Money Supply Process

Question 1

3 players in the money supply process

Answer 1

Central bank

Banks

Depositors

Question 2

Fed assets and liabilities (2,2)

Answer 2

Assets:
Securities
Loans

Liabilities
Currency in circulation
Reserves

So basically same but reserves swap sides

Question 3

Now compare this to banks assets and liabilities

Answer 3

Assets: Reserves dick suck lips
Reserves (liability for central bank!)
Loans
Securities
Deposits at other banks

Liabilities CBNB (Chinese be non baddies)
Checkable deposits
Borrowings
Non transaction deposits
Bank capital

Question 4

Monetary base (high powered money) formula

Answer 4

MB = C + R

C currency in circulation
R reserves

Monetary base is currency in circulation + reserves

Question 5

We will look at the effect of open market purchase/sales from a bank on the balance sheet of the bank and Fed.

Question 6

Open market purchase from a bank- e.g FED purchases 100m bonds from a bank

Effect on balance sheet of
A) bank
B) fed
C) overall net result

Answer 6

For bank
Securities fall by 100m (securities fall) , since sold to Fed.
Reserves increase by 100m

So overall unchanged

For Fed
Assets increase 100m (securities increase) and liabilities increase 100m (reserves increase)

Overall net result: reserves have increase by 100m, so monetary base has risen! (C+R)

Question 7

Open market purchase from a nonbank e.g Fed purchases 100m bonds from an individual.

Effect on balance sheet of
A) bank
B) fed

Answer 7

Assuming the person selling the bonds then deposits the funds in a bank:

Bank: assets (reserves) increase , but they now have have a liability of checkable deposits.

Fed: Same result as purchasing from a bank (increase in security and reserves, net increase in reserves so increase in monetary base)

Question 8

What if the person selling the bank cashes the check

A) for the person (nonbank public)
B) for the FED
C) overall

Answer 8

A) Securities fall (since sold the bonds) but currency increases,

Both are assets, so offset each other so no change.

B) Assets (Securities) increase, but no change in reserves this time, but an increase in liabilities (currency in circulation is a liability for Fed)

C) MB increases by the amount of the open market purchase (since C increases!)

Question 9

So what does the effect of an open market purchase on reserves depend on?

Answer 9

Whether they keep proceeds in currency or deposit it at a bank (If at a bank - reserves increase, If cash it in - currency in circulation increases)

But it ALWAYS increases the monetary base by the amount of the open market purchase!

Question 10

An open market purchase ALWAYS increases the monetary base by the amount of the open market purchase! (Either through C (for cashing in Fed cheque) or R (depositing money in bank))

Question 11

Open market sale (2 characteristics)

Answer 11

Reduces MB by amount of the sale

No change in reserves

So opposite of open market purchase!

Question 12

Effect of swapping deposits into currency for

Nonbank public
Banks
Fed

(Tricky last one: think!)

Answer 12

A) fall in checkable deposits, but increase in currency, so overall no change in assets

B) fall in liabilities (since checkable deposits fall), however also a fall in assets since reserves fall too

C) Currency in circulation increase, but reserves fall, (both are liabilities, so offset so net effect is no change in liabilities. (Supports the idea of MB being a relatively stable variable!!!)

Question 13

Fed makes a loan to a financial institution

Effect on banks and fed and monetary base

Answer 13

Banks - increase in reserves, however increase in liabilities (borrowing)

Fed - increase in assets (loans) , and an increase in reserves

Since reserves increase, monetary base also increases by that amount

Question 14

Other factors that impact monetary base (3)

Answer 14

Float - the delay in the clearing of cheques causes an increase in currency circulationg (so MB increases)

Treasury deposits at the Fed - moving deposits from bank decreases reserves and the monetary base!

Interventions in the FEM

Question 15

OMO is controlled by the fed (buying/selling bonds)
What can the Fed not control, and how can we model this?

Answer 15

Fed can not determine the amount borrowing of the banks
So model by splitting monetary base into 2 components
MBn = MB - BR
MB - non borrowed money base
MB = money base
BR = borrowed reserve

(Basically Non borrowed money base is the difference between monetary base and borrowed reserves!)

Question 16

Money supply relationship with MBn and BR

Answer 16

Positively related to both

Question 17

What else determines money supply (5 including the first 2)

Answer 17

Changes in MBn (pos rel)

Changes in BR from the fed (pos rel)

Changes in required reserve ratio (neg rel)

Change in excess reserves (neg rel)

Change in currency holdings (neg rel - if holding more cash rather than in banks, it can’t be lent, limiting deposit expansion.)

Question 18

Neg relationship because the ones reduce/limit deposit creation/expansion

Question 19

Money supply expression also key assumption to use later

Answer 19

M = m x MB

M = money supply
MB = monetary base
m = money multiplier

We assume money supply is M1 which is currency + checkable deposits M=C+D (used for derivation on multiplier pg 23)

(In monetary approach to BOP remember it is instead M=m(D+F) same thing but slightly diff!

Question 20

How to derive the expanded Money base expression

(Hint make assumption)

Find currency and excess reserve ratio

Answer 20

Assume currency and excess reserves grow proportionately with checkable deposits D

c = C/D = currency ratio
e = ER/D = excess reserves ratio

Question 21

Derivation continued…
Total reserves (R) have to equal…
Total required reserves (RR has to equal)
How can we combine the 2 expressions?

Answer 21

A) Total reserves = sum of required reserves and excess reserves

R = RR + ER

B) RR = r x D
r = required reserve ratio
D is checkable deposits

C) Sub RR into first equation
R = (r x D) + ER

Question 22

This gives us the final derivation for money base

Answer 22

MB = C + R

And R = (r x D) + ER

So
MB = C+ (r x D) +ER

Question 23

How to derive the money multiplier pg 81

Answer 23

Rearrange the previous currency and excess reserve ratios
c = C/D rearrange to C = cD
e = ER/D rearrange to ER = eD

Sub into expanded MB equation (MB = C + (r x D) + ER) :
MB = cD + rD + eD which factorises to MB = D(c+r+e)

Move (c+r+e) to other side
MB x 1/(c+r+e) = D

Remember we defined Money supply as M1 (currency + checkable deposits) M = D+C
C = cD so M=D+cD which factorises to M=D(1+c)

S0
M = MB x 1/(c+r+e) (1+c)
Which finalises to
M = MB x (1+c)/c+r+e

Where 1+c/c+r+e is money multipler m!!!

Question 24

Quantative easing EFFECT ON money base and supply 2007-2017

Answer 24

Purchase of assets quintupled balance sheet and 350% increase in base.

No change in money supply since excess reserves rose dramatically!!