supply:** 1. **Nonborrowed Monetary Base (MBn)** and **Borrowed Reserves (BR)**: - **MBn** represents the part of the monetary base not borrowed from the central bank. - **BR** represents the reserves banks borrow from the central bank. - **Impact**: An increase in either **MBn** or **BR** increases the money supply because the money multiplier is typically greater than 0. This means more reserves allow banks to lend more, increasing the money supply. 2. **Required Reserve Ratio (rr)**: - This is the fraction of deposits banks are required to hold as reserves. - **Impact**: A higher required reserve ratio reduces the money supply because banks have to keep more reserves and can lend out less, decreasing the money multiplier (since you're dividing by a larger number). 3. **Excess Reserves Ratio (e)**: - This is the extra reserves banks hold beyond what's required. - **Impact**: If banks hold more excess reserves, the money supply decreases. This happens because fewer reserves are available for lending, reducing the multiplier. 4. **Currency Holdings (c)**: - This represents how much currency people hold relative to deposits. - **Impact**: - **Normal Circumstance (Low e)**: If people hold more currency (rather than keeping it in the bank as deposits), the money supply falls. This is because currency in circulation does not multiply like deposits, which limits multiple deposit creation. - **High Excess Reserves (High e)**: In unusual circumstances (like when banks hold a lot of excess reserves), when currency is withdrawn from deposits, the decrease in excess reserves can free up reserves for more lending, potentially increasing the money multiplier and raising the money supply. **[Quantitative Easing]** **definition:**Quantitative Easing (QE) is a monetary policy where central banks buy financial assets like government bonds to inject money into the economy and lower long-term interest rates. It\'s used when traditional tools, like lowering interest rates, no longer work effectively. **Theory and Example (2007-2017):** - In response to the 2007 financial crisis, the U.S. Federal Reserve launched large-scale QE programs, buying assets to boost the economy. - By 2017, these purchases expanded the monetary base by 350%, but the money supply (M1) only increased by 150%. **Reason:** - Despite a larger monetary base, the **money multiplier** fell by 50%, reducing the potential increase in the money supply. - This drop happened because banks held large excess reserves due to the Fed paying interest on them, making it more attractive for banks to keep reserves than to lend them out. This caused the **excess reserves ratio** to rise dramatically, limiting the expansion of the money supply despite QE. **Conclusion:**\ While QE expanded the monetary base significantly, it didn't cause a proportional increase in the money supply due to banks\' preference to hold onto excess reserves, leading to a lower money multiplier. SEE NOTES PG21 FOR FORMULA SHEET