Introduction to the Money Supply Process

1
Introduction to the Money Supply Process

• Fundamental Property -- Money supply expands when
  banks make loans (or more generally, expand loans
  or buy bonds)

2
Deposit Expansion The Individual
Bank

• Consider the following example.
• (rD 0.10, rT 0.05)
• Chase
• R 20000 D 70000
• L 90000 T 80000
• Bonds 50000 E 10000

3
Computing Required and Excess Reserves

• Chase rD
  0.10
• R 20000 D 70000 rT 0.05
• L 90000 T 80000
• Bonds 50000 E 10000
• RR rDD rTT (0.10)(70000)
• (0.05)(80000) 11000
• ER R - RR 20000 - 11000 9000

4
Loan of 900 Step 1 -- Loan
is Approved

• Chase
• R 20000 D 79000
• L 99000 T 80000
• Bonds 50000 E 10000
• Borrower signs loan contract,
• receives check from bank.

5
Step 2 -- Loan is Spent

• Chase
• R 11000 D 70000
• L 99000 T 80000
• Bonds 50000 E 10000
• Seller deposits check in her bank.
• Fleet
• ?R 9000 ?D 9000

6
Bank Loaning and Money Supply Expansion

• Consider M2 C D T MMMF
• ? ?M2 ?C ?D ?T ?MMMF
• Our example
• ?M2 0 9000 0 0 9000
• (Chases loan leads to
  new deposits for Fleet.)

7
Key Concepts Money Supply Expansion

• Key is step 1, Chase expands its deposit
  commitments without changing its reserves.
• Note -- Process is symmetric. Repayment or
  liquidation of loan leads to decrease in M2 (by
  the amount of the loan).

8
Deposit Expansion The Banking System

• Multiple Expansion -- An initial change in bank
  reserves prompted by the Federal Reserve leads to
  an eventual increase in the money supply which is
  a multiple of that initial change.

9
Developing a Formula for Multiple Expansion

• Define -- The Monetary Base, or
• High Powered Money (H)
• H C R

10
Key Properties The Monetary
Base

• The monetary base (H) is unaffected by changes in
  public asset holdings.
• The monetary base (H) is also unaffected by bank
  loaning.
• Important factors that change H Open Market
  Operations and Discount Loans (DL).

11
Discount Loans and the Monetary
Base

• Example 1 -- Chase borrows 100 from the Federal
  Reserve.
• Chase
• ?R 100 ?DL 100
• ?H ?C ?R 0 100 100

12
Open Market Operations and the Monetary Base

• Example 2 -- The Federal Reserve buys a 100 bond
  from Chase.
• Chase
• ?Bonds - 100
• ?R 100
• ?H ?C ?R 0 100 100

13
The Nonborrowed Base

• The Nonborrowed Base (HNON)
• HNON H - DL
• Key property -- The nonborrowed base is only
  affected by open market operations.

14
A Formula for Money Supply Determination

• Define the following variables.
• k C/D
• t T/D
• e ER/D

15
Money Supply Determination The Formula

• M2 (1 k t) (HNON DL) MMMF
• (k rD rTt e)
• The money multiplier (m2)

16
Computing the Money Multiplier An Example

• Suppose that
• C 550 rD 0.10
• D 600 rT 0.03
• T 3000
• ER 10.
• Compute the money multiplier (m2).

17
Computing the Ratios

• k C/D 550/600 0.917
• t T/D 3000/600 5.000
• e ER/D 10/600 0.0167

18
Plugging Into The Multiplier
Formula

• m2 1 k t
• k rD rTt e
• ?m2 1 0.917 5.0
• 0.917 0.10 (0.03)(5.0) 0.0167
• m2 5.84

19
Effects of HNON and DL
on M2 Determination

• Since M2 (m2)(HNON DL),
• ?M2 (m2)(? HNON),
• ?M2 (m2)(?DL).
• In other words,
• HNON? ? M2?
• DL? ? M2?
• Changes in HNON or DL give banks reserves,
  greater ability to loan.

20
Effects of Reserve Ratios on M2 Determination

• Increases in reserve ratios hinder bank loaning,
  thereby decreasing the multiplier and M2.
• m2 1 k t
• k rD rTt e
• rD? ? m2? ? M2?
• rT? ? m2? ? M2?

21
Effects of k (C/D) and t (T/D) on M2 Determination

• Changes in k and t have different effects on bank
  loaning, the multiplier, and M2.
• m2 1 k t
• k rD rTt e
• k? ? m2? ? M2?
• t? ? m2? ? M2?

22
Effects of e (ER/D) on M2

• Changes in e affect the multiplier, which affects
  M2.
• m2 1 k t
• k rD rTt e
• e? ? m2? ? M2?

23
M2 Determination Summary

• First, the formula again.
• M2 (1 k t) (HNON DL) MMMF
• (k rD rTt e)

24
A Summary Table

• HNON? ? M2?
• DL? ? M2?
• rD? ? M2?
• rT? ? M2?
• k? ? M2?
• t? ? M2?
• e? ? M2?

25
The Multiplier -- Trying to Control the Money
Supply

• M2 (1 k t) (HNON DL) MMMF
• (k rD rTt e)
• Federal Reserve controls HNON, rD, and rT.
• But M2 is also determined by public asset holding
  (k, t, MMMF) and bank behavior (e, DL).

26
Can the Federal Reserve Control the Money Supply?

• Practical Solution -- The Federal Reserve tries
  to control money supply growth within a given
  target range. If actual M2 growth falls within
  the range, M2 is considered controlled.

27
The Multiplier Effect and Controlling M2

• Consider formula for M2 determination (apart from
  MMMF), written as follows (recall that H HNON
  DL).
• M2 (m2)(H)

28
M2 Determination in Growth Rates

• Since the levels are multiplicative, the growth
  rates are additive
• Growth in M2 ?
• (Growth in m2) (Growth in H)

29
Implications for M2 Control

• Growth in M2 ?
• (Growth in m2) (Growth in H)
• If the multiplier is roughly constant over time
  (growth in m2 ? 0), then the growth rate of M2
  will approximate closely the growth rate of the
  monetary base.

30
Difficulties in M2 Control

• Growth in M2 ?
• (Growth in m2) (Growth in H)
• But if the multiplier changes over time (growth
  rate either positive or negative), then the
  growth rate of M2 will deviate from the growth
  rate of the monetary base.

31
Non-Federal Reserve Changes in M2

• Best solution constant multiplier, zero DL.
  Unfortunately, not true.
• Second best solution predictable multiplier and
  DL.
• How to predict non-Fed controlled changes in M2?
  What determines movements in the components
  (k, t, e, DL, MMMF)?