4. The money supply process Flashcards
What does the Fed create?
It does not create money supply, it creates the money base.
B = C + R C = currency in circulation R = bank reserves (cash in vaults + bank deposits at fed)
What is the meaning of the monetary base?
The liabilities of the Fed to the private sector of the economy.
B = C + R
Currency in Circulation is the money the fed owns to people and firms
Bank reserves is the money the fed owns to banks
How do central banks create/change the monetary base?
Open market operations and loans.
What are open-market operations?
Purchases and sales of securities by central banks
Usually trades of US treasury bonds
Purchase of any security by fed increases monetary base and sale reduces monetary base
How are loans used to change the monetary base?
Can change monetary base by lending money to a financial institution, usually with a discount loan to a bank.
Fed sets the interest rate on discount loans called the discount rate
How does the Fed’s balance sheet look like?
Assets: Securities, loans to financial institutions
Liabilities: currency in circulation, bank reserves
Why is M usually larger than B?
Because banks’ checking deposits usually exceed their reserves
D > R
What other than the monetary base affects money supply?
Depends on behavior of bank and and their customers
How does a bank create money?
A bank gives people deposits in return for currency
Then it lends out part of the currency.
The amount of deposits remain the same but the currency in circulation increases, thus increasing money supply
M = C + D
Monetary base ( B = C + R) remains same
Does money supply increase infinitely when banks lend money?
No, the amount by which the money supply increases, decreases due to leakages to reserves and cash.
Not all of the loans are redeposited. Some of the money is kept as cash or reinvested.
Not all of the deposits are lent out again. Some of it is kept as reserves.
What is the formula for Money Supply?
M = ((C/D + 1)/(C/D + R/D)) * B
M is determined by C/D, the currency-deposit ratio and R/D, the reserve-deposit ratio and the monetary base
Denote the fraction with m, so we have:
M = mB
m is greater than 1 if R/D is less than 1
m is usually greater than 1, so we call m the money multiplier
What happens if C/D or R/D changes?
If C/D or R/D increase, the fraction decreases, so money supply decreases
These ratios represent the money leakages, thus the greater they are the less money is multiplied
higher C/D: more leakage in cash
higher D/R: more leakage in reserves
