Economics 374 Dr. John F. Olson
Monetary Theory and Policy Spring 2004
Money Supply Process Handout
THE MONEY SUPPLY PROCESS
Public's (households and businesses) Balance Sheet:
Assets | Liabilities & Net Worth
|
money | debts
currency | bank loans
bank deposits | mortgages
financial securities | RPs sold
bonds |
stocks | net worth
RPs bought |
other wealth & property |
real estate |
Banks' Balance Sheet:
Assets | Liabilities & Net Worth
|
reserves | household and business deposits
vault cash | checkable
reserve deposits @ FRB | non-checkable (time & savings)
loans | discount window loans from FRBs
federal funds sold | federal funds bought
RPs bought | RPs sold
loans to households |
loans to businesses |
mortgages | long-term debt
securities |
U.S. government | equity or net worth
municipals |
other assets |
Federal Reserve Balance Sheet:
Assets | Liabilities & Net Worth
|
discount window loans | FR notes (currency outstanding)
securities | reserve deposits of banks
RPs bought | RPs sold
U.S. government |
other | U.S. Treasury deposits
| foreign & other deposits
|
other assets | equity, net worth, &/or capital
foreign exchange |
gold |
The money supply process depends upon the economic behavior of the public and banks, and the policy actions of the monetary authorities (the Federal Reserve and some Treasury operations).
Definitions: D - bank deposits C - currency held by the public
R - bank reserves M - the money supply (= C + D )
r = the reserve ratio (= R/D )
c = the currency ratio (= C/D )
B - the monetary base or high-powered money (= C + R )
Using the relationships M = C + D and B = C + R one can derived using simple algebra the expression:
M = [(1+c)/(r+c)] * B
The term in []'s is known as the "money multiplier". Its value is determined by the values of "c" and "r" which are, in turn, determined by the behavior (choices) of the public and banks.
The monetary base has two components -- bank reserves and the currency held by the public.
Bank reserves are composed of vault cash (currency in the banks) and reserve deposits held at the Federal Reserve. The level of reserves banks hold is determined in large part by reserve requirements; that is, banks are required to hold a fraction of their deposit liabilities as reserves --- banks may extend credit (make loans, acquire certain securities) with the remaining amount. Because of penalties for deficient reserve positions, banks choose to hold excess reserves; that is, total reserves equal required reserves plus excess reserves.
The reserve component of the base can also be separated into borrowed reserves (discount window loans to banks from the Federal Reserve Banks) and non-borrowed reserves. The monetary authorities can affect the amount of borrowed reserves by changing the discount rate. The monetary authorities can affect the amount of non-borrowed reserves by purchasing (selling) securities --- open market operations --- and crediting (debiting) the banks' reserve deposit accounts.
The public determines (chooses) the amount of currency it holds by converting bank deposit money into currency (or vice versa) --- as the public increases its currency holdings, it reduces reserves (vault cash) in the banking system. Banks can replenish vault cash by drawing on their reserve deposits at the Federal Reserve.
Questions: What explains the growth (movements) in the money supply? What explains changes in the monetary base? What explains changes in the money multiplier? What economic variables determine "c", "r", excess reserves, and borrowed reserves?