Central Bank and Money Supply Processes
Central Bank and Money Supply Processes
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FINC5090 Finance in The Global Economy
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Lecture 8 National income, exchange rate, earnings growth and stock markets (II)
The central bank’s balance sheet
Multiple deposit creation
The money multiplier
Quantitative easing and the money supply, 2007 – 2017
Monetary policy during the pandemic
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1. The central bank’s balance sheet: preview
‘Whenever a central bank transacts with the rest of the world — that is when it issues currency, conducts foreign exchange operations, invests its own funds, engages in emergency liquidity assistance, and, last but not least conducts monetary policy operations — all of these operations affect its balance sheet’ (Bindseil 2004)
In Week 4, you learned that households and firms settle transactions using either currency or bank deposit account transfer. The central bank balance sheet is vital in underpinning (i.e. supporting the confidence in) both types of payments/money.
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1. The central bank’s balance sheet
Liabilities
Currency in circulation: in the hands of the public
Reserves: bank deposits at the Fed and vault cash
Required reserve and excess reserve
Government securities: holdings by the Fed that affect money supply and earn interest
Discount loans: provide reserves to banks and earn the discount rate
Federal Reserve System
Assets Liabilities
Securities Currency in circulation
Loans to Financial Institutions Reserves
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1. The central bank’s balance sheet: monetary base
The monetary base (MB) equals currency in circulation C plus the total reserves in banking system R.
The monetary base is also known as the high-powered money.
MB = C + R
The FED exercises control over the monetary base through:
open market operations (nonborrowed monetary base): purchase/sale of government bonds through primary dealers.
extension of discount loans to banks (borrowed reserves)
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1. The central bank’s balance sheet: monetary base
Open market purchase from a bank (assume the Fed purchases $100m securities)
Net result is that reserves have increased by $100
No change in currency
Monetary base has risen by $100
Banking System Blank Blank
Assets Blank Liabilities
Securities −$100m Blank
Reserves +$100m Blank
Federal Reserve System Blank Blank Blank
Assets Blank Liabilities Blank
Securities +$100m Reserves +$100m
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1. The central bank’s balance sheet: monetary base
Open market purchase from the non-bank public
assume the Fed purchases $100m securities and the person holds cash (increases currency in circulation by $100m).
if the person selling bonds to the Fed deposits the Fed’s check in the bank (reduces currency in circulation but increases reserves by $100m, assuming the required reserve ratio is 100%).
Banking System Blank Blank Blank
Assets Blank Liabilities Blank
Reserves +$100m Checkable deposits +$100m
Federal Reserve System Blank Blank Blank
Assets Blank Liabilities Blank
Securities +$100m Reserves +$100m
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1. The central bank’s balance sheet: monetary base
The influence of open market operation on the monetary base
The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency (increase currency in circulation) or in deposits (increase reserves).
The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase.
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1. The central bank’s balance sheet: monetary base
Loans to financial institutions (assume a bank borrows $100m from the Fed)
Monetary liabilities of the Fed have increased by $100
Monetary base also increases by this amount
Banking System Blank Blank Blank
Assets Blank Liabilities Blank
Reserves +$100m Loans +$100m
Blank Blank (borrowing from Fed) Blank
Federal Reserve System Blank Blank Blank
Assets Blank Liabilities Blank
Loans +$100m Reserves +$100m
(borrowing from Fed) Blank Blank Blank
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1. The central bank’s balance sheet: monetary base
Fed’s ability to control the monetary base
Open market operations are controlled by the Fed.
The Fed cannot determine the amount of borrowing by banks from the Fed.
Split the monetary base into two components:
MBn= MB − BR
The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from
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2. Multiple deposit creation: the simple model
Multiple deposit creation: when the central bank supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount.
Assume the central bank purchases $100m securities from a bank called First National Bank which provides the bank with $100m excess reserves. First National Bank and make a loan using the excess reserves.
Further assume the borrower of the First National Bank makes $100m deposits at Bank A and Fed requires 10% of the total deposits to be stored in reserves ($10m required reserve and $90m excess reserves).
Bank A Blank Blank Blank
Assets Blank Liabilities Blank
Reserves +$100m Checkable deposits +$100m
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2. Multiple deposit creation: the simple model
Bank A can made loans for the entire $90m excess reserve (convert $90m reserve into loans).
Assume the borrower deposits the borrowed $90m in another bank, Bank B. Bank B will record $90m deposit as a liability and keep 10% *90 =$9m in the required reserves. The rest $81m will be lent out to another borrower.
Assets Blank Liabilities Blank
Reserves +$10 deposits +$100m
Loans +$90 Blank Blank
Assets Blank Liabilities Blank
Reserves +$9 deposits +$90
Loans +$81 Blank Blank
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2. Multiple deposit creation: the simple model
Bank Increase in Deposits ($) Increase in Loans ($) Increase in Reserves ($)
First National 0.00 100.00 m 0.00
A 100.00 m 90.00 m 10.00 m
B 90.00 m 81.00 m 9.00 m
C 81.00 m 72.90 m 8.10 m
D 72.90 m 65.61 m 7.29 m
E 65.61 m 59.05 m 6.56 m
F 59.05 m 53.14 m 5.91 m
Total for all banks 1,000.00 m 1,000.00 m 100.00 m
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2. Multiple deposit creation: simple deposit multiplier
The multiple increase in deposits generated from an increase in the banking system’s reserves is called the simple deposit multiplier.
In our example, the required reserve rate is 10% and the simple deposit multiplier is 10.
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2. Multiple deposit creation: critique of the simple model
The simple model seems to indicate that the Fed is able to exercise complete control over the level of checkable deposits but
Holding cash stops the process
Currency has no multiple deposit expansion
Banks may not use all of their excess reserves to buy securities or make loans.
Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change.
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2. Multiple deposit creation: factors that determine the money supply
Changes in the nonborrowed monetary base MBn
The money supply is positively related to the non-borrowed monetary base MBn
Changes in borrowed reserves from the Fed
The money supply is positively related to the level of borrowed reserves, BR, from the Fed
Changes in the required reserves ratio
The money supply is negatively related to the required reserve ratio.
Changes in currency holdings
The money supply is negatively related to currency holdings.
Changes in excess reserves
The money supply is negatively related to the amount of excess reserves.
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2. Multiple deposit creation: factors that determine the money supply
Player Variable Change in Variable Money Supply Response Reason
Federal Reserve System Non-borrowed monetary base, MBn ↑ ↑ More MB for deposit creation
Blank Required reserve ratio, rr ↑ ↓ Less multiple deposit expansion
Banks Borrowed reserves, BR ↑ ↑ More MB for deposit creation
Blank Excess reserves ↑ ↓ Less loans and deposit creation
Depositors Currency holdings ↑ ↓ Less multiple deposit expansion
Note: Only increases (↑) in the variables are shown. The effects of decreases on the money supply would be the opposite of those indicated in the “Money Supply Response” column.
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3. The money multiplier
Money supply is determined by the central bank, depositors and banks through their influences on the five variables.
Define money as currency plus checkable deposits: M1
Link the money supply (M) to the monetary base (MB) and let m be the money multiplier
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3. The money multiplier: deriving the money multiplier
Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D.
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio
The total amount of reserves (R) equals the sum of required reserves (RR) and excess reserves (ER).
R = RR + ER
The total amount of RR equals the required reserve ratio (rr) time the amount of checkable deposits D.
RR = rr x D
Substituting for RR in R = RR + ER
R = (rr x D) + ER
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3. The money multiplier: deriving the money multiplier
The monetary base MB equals currency (C) plus reserves (R):
MB = C + R = C + (rr × D) + ER
Equation reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency, and excess reserves.
Recall that
c = {C/D} = currency ratio => C = c x D
e = {ER/D} = excess reserves ratio => ER = e x D
MB = C + R = C + (rr × D) + ER = (c x D) + (rr × D) + (e x D) = (c + rr + e) x D
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3. The money multiplier: deriving the money multiplier
MB = (c + rr + e) x D
Divide both sides by the term in parentheses
Money supply M is the sum of currency C and checkable deposits D:
M = C + D and C = c x D =>M = (1+c) x D
Substituting again
The money multiplier is then
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3. The money multiplier: deriving the money multiplier
Example: rr = required reserve ratio = 10%, C = currency in circulation = $400B, D = checkable deposits = $800B, ER = excess reserves = $0.8B
M=money supply (M1) = C + D = $1,200B,
c=$400B/$800B = 0.5, e = $0.8B/$800B = 0.001,
This is less than the simple deposit multiplier (1/0.1 = 10).
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4. QE and the money supply, 2007 – 2017
When the global financial crisis began in the fall of 2007, the Fed initiated lending programs and large-scale asset-purchase programs in an attempt to bolster the economy.
By the fall of 2017, these purchases of securities had led to a quintupling of the Fed’s balance sheet and a 350% increase in the monetary base.
These lending and asset-purchase programs resulted in a huge expansion of the monetary base and have been given the name “quantitative easing.”
This increase in the monetary base did not lead to an equivalent change in the money supply because excess reserves rose dramatically.
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Figure 1 M1 and the Monetary Base, 2007–2020
Source: Federal Reserve Bank of St. Louis, FRED database
https://fred.stlouisfed.org/series/BOGMBASE and https://fred.stlouisfed.org/series/M1SL.
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Figure 2 Excess Reserves Ratio and Currency Ratio, 2007–2020
Source: Federal Reserve Bank of St. Louis, FRED database
https://fred.stlouisfed.org/series/EXCSRESNS, https://fred.stlouisfed.org/series/CURRCIR, and https://fred.stlouisfed.org/series/TCDNS
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5. Monetary policy during the pandemic
The Covid-19 pandemic interrupted the so-called tapering, the gradual scaling back of the QE purchases introduced during the previous crisis.
Even more extraordinary steps were taken in March 2020: the QE asset purchase program was made unlimited and expanded to include additional mortgage-backed securities.
New loan facilities to support credit to businesses and consumers for $300B, a first for monetary policy in the US. However, similar programs already existed in Europe and Japan for their implementation of QE.
In recognition of the ballooning reserves, the Federal Reserve eliminated the reserve requirement. The simple deposit multiplier is no longer defined!
Overall, the Fed balance sheet doubled from its January 2020 levels.
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Figure 3 Federal Reserve balance sheet, 2018–2022
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