Chapter 15

Money supply Process

• Four players in the Money Supply Process• Functions of the central Bank• The central Bank Balance sheet• Monetary Policy• Control of the Monetary Base• Deposit Creation

Four players in the Money Supply Process

(1) The central Bank: The government agency that oversees the banking

system , and is responsible for the conduct of monetary policy.

(2) Banks (Depository Institutions): The financial Intermediaries that accept deposits from

individuals & institutions and make loans : commercial banks , savings& loan associations & credit Unions

(3) Depositors: Individuals and institutions that hold deposits in

banks.

(4) Borrowers from banks: Individuals and institutions that borrow from the

depository Institutions , and institutions that issue bonds that are purchased by the Depository Institutions.

Functions of the Central Bank:

(1) Monopoly of Note Issuing: Central bank concentrated on the Management

of government accounts, and on the issuing of notes.

(2) Lender of the last Resort: the central bank is the provider of reserves to

financial institutions. When no else would provide them in order to prevent a financial crisis.

(3) Government Banker: A) The central bank keeps an account for the treasury, into

which its revenues are deposits , and from which its expenses are met

B) It acts as a government agent for the management of the National Debt (conducting short term & long term loans for the government)

c) It is responsible for implementing government monetary policy , which aims at controlling the amount of money in circulation (to control the inflation rate)

d) It has the important job of controlling foreign exchange

(4) A Banker’s Bank: The central bank holds deposits made by

commercial banks, which appear in its balance sheet in the liability side( appear in the balance sheet of commercial banks in the asset side)

5) Control of credit and cash available to the public

The central Bank Balance sheet

• Total assets = total liabilities + capital• The central banks assets are those things it

owns and claims it has on outside entities• The central bank’s liabilities are debts it owes,

or claims that outside entities have on the central bank

• The central bank’s capital accounts are simply the difference between its total assets and total liabilities

The Central bank Assets liabilities Government securities Currency in circulation Discount Loans Reserves

Liabilities: Currency in circulation : is the amount of currency in

the hands of the publicCurrency held by depository institutions is also a

liability of the central bank Reserves: reserves are Assets for the banks, but

liabilities for the central bank. This is because the banks can demand payment on them at any time, and the central bank is required to satisfy its obligation

Assets : Government Securities: these covers the central

bank’s holdings of securities issued by the treasury.

Discount loans: the central bank can provide reserves to the banking system by making discount loans to banks

Tools of Monetary Policy

• Monetary policy is deliberate action taken to affect the size of the Economy’s Money supply for the purpose of promoting economic stability and maximum output and employment with a minimum of inflation

First: the three major tools of Monetary policy

(1) Open market operations

(2) Setting reserves requirements for commercial banks and other depository institutions

(3) Setting the level of the discount rate

(1) Open market operations

• The central bank can directly affect the amount of bank reserves by buying or selling government securities ( stock, bonds) , in the open market where these securities are traded. Such transactions are called open market operations

• When the central bank conducts open market purchases, it buys government bonds and puts reserves into the banking system, causing an expansion of demand deposits and other checkable deposits, and hence an increase in the economy’s money supply

• When the central bank conducts open market sales , it sells government bonds and takes reserves out of the banking system, causing a contraction of demand deposits and other checkable deposits, and hence a decrease in the economy’s money supply

A) Open market Purchases

• Suppose that the central bank buy 1000 of government securities in open market, and that the seller is a commercial bank

• The central bank pays the commercial bank by increasing the commercial bank’s reserves account by the amount of 1000

The changes in the central bank’s balance sheet

Assets liabilities Gov securities 1000 commercial bank 1000 Reserves deposits

The changes in the commercial bank’s balance sheet

Assets liabilities Deposits at the Central bank( Reserves) +1000Gov securities – 1000

• Suppose that the central bank buys 1000 of gov securities in the open market from an individual or a business (or corporation) other than a bank.

• The central bank simply makes out a check for 1000 drawn against it and payable to the seller deposits the check in a commercial bank. The commercial bank for collection, and the commercial bank’s reserves account at the central bank is increased by 1000

The changes in the central bank’s balance sheet

Assets liabilities Securities +1000 commercial bank+ 1000 Reserves deposits

The changes in the commercial bank’s balance sheet

Assets liabilities Deposits at the Demand deposits Central bank +1000 +1000

• In general, we can say that commercial bank reserves are increased by the amount of central bank open market purchase no matter whether the seller of the securities is a bank or a nonbank

B) Open market Sales

• Suppose that the central bank sells 1000 of government securitiesin open market, and that the buyer is a commercial bank

• The central bank takes payment from the commercial bank by reducing the commercial bank’s reserves account by the amount of 1000

The changes in the central bank’s balance sheet

Assets liabilities Gov securities – 10 00 commercial bank - 1000 Reserves deposits

The changes in the commercial bank’s balance sheet

Assets liabilities Deposits at the Central bank -1000Gov securities+1000

• What if the buyer of the 1000 of gov securities sold by the central bank is an individual or business other than a bank?

• Suppose that payment is made to the central bank with a check drawn against the buyer’s deposit at a commercial bank. When the central bank receives the check, it decreases the commercial bank’s reserves deposits at it by 1000

The changes in the central bank’s balance sheet

Assets liabilities Securities -1000 commercial bank-1000 Reserves deposits

The changes in the commercial bank’s balance sheet

Assets liabilities Deposits at the Demand deposits Central bank -1000 -1000

• In general , we can say that bank reserves are decreased by the amount of central bank open market sales, regardless of whether the buyer is a bank or a nonbank.

(2) Legal Reserves Requirements

• The central bank has the authority to set the required reserve ratios within limits. The required reserves ratio establishes the minimum amount of reserves that banks must hold against demand deposits liabilities . How does the central bank affect the economy’s money supply by changing bank reserve requirements?

• Suppose that all banks in the banking system are fully loaned up and that the required reserve ratio is 10% . The balance sheet of a commercial bank would look like

Assets liabilities Reserves 100000 Demand deposits 1000000

(A) Increase in the legal Reserves Requirement

• Suppose that the central bank wants to tighten up the economy’s money supply, this means that the central bank wants to force the banks in the banking system to reduce their lending activity or their holdings of other earnings.

• Suppose that the central bank increase the legal reserve requirement from 10% to 12%. Our bank is now required to hold 120,000 of reserves against its 1000000 of demand deposits

• Since it only has 100000 of reserves, it is 20000 short. In order to make up this deficiency, the bank must reduce its loans or sell off 20000 of its other earnings assets

(B) Decrease in the legal Reserves Requirement

• If the central bank wants to increase the money supply, it can reduce the reserves requirement.

• Suppose that the central bank reduce the required reserve ratio from 10% to 8%. Our bank is now required to hold 80000 of reserves against its 1000000 of demand deposits

• Therefore , it has 20000 of excess reserves.

• In general, we can say that an increase in the required reserve ratio will force a money supply reduction. A decrease in the required reserve ratio increase the amount of excess reserves, encouraging banks to increase lending and deposit expansion, thereby increasing the money supply.

(3) Setting the Discount Rate

• The depository institutions make loans to the public, and the central banks make loans to depository institutions.

• Banks naturally find it attractive to borrow from the central bank, whenever the interest rates they can earn from making loans to business and consumers greater than the discount rate.

• On the other hand, when the discount rate is higher than these interest rates, banks are discourage from borrowing at the central bank.

• In general, we can say that if the central bank raises the discount rate, bank borrowing is reduced, and the amount of reserves in the banking system falls . this tends to deposit contraction, and a reduction in the size of the money supply

• If the central bank lowers the discount rate, bank borrowing rises, causing an increase in reserves and deposit expansion and hence an increase in the money supply

Control of the Monetary Base

• The monetary base consists of those liabilities of the Monetary authorities

• MB = C+ RMB is the monetary baseC currency in circulationR total Reserves in Banking system

• How will a central bank sale of 100 of government bonds to banks affect the monetary base & reserves?

Banking system Assets liabilities Securities +100Reserves -100

The Central Bank

Assets liabilities Gov securities-100 Reserves -100

change in monetary base = -100 change in reserves = -100

• How will a central bank sale of 100 of government bonds to the nonbank public affect the monetary base & reserves if the nonbank public pays for the bonds with checks?

Nonpublic public Assets liabilities Securities +100checkabledeposits-100

BANKING SYSTEM Assets Liabilities Reserves -100 checkable deposits - 100

central bank

Government securities -100 Reserves -100Change in monetary base =-100Change in reserves = -100

• How will a central bank sale of 100 of government bonds to the nonbank public affect the monetary base & reserves if the nonbank public pays for the bonds with currency?

Nonpublic public Assets liabilities Securities +100Currency -100

central bank

Government securities -100 currency in circulation -100

Change in monetary base =-100Change in reserves = 0

Multiple Deposits creation: A simple Model

• When the central bank supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount .this process is called multiple deposits creation

A- How the central bank provides Reserves to the banking system

• The central bank provides reserves to the banking system by purchasing bonds or by making loans o the bank

(1) Suppose that the central bank makes 100 discount loan to the first National bank

First National Bank Assets Liabilities Reserves 100 Discount loan 100

The central Bank Assets Liabilities Discount loan 100 Reserves 100

(2) Suppose that the central bank buy 100 worth of bonds from the first National Bank, and pays for them with a check written on itself.

First National Bank Assets Liabilities Reserves 100 securities - 100

The central Bank Assets LiabilitiesSecurities 100 Reserves 100

B- Deposits creation : the single Bank

• When a bank acquires additional excess reserves , either through the sale of securities or a discount loan from the central bank, it can lend the amount of its excess reserves, thereby expanding deposits by an amount = to the increase in reserves.

First National Bank Assets Liabilities securities - 100 loans +100

C- Deposit creation : the banking system

• Although an individual bank can lend& create deposits of an amount equal to its excess reserves, the banking system can generate a multiple expansion of deposits, when reserves in the system increase.

• When the central bank provides additional reserves to the banking system, checkable deposits, and therefore the money supply increase by an amount that exceeds the initial change in reserves.

• The formula for the simple deposits Multiplier can be written as:

∆ D= ⅟r × ∆ R Where∆ D represents change in total checkable deposits in the

banking system r represents required reserve ratio ∆ R represents change in reserves for the banking system

Increase in reserves

Increase in loans

Increase in deposits

bank

0 100 0 First national

10 90 100 A

9 81 90 B

8.10 72.90 81 C

7.29 65.61 72.90 D

6.56 59.05 65.61 E

5.91 53.14 59.05 F

100 1000 1000 Total for all banks

• Also a decline in the banking system’s reserves will cause a multiple contraction of deposits, a process opposite that of multiple deposits creation.

Critique of the simple Model

• If some proceeds from loans are used to raise the holdings of currency, checkable deposits will not increase by as much as our simple model of multiple deposit creation tells us