Chapter 14
The Money
Supply Process
Players in the Money Supply Process
• The goal is to understand how deposits (which
is the largest component of M) are created in
the banking system
• Four players:

Central bank (Federal Reserve System)

Banks (depository institutions; financial
intermediaries)

Depositors (individuals and institutions)

Borrowers (individuals and institutions)
13-2
Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Reserve Balances
Applied Vault Cash
• Monetary Liabilities



Currency in circulation—in the hands of the public
Reserves—bank deposits at the Fed and vault cash
The sum of these components is called the monetary base: MB=C+R
• Assets


Government securities—holdings by the Fed that affect money
supply and earn interest
Discount loans—provide reserves to banks and earn the discount
rate
13-3
Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
• The central bank controls the monetary base through
open market operations and the discount window

Specifically, the central bank controls the reserves component
of the monetary base
13-4
Open Market Operations
• (i) Expansionary

Permanent (dynamic)
• Open Market Purchase

Temporary (defensive)
• Repo
• (ii) Contractionary

Permanent (dynamic)
• Open market sale

Temporary (defensive)
• Reverse repo
13-5
Permanent Open Market Operations

Open market purchase: A purchase of bonds by the
Fed
• injects money to the system
• expansionary

Open market sale: A sale of bonds by the Fed
• drains money from the system
• contractionary
13-6
Story of a Temporary Open Market
Operation
1) RA Team Forecasts total supply of balances



Currency in circulation (CIC)
Float
Treasury Balance
• A forecast for total supply of balances is
prepared
Ex: $12 billion
13-7
Story of an Open Market Operation
(Cont’d)
2) Economist Team:
• Forecast demand for balances based on
historical averages, special days, fed
funds rate in the morning
Ex: $15 billion
OMO need for the day is $3 billion
13-8
Story of an Open Market Operation
(Cont’d)
3) FRBNY Trading Desk:
• Announce that the Fed will purchase
securities worth $3 billion (overnight)
• In essence, the Fed is lending $3 billion
to the market
13-9
Story of an Open Market Operation
(Cont’d)
• Receive propositions from dealers:
• Each dealer offers a quantity to borrow from the Fed and the cost
of borrowing. Ex:



Dealer 1: Sell $1 bn., at 3%
Dealer 2: Sell $2 bn., at 2.5 %
Dealer 3: Sell $1.5 bn., at 2.75%
• Rank the offers from the highest to the lowest interest rate (Fed
tries to lend at the highest rate possible), and fill the total quantity



$1 bn. from Dealer 1
$1.5 bn. from Dealer 3
$0.5 bn. from Dealer 2
• As the Fed purchases these securities from the dealers, it makes
the payment by increasing their reserve balances
13-10
Open Market Operations
• How does an open market operation
affect the balance sheets?
• 3 scenarios:

Open market purchase from a bank

Open market purchase from non-bank
public:
i) Seller keeps the proceeds in deposits
ii) Seller keeps the proceeds in cash
13-11
Open Market Purchase from a Bank
Banking System
Assets
Liabilities
Securities
-$100
Reserve
Balances
+$100
•
•
•
•
•
•
Federal Reserve System
Assets
Securities
Liabilities
+$100 Reserve
Balances
+$100
Suppose Fed purchases $100 from a bank
Securities move from the banking system to the CB
CB pays for securities: Deposit the bank’s Fed account
Net result is that reserves have increased by $100
No change in currency
Monetary base (=C+R) has risen by $100
13-12
Open Market Purchase from
Non-Bank Public (seller keeps proceeds in
deposit)
• --Most likely scenario in real life
Non-Bank Public
Banking System
(Dealer)
(Dealer’s Bank)
A
A
L
A
L
L
Securities -100
Securities
Deposits
Deposits 100
RB
100
100
Central Bank
Securities 100
Currency
RB
100
13-13
• Securities move from NB public to CB
• CB pays for the securities by wire
transfer/writing a check
• NB public deposits the check to his/her bank:
Deposits and Reserves increase
• Final effect on Reserves: +100
• Final effect on MB: +100
• Identical net impact on MB as the purchase
from a bank
13-14
Open market purchase from non-bank public: seller
keeps proceeds in cash
NB Public
Banking System
Sec. -100
Sec.
Dep. 100
RB 100
-100
Cur.
VC -100
Dep. 100
-100
CB
Sec. 100 Cur. 100
RB 100
VC -100
100
13-15
• Securities move from NB Public to the CB
• CB pays for securities by writing a check, no
effect yet
• The person deposits the check: Deposits and
Reserve Balances increase
• The person asks for cash: Deposits and VC
decrease, CIC increases
• Net effect on reserves: 0 (Increase in RB and
decrease in VC offset each other)
• Net effect on MB: +100
13-16
Open Market Purchase: Summary
• 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 or in deposits
• The effect of an open market purchase
on the monetary base always increases
the base by the amount of the purchase
13-17
Video on the Fed’s balance sheet
• http://www.youtube.com/watch?v=MILF9GeMDQ
• Recent changes on the balance sheet:
• http://clevelandfed.org/research/data/cre
dit_easing/index.cfm
13-18