anthony patrick o’brienfuangfah.econ.cmu.ac.th/teacher/nisit/files/ho_mb1e_ch14.pdf · © 2012...

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

R. GLENN

HUBBARDANTHONY PATRICK

O’BRIEN

Money,

Banking, and

the Financial System


The Federal Reserve’s Balance

Sheet and the Money Supply

Process

C H A P T E R 14

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

14.1

14.2

14.3

Explain the relationship between the Fed’s balance sheet and the monetary base

Derive the equation for the simple deposit multiplier and understand what it means

Explain how the behavior of banks and the nonbank public affect the money

multiplier

14A Appendix: Describe the money supply process for M2


GEORGE SOROS, “GOLD BUG”

• While some individual investors, known as “gold bugs,” have always

wanted to hold gold, the surge in demand for gold during 2009 and 2010

surprised many economists. John Paulson, Thomas Kaplan, and George

Soros are some of the famous hedge fund managers with a preference

for gold.

• For many, holding gold is a way to hedge the risk of inflation created by a

rapid increase in the money supply.

• An Inside Look at Policy on page 434 discusses the Federal Reserve’s

“exit strategy” from the increases in reserves and the money supply that

resulted from its policies during the financial crisis of 2007–2009.

C H A P T E R 14 The Federal Reserve’s Balance

Sheet and the Money Supply

Process

© 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 46

Key Issue and Question

Issue: During and immediately following the financial crisis, bank

reserves increased rapidly in the United States.

Question: Why did bank reserves increase rapidly during and after the

financial crisis of 2007–2009, and should the increase be a concern to

policymakers?


14.1 Learning Objective

Explain the relationship between the Fed’s balance sheet and the monetary base.


The Federal Reserve’s Balance Sheet and the Monetary Base

Our model of how the money supply is determined includes three actors:

1. The Federal Reserve, which is responsible for controlling the money supply

and regulating the banking system.

2. The banking system, which creates the checking accounts that are the most

important component of the M1 measure of the money supply.

3. The nonbank public, which refers to all households and firms. The nonbank

public decides the form in which they wish to hold money—for instance, as

currency or as checking account balances.

Figure 14.1 The Money Supply Process

Three actors determine the money supply: the central bank (the Fed), the nonbank public, and the

banking system.•



The process starts with the monetary base, which is also called high-

powered money.

Monetary base (or high-powered money) The sum of bank reserves and

currency in circulation.

Monetary base = Currency in circulation + Reserves.

The money multiplier links the monetary base to the money supply. As long as

the value of the money multiplier is stable, the Fed can control the money

supply by controlling the monetary base.

There is a close connection between the monetary base and the Fed’s balance

sheet, which lists the Fed’s assets and liabilities.


Table 14.1 The Federal Reserve’s Balance Sheet



• Reserve deposits are assets for banks, but they are liabilities for the Fed

because banks can request that the Fed repay the deposits on demand with

Federal Reserve Notes.

The Monetary Base

Currency in circulation Paper money and coins held by the nonbank public.

Vault cash Currency held by banks.

Currency in circulation = Currency outstanding – Vault cash.

Bank reserves Bank deposits with the Fed plus vault cash.

Reserves = Bank deposits with the Fed + Vault cash.



Required reserves Reserves that the Fed compels banks to hold.

Excess reserves Reserves that banks hold over and above those the Fed

requires them to hold.

Required reserve ratio The percentage of checkable deposits that the Fed

specifies that banks must hold as reserves.

Reserves = Required reserves + Excess reserves.

Reserves = Required reserves + Excess reserves.



How the Fed Changes the Monetary Base

Open market operations The Federal Reserve’s purchases and sales of

securities, usually U.S. Treasury securities, in financial markets.

Open market purchase The Federal Reserve’s purchase of securities, usually

U.S. Treasury securities.

Open market operations are carried out by the Fed’s trading desk, which buys

and sells securities electronically with primary dealers.

In 2010, there were 18 primary dealers, who are commercial banks, investment

banks, and securities dealers.

In an open market purchase, which raises the monetary base, the Fed buys

Treasury securities.

The Fed increases or decreases the monetary base by changing the levels

of its assets—that is, the Fed changes the monetary base by buying and

selling Treasury securities or by making discount loans to banks.



We use a T-account for the whole banking system to show the results of the

Fed’s open market purchase:

The Fed’s open market purchase from Bank of America increases reserves by

$1 million and, therefore, the monetary base increases by $1 million. A key

point is that the monetary base increases by the dollar amount of an open

market purchase.



Open market sale The Fed’s sale of securities, usually Treasury securities.

Because reserves have fallen by $1 million, so has the monetary base. We can

conclude that the monetary base decreases by the dollar amount of an open

market sale.



The public’s preference for currency relative to checkable deposits does not

affect the monetary base. To see this, consider what happens if households

and firms decide to withdraw $1 million from their checking accounts.

One component of the monetary base (reserves) has fallen while the other

(currency in circulation) has risen.



Discount Loans

Discount loan A loan made by the Federal Reserve, typically to a

commercial bank.

Discount loans alter bank reserves and cause a change in the monetary

base. An increase in discount loans affects both sides of the Fed’s balance

sheet:

As a result of the Fed’s making $1 million of discount loans, bank reserves and

the monetary base increase by $1 million.



If banks repay $1 million in discount loans to the Fed, reducing the total

amount of discount loans, then the preceding transactions are reversed.

Discount loans fall by $1 million, as do reserves and the monetary base:



Comparing Open Market Operations and Discount Loans

Discount rate The interest rate the Federal Reserve charges on discount

loans.

Both open market operations and discount loans change the monetary

base, but the Fed has greater control over open market operations.

The discount rate 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.

The monetary base has two components: the nonborrowed monetary base,

Bnon, and borrowed reserves, BR, which is another name for discount loans.

We can express the monetary base, B, as

The Fed has control over the nonborrowed monetary base.

B = Bnon + BR.



Making the Connection

Explaining the Explosion in the Monetary Base

The monetary base increased sharply in the fall of 2008. Most of the increase

occurred because of an increase in the bank reserves component, not the

currency in circulation component.

In this case, the Fed’s holdings of Treasury securities actually fell while the

base was exploding.

As the Fed began to purchase assets connected with Bear Stearns and AIG,

the asset side of its balance sheet expanded, and so did the monetary base.

There is an important point connected with this episode for understanding the

mechanics of increases in the monetary base: Whenever the Fed purchases

assets of any kind, the monetary base increases. It doesn’t matter if the assets

are Treasury bills, mortgage-backed securities, or computer systems.




Explaining the Explosion in the Monetary Base

In the fall of 2008 when the Fed began to purchase hundreds of billions of

dollars worth of mortgage-backed securities and other financial assets, it was

inevitable that the monetary base would increase.




Derive the equation for the simple deposit multiplier and understand what it means.


We now turn to the money multiplier to further understand the factors that

determine the money supply.

The money multiplier is determined by the actions of three actors in the

economy: the Fed, the nonbank public, and banks.

The Simple Deposit Multiplier

Multiple Deposit Expansion

How a Single Bank Responds to an Increase in Reserves

Suppose that the Fed purchases $100,000 in Treasury bills (or T-bills) from

Bank of America, increasing its reserves that much. Here is how a T-account

can reflect these transactions:


Next, Bank of America extends a loan to Rosie’s Bakery by creating a checking

account and depositing the $100,000 principal of the loan in it. Both the asset

and liability sides of Bank of America’s balance sheet increase by $100,000:


If Rosie’s spends the loan proceeds by writing a check for $100,000 to buy

ovens from Bob’s Bakery Equipment and Bob’s deposits the check in its

account with PNC Bank, Bank of America will have lost $100,000 of reserves

and checkable deposits:


How the Banking System Responds to an Increase in Reserves After PNC

has cleared the check and collected the funds from Bank of America, PNC’s

balance sheet changes as follows:


Suppose that PNC makes a $90,000 loan to Jerome’s Printing who writes a

check in that amount for equipment from Computer Universe who has an

account at SunTrust Bank. The balance sheets change as follows:


Suppose that SunTrust lends its new excess reserves of $81,000 to Howard’s

Barber Shop to use for remodeling. When Howard’s spends the loan proceeds

and a check for $81,000 clears against it, the changes in SunTrust’s balance

sheet will be as follows:


If the proceeds of the loan to Howard’s Barber Shop are deposited in another

bank, checkable deposits in the banking system will rise by another $81,000.

To this point, the $100,000 increase in reserves supplied by the Fed has

increased the level of checkable deposits by $100,000 + $90,000 + $81,000 =

$271,000. This process is called multiple deposit creation.

Multiple deposit creation Part of the money supply process in which an

increase in bank reserves results in rounds of bank loans and creation of

checkable deposits and an increase in the money supply that is a multiple of

the initial increase in reserves.



Calculating the Simple Deposit Multiplier

Simple deposit multiplier The ratio of the amount of deposits created by

banks to the amount of new reserves.

∆𝐷 = $100,000 + 0.9 × $100,000 + 0.9 × 0.9 × $100,000+ 0.9 × 0.9 × 0.9 × $100,000 + . . .

Or, simplifying: ∆𝐷 = $100,000 × 1 + 0.9 + 0.92 + 0.93+ . . . .



An infinite series, such as 1 + 0.9 + 0.92 + 0.93+ . . . , reduces to:

1

1 − 0.9=

1

0.10= 10.

So, ∆𝐷 = $100,000 × 10 = $1,000,000.

Simple deposit multiplier =1

𝑟𝑟𝐷.

We can derive an equation showing how a change in deposits, ∆𝐷, is related to

an initial change in reserves, ∆𝑅:

∆𝐷 =∆𝑅

𝑟𝑟𝐷,

or, in our example,

∆𝐷 =$100,000

0.10= $1,000,000.



Explain how the behavior of banks and the nonbank public affect the

money multiplier.


In deriving the money multiplier, we made two key assumptions:

1. Banks hold no excess reserves.

2. The nonbank public does not increase its holdings of currency.

In order to build a complete account of the money supply process, we change

the simple deposit multiplier in three ways:

1. Rather than a link between reserves and deposits, we need a link between

the monetary base and the money supply.

2. We need to include the effects on the money supply process of changes in

the nonbank public’s desire to hold currency relative to checkable deposits.

3. We need to include the effects of changes in banks’ desire to hold excess

reserves relative to deposits.

Banks, the Nonbank Public, and the Money Multiplier

The Effect of Increases in Currency Holdings and Increases in

Excess Reserves


We need to derive a money multiplier, m, that links the monetary base, B, to the

money supply, M:

𝑀 = 𝑚 × 𝐵.

This equation tells us that the money multiplier is equal to the ratio of the

money supply to the monetary base:

𝑚 =𝑀

𝐵.

The money supply is the sum of currency in circulation, C, and checkable

deposits, D. The monetary base is the sum of currency in circulation and bank

reserves, R. To expand the expression for the money multiplier, we separate

reserves into its components: required reserves, RR, and excess reserves:

𝑚 =𝐶 + 𝐷

𝐶 + 𝑅𝑅 + 𝐸𝑅


Deriving a Realistic Money Multiplier


The excess reserves-to-deposit ratio (ER/D) measure banks’ holdings of

excess reserves relative to their checkable deposits. We can introduce the

deposit ratios into our expression for the money multiplier this way:

𝑚 =𝐶 + 𝐷

𝐶 + 𝑅𝑅 + 𝐸𝑅×

1/𝐷

1/𝐷=

𝐶/𝐷 + 1

𝐶/𝐷 + 𝑅𝑅/𝐷 + 𝐸𝑅/𝐷.

Since the ratio of required reserves to checkable deposits is the required

reserve ratio, rrD, then:

𝑚 =𝐶/𝐷 + 1

𝐶/𝐷 + 𝑟𝑟𝐷 + 𝐸𝑅/𝐷.


Currency-to-deposit ratio (C/D) The ratio of currency held by the nonbank

public, C, to checkable deposits, D.


So, we can say that because:

Money supply = Money multiplier × Monetary basethen,

𝑀 =𝐶/𝐷 + 1

𝐶/𝐷 + 𝑟𝑟𝐷 + 𝐸𝑅/𝐷× 𝐵.


With the following values: C = $500 billion, D = $1,000 billion, rrD = 0.10, and

ER = $150 billion, the money multiplier is:

𝑚 =0.5 + 1

0.5 + 0.10 + 0.15=

1.5

0.75= 2.

A money multiplier of 2 means that every $1 billion increase in the monetary

base will result in a $2 billion increase in the money supply.


There are several points to note about the expression above linking the money

supply to the monetary base:

1. The money supply will change in the same direction of a change in either the

monetary base or the money multiplier.

2. An increase in the currency-to-deposit ratio (C/D) causes the value of the

money multiplier and the money supply to decline.

3. An increase in the required reserve ratio, rrD, causes the value of the money

multiplier and the money supply to decline.

4. An increase in the excess reserves-to-deposit ratio (ER/D) causes the value

of the money multiplier and the money supply to decline.


𝑀 =𝐶/𝐷 + 1

𝐶/𝐷 + 𝑟𝑟𝐷 + 𝐸𝑅/𝐷× 𝐵.


Solved Problem 14.3

Using the Expression for the Money Multiplier

Consider the following information:

Bank reserves = $500 billion

Currency = $400 billion

a. If banks are holding $80 billion in required reserves, and the required

reserve ratio = 0.10, what is the value of checkable deposits?

b. Given this information, what is the value of the money supply (M1)? What is

the value of the monetary base? What is the value of the money multiplier?



Solved Problem

Step 2 Answer part (a) by calculating the value of checkable deposits. The value of

required reserves is equal to the value of checkable deposits multiplied by the

required reserve ratio:

𝑅𝑅 = 𝐷 × 𝑟𝑟𝐷 .$80 billion = 𝐷 × 0.10

𝐷 = ($80 billion/0.10) = $800 billion.

Step 3Answer part (b) by calculating the values of the money supply, the monetary

base, and the money multiplier. The M1 measure of the money supply equals

the value of currency in circulation plus the value of checkable deposits:

𝑀 = 𝐶 + 𝐷 = $400 billion + $800 billion = $1,200 billion.

The monetary base is equal to the value of currency in circulation plus the value of

bank reserves:

𝐵 = 𝐶 + 𝑅 = $400 billion + $500 billion = $900 billion.

Solving the Problem

Step 1 Review the chapter material.

Solved Problem 14.3




Solved Problem

We can calculate the money multiplier two ways. First, note that the money multiplier is

equal to the ratio of the money supply to the monetary base:

𝑚 =𝑀

𝐵=$1,200 billion

$900 billion= 1.33.

Or, using the expression for money multiplier:

𝑚 =($400 billion/$800 billion

($400 billion/$800 billion)+0.10+($420 billion/$800 billion)

=1.5

1.125= 1.33.

Solving the Problem


Solved Problem 14.3



Recall that the monetary base is the sum of borrowed plus nonborrowed

reserves: B = Bnon + BR. Rewriting the relationship between the money supply

and the monetary base:

𝑀 =𝐶/𝐷 + 1

𝐶/𝐷 + 𝑟𝑟𝐷 + 𝐸𝑅/𝐷× (𝐵𝑛𝑜𝑛 + 𝐵𝑅).

We now have a complete description of the money supply process.



The Money Supply, the Money Multiplier, and the Monetary Base

During the 2007–2009 Financial Crisis

Figure 14.2 Movements in the Monetary Base, M1, and the Money Multiplier, 1990–2010

Panel (a) shows that beginning in the fall of 2008, the size of the monetary base soared. M1 also

increased, but not nearly as much.

As panel (b) shows, the value of the money multiplier declined sharply during the same period.•



Why did the monetary base increase so much more than M1? Figure 14.3

helps to solve the mystery.


Figure 14.3

Movements in (C/D)

and (ER/D)

The currency-to-deposit ratio

(C/D) had been gradually

trending upward since 1990,

but it fell during the financial

crisis of 2007–2009.

At the same time, the excess

reserves-to–deposits ratio

(ER/D) soared, increasing

from almost zero in

September 2008—because

banks were holding very few

excess reserves—to about

1.3 in the fall of 2009. Banks

began to hold more excess

reserves than they had

checkable deposits.•



Did the Fed’s Worry over Excess Reserves Cause the

Recession of 1937–1938?

Following the end of the bank panics in early 1933, excess reserves in the

banking system soared.

Many banks had suffered heavy losses and had a strong desire to remain

liquid. Nominal interest rates had also fallen to very low levels, which reduced

the opportunity cost of holding reserves at the Fed.

By late 1935, unemployment remained high and inflation low. Nevertheless, the

Fed’s Board of Governors worried about a rapid increase in stock prices and

some feared an increase in the inflation rate.

The Board of Governors decided to reduce excess reserves by raising the

required reserve ratio.

But the Fed’s policy ignored the reasons banks during this period were holding

excess reserves. As bank loans contracted, so did the money supply. The

economy fell into recession again in 1937.




Did the Fed’s Worry over Excess Reserves Cause the

Recession of 1937–1938?

The Fed reversed course in April 1938 by cutting the required reserve ratio. But

the damage had been done. Most economists believe that the Fed’s actions in

raising the required reserve ratio contributed significantly to the recession.



In 2010, banks’ enormous holdings of excess reserves left investors,

policymakers, and economists concerned about the implications for future

inflation.

If banks were to suddenly begin lending the nearly $1 trillion in excess reserves

they held in November 2010, the result would be an explosion in the money

supply and, potentially, a rapid increase in inflation.

Fear of this potential for a much higher rate of inflation in the future drove some

investors in 2010 to buy gold.




Worried About Inflation? How Good Is Gold?

In 2010, many investors bought gold because they were worried about the

possibility that increases in reserves and the money supply might lead to much

higher rates of inflation in the future.

But how good an investment is gold? Gold clearly has some drawbacks as an

investment: Gold pays no interest or dividend; it has to be stored and

safeguarded.

Because gold pays no interest, it is difficult to determine its fundamental value

as an investment. Gold’s value as an investment depends on how likely its

price is to increase in the future because its rate of return is entirely in the form

of capital gains.

Many individual investors believe that gold is a good hedge against inflation

because the price of gold can be relied on to rise if the general price level rises.

But is this view correct? The record of the past 30 years was not encouraging.




Worried About Inflation? How Good Is Gold?

The real price of gold, calculated by dividing the nominal price of gold by the

consumer price index, shows that even after the strong nominal price increases

of 2009 and 2010, the real price of gold was still 30% below its September

1980 level. In other words, in the long run, gold has proven a poor hedge

against inflation.



Answering the Key Question

At the beginning of this chapter, we asked the question:

“Why did bank reserves increase rapidly during and after the financial crisis of

2007–2009, and should the increase be a concern to policymakers?”

As we have seen in this chapter, the rapid increase in bank reserves that

began in the fall of 2008 was a result of the Fed purchasing assets.

Whenever the Fed purchases an asset, the monetary base increases. Both

components of the base increased in 2008, but the increase in reserves was

particularly large. Banks were content to hold large balances of excess

reserves because the Fed was paying interest on them and because of the

increased risk in alternative uses of the funds. Inflation remained very low

through mid-2010, but some policymakers were concerned that, ultimately, if

banks began to lend out their holdings of excess reserves, a future increase

in the inflation rate was possible.


AN INSIDE LOOK AT POLICY

Fed’s Balance Sheet Needs Balancing Act

WASHINGTON POST, Federal Reserve Hopes Clear Exit Strategy Will Boost Market Confidence

• After two years of taking aggressive steps to stimulate a weak economy, the

Federal Reserve had to decide how to phase out its initiatives in order to

reduce the risk of inflation.

• Reducing the growth of the money supply and raising interest rates

threatened to slow an economy that suffered from high unemployment.

• Analysts believe that changing the interest rate on reserves will become a

more important tool to control the growth of the money supply.

• The Fed had to decide what to do with its holdings of $1 trillion of mortgage-

backed securities. Selling the securities would pull money out of the economy

at the risk of driving up interest rates.

• The key to chairman Ben Bernanke’s strategy is to win the confidence of

market participants in the Fed’s ability to drain cash from the financial system.

Key Points in the Article


AN INSIDE LOOK AT POLICY

The table below documents the rapid increase in the Fed’s holdings of

federal agency debt and mortgage-backed securities between July 2008

and July 2010. The increase in its debt holdings was over $1.5 trillion over

this two-year period.


APPENDIX

The Money Supply Process for M2

14A Describe the money supply process for M2

M2 is a broader monetary aggregate than M1, including not only currency, C,

and checkable deposits, D, but also nontransaction accounts. These

nontransaction accounts consist of savings and small-time deposits, which we

will call N, and money market deposit accounts and similar accounts, MM. So

we can represent M2 as:

M2 = C + D + N + MM.

We can express M2 as the product of an M2 multiplier and the monetary base:

M2 = (M2 multiplier) x Monetary base.

𝑀2multiplier =1 + (𝐶/𝐷) + (𝑁/𝐷) + (𝑀𝑀/𝐷)

(𝐶/𝐷) + 𝑟𝑟𝐷 + (𝐸𝑅/𝐷).

anthony patrick o’brienfuangfah.econ.cmu.ac.th/teacher/nisit/files/ho_mb1e_ch14.pdf · © 2012...

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