Money Supply Process Flashcards
3 players in the money supply process
Central bank
Banks
Depositors
Fed assets and liabilities (2,2)
Assets:
Securities
Loans
Liabilities
Currency in circulation
Reserves
So basically same but reserves swap sides
Now compare this to banks assets and liabilities
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
Monetary base (high powered money) formula
MB = C + R
C currency in circulation
R reserves
Monetary base is currency in circulation + reserves
We will look at the effect of open market purchase/sales from a bank on the balance sheet of the bank and Fed.
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
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)
Open market purchase from a nonbank e.g Fed purchases 100m bonds from an individual.
Effect on balance sheet of
A) bank
B) fed
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)
What if the person selling the bank cashes the check
A) for the person (nonbank public)
B) for the FED
C) overall
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!)
So what does the effect of an open market purchase on reserves depend on?
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!
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))
Open market sale (2 characteristics)
Reduces MB by amount of the sale
No change in reserves
So opposite of open market purchase!
Effect of swapping deposits into currency for
Nonbank public
Banks
Fed
(Tricky last one: think!)
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!!!)
Fed makes a loan to a financial institution
Effect on banks and fed and monetary base
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
Other factors that impact monetary base (3)
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
OMO is controlled by the fed (buying/selling bonds)
What can the Fed not control, and how can we model this?
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!)
Money supply relationship with MBn and BR
Positively related to both
What else determines money supply (5 including the first 2)
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.)
Neg relationship because the ones reduce/limit deposit creation/expansion
Money supply expression also key assumption to use later
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!
How to derive the expanded Money base expression
(Hint make assumption)
Find currency and excess reserve ratio
Assume currency and excess reserves grow proportionately with checkable deposits D
c = C/D = currency ratio
e = ER/D = excess reserves ratio
Derivation continued…
Total reserves (R) have to equal…
Total required reserves (RR has to equal)
How can we combine the 2 expressions?
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
This gives us the final derivation for money base
MB = C + R
And R = (r x D) + ER
So
MB = C+ (r x D) +ER
How to derive the money multiplier pg 81
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!!!
Quantative easing EFFECT ON money base and supply 2007-2017
Purchase of assets quintupled balance sheet and 350% increase in base.
No change in money supply since excess reserves rose dramatically!!
