Central Banks & The Money Supply

Question 1

What are the CB’s tools?

Answer 1

• Open Market Operations

- Discount Loans

Question 2

What are the CB’s motivations?

Answer 2

• Public Interest View
  
  • To maximise society’s wellbeing, generate price stability, promote high employment, generate high economic growth
• Principal Agent View
  
  • To maximise their own wellbeing, they increase their power, prestige and influence
  • Makes it possible for them to chose policies to re-elect incumbent Presidents/Prime Ministers: Political Business Cycle
    
    • RBA takes actions to decrease interest rate: increase economic activity: incumbent re-elected

Question 3

What is the money supply process?

Answer 3

• MS = B * m

- Money supply = monetary base * money multiplier

Question 4

What is the monetary base?

Answer 4

• B = R + C

- Monetary Base = Reserves + Currency in Circulation

Question 5

What is the money multiplier?

Answer 5

• The Money Multiplier links the monetary base to the money supply
  
  • Determined by the central bank, banking system and non-bank public
• When the money multiplier is stable the Fed can control the money supply by controlling the monetary base

Question 6

What are the Fed’s assets?

Answer 6

• Used to change the monetary base and make the CB earnings (independence)
• Securities
  
  • Treasury Bonds
  • Other securities
• Discount Loans to financial institutions
  
  • aka Borrowed Reserves

Question 7

What are the Fed’s liabilities?

Answer 7

• Currency held by nonbank public (C) (in circulation)
  
  • C = currency outstanding - vault cash
• Reserves held by banks (R)

Question 8

What are reserves held by banks (R)?

Answer 8

• R = Banks deposit’s with Central Banks + Vault Cash (cash held by CB)
• R = RR (Required reserves) + ER (Excess reserves)
  
  • Required reserves are reserves that the Fed requires banks to hold
  • Excess reserves are reserves that banks hold above those the Fed requires them to hold

Question 9

What is RRD?

Answer 9

• RRD: Required Reserve Ratio
• RRD = RR/D
  
  • RRD = Required Reserves/Checkable Deposits
  • So a portion of these deposits should be kept as required reserves

Question 10

How does the Fed change the monetary base?

Answer 10

• By changing the levels of its assets
  
  • Through buying and selling T-securities or making discount loans to banks
• Open Market Operations
• Discount Loans
• Both OMP and Discount Loans change the Monetary Base, but the Fed has greater control over OMP’s

Question 11

What are OMO’s?

Answer 11

• The Fed’s purchases and sales of securities, usually T-Bills, in financial markets
  
  • Open market purchase/sale
• Carried out electronically with primary dealers by the Fed’s trading desk
• The Public’s preference for currency relative to checkable deposits does not affect the monetary base

Question 12

What are discount loans?

Answer 12

• Loan from the Fed to commercial bank
• These alter bank reserves
• An increase in discount loans affects both sides of the Fed’s balance sheet

Question 13

What is the discount rate?

Answer 13

• Discount rate is the interest rate the Fed charges on discount loans
  
  • Differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets

Question 14

What is the monetary base and what does the Fed control?

Answer 14

• The monetary base (B) includes: the non-borrowed monetary base (Bnon, from OMO) and borrowed monetary base (BR, from discount loans, i.e. the borrowed reserves, same as discount loans)
  
  • This also equals Currency + Reserves as Assets = Liabilities
• The Fed has control over the non-borrowed monetary base

Question 15

What is The Simple Deposit Money Multiplier?

Answer 15

• Helps us understand factors that determine MS
• Determined by the Fed, the nonbank public, and banks
• Two Assumptions
  
  • ER = 0
    
    • Banks hold no excess reserves
  • ∆c = 0
    
    • Non bank public does not change it’s holding of currency
• m = 1/RRD

Question 16

What is the complete description of the complete money multiplier?

Answer 16

• As B = Bnon + BR:
• M = ((C/D) + 1)/((C/D)+(RR/D)+(ER/D))) x (Bnon + BR)
• An increase in the non-borrowed base (Bnon) based on the actions of the Fed through OMP’s causes the money supply to increase because the monetary base increases, and more reserves are available for deposit expansion
• An increase in the required reserve ratio (RRD) based on the actions of the Fed causes the money supply to decrease because fewer reserves can be leant out and the value of the the money multiplier falls
• An increase in the currency-to-deposit ratio (C/D) based on the actions of the non-bank public causes the money supply to decrease because the value of the money multiplier falls, reducing deposit expansion
• An increase in the excess reserves to despot ratio (ER/D_ based on the actions of banks causes the money supply to decrease because the value of the money multiplier falls, reducing deposit expansions
• Monetary Base can only be affected by the central bank

Question 17

What is the complete money multiplier?

Answer 17

• Assumptions
  
  • ER > 0
    
    • Banks can hold excess reserves
  • ∆C ,= 0
    
    • Non bank public’s holding of currency can change
• MS is positively related to m and B
• C/D is negatively related to m and MS
• RRD (RR/D) is negatively related to m and MS
• ER/D is negatively related to m and MS

Question 18

What is m in terms of M1?

Answer 18

m = M1/B

Question 19

How are reserves classified?

Answer 19

NOT M1

Question 20

The money multiplier declined significantly during 1930-1933 and 2008-2010. The M1 decreased by 25% in the period of 1930-1933 but increased by more than 20% during the recent financial crisis. What explains the difference in outcomes?

Answer 20

The difference is that the monetary base increased dramatically during the recent financial crisis, which was more than enough to offset the fall in the multiplier. During the Great Depression, the monetary base rose modestly, if at all.