Money banking and the financial system 1e by hubbard and OBrien chapter 14

R. GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

14

The Federal Reserve’s Balance
Sheet and the Money Supply
Process

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
14.1

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

14.2

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

14.3

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

14A

Appendix: Describe the money supply process for M2

© 2012 Pearson Education, Inc. Publishing as Prentice Hall


CHAPTER

14

The Federal Reserve’s Balance
Sheet and the Money Supply
Process

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.

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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?

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14.1Learning Objective
Explain the relationship between the Fed’s balance sheet and the monetary base.

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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.•

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.
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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.

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Table 14.1 The Federal Reserve’s Balance Sheet

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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.
• 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.

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Reserves = Required reserves + Excess reserves.
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.

Reserves = Required reserves + Excess reserves.
Required reserve ratio The percentage of checkable deposits that the Fed
specifies that banks must hold as reserves.

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How the Fed Changes the Monetary Base
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.
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.

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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.

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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.

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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.
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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.
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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:

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Comparing Open Market Operations and Discount Loans
Both open market operations and discount loans change the monetary
base, but the Fed has greater control over open market operations.
Discount rate The interest rate the Federal Reserve charges on discount
loans.
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
B = Bnon + BR.
The Fed has control over the nonborrowed monetary base.

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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.

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Making the Connection

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.

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14.2Learning Objective
Derive the equation for the simple deposit multiplier and understand what it means.

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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.
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:

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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:

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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:

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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.
The Simple Deposit Multiplier
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Calculating the Simple Deposit Multiplier

Simple deposit multiplier The ratio of the amount of deposits created by
banks to the amount of new reserves.

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