Money and Banking (8): The Money Supply Process

As we have seen in The Behavior of Interest Rates, movements in the money supply affect interest rates and inflation.

From What Is Money, we know that the money supply can be measured as M1 and M2. There are three players in the money supply process: the central bank, banks, and depositors.

Of the three, the central bank, the Fed, is the most important. It influences the money supply indirectly, through the conduct of monetary policy.

The Fed’s Balance Sheet

Just like a company, the Fed has its own balance sheet, but its items are different. The Fed’s balance sheet is very important for understanding monetary policy.

Let’s look at a simplified version.

Assets	Liabilities
Securities	Currency in circulation
Loans to financial institutions	Reserves

Liabilities

There are two liabilities on the balance sheet, currency in circulation and reserves. An increase in either or both raises the monetary base.

Currency in circulation

The Fed issues currency. Currency in circulation is the amount of currency in the hands of the public.

Reserves

All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks. Reserves are assets for banks but liabilities of the Fed.

Required reserves (which the Fed requires banks to hold) + excess reserves (any additional reserves that banks choose to hold) = total reserves.

Since March 2020, the reserve requirement has been 0%, so all reserves are now excess reserves.

Assets

The two assets on the Fed’s balance sheet can change the money supply and earn income.

Securities

This category covers the Fed’s holdings of securities issued by the U.S. Treasury.

By purchasing securities, the Fed provides reserves to the banks.

Loans to financial institutions

The second way the Fed can provide reserves to the banking system is by making loans to banks and other financial institutions.

The interest rate charged to banks for these loans is called the discount rate, one of the three policy tools that the Fed uses.

The Monetary Base

The sum of the Fed’s monetary liabilities (currency in circulation and reserves) and the U.S. Treasury’s monetary liabilities (Treasury currency in circulation, primarily coins) is called the monetary base.

The monetary base (high-powered money) equals currency in circulation C plus the total reserves in the banking system, R.

The Fed can directly influence the monetary base, which affects how many reserves are in the banking system, and so it indirectly influences the money supply.

Open Market Operations

The primary way to control the monetary base is through open market operations.

Open Market Purchase from a Bank

The Fed purchases $100 million of bonds from banks. The banking system swaps $100 million of securities for $100 million of reserves, both on the asset side. The Fed has an additional $100 million of reserves in its liabilities.

	Assets	Liabilities
Banking system	Securities −$100m · Reserves +$100m
The Fed	Securities +$100m	Reserves +$100m

Result:
R +100 · C 0 · MB +100
Money supply: M 0 (reserves are not part of M)

Open Market Purchase from the Nonbank Public

The Fed purchases $100 million of bonds from people or corporations. The nonbank public receives a $100 million check from the Fed for the bonds.

Case 1: Depositing the Check

If the nonbank public deposits the check, the banking system gains $100 million in reserves, which increases the Fed’s liabilities by the same amount.

	Assets	Liabilities
Nonbank public	Securities −$100m · Checkable deposits +$100m
Banking system	Reserves +$100m	Checkable deposits +$100m
The Fed	Securities +$100m	Reserves +$100m

Result:
R +100 · C 0 · MB +100
Money supply: M +100 (new deposits)

Case 2: Cashing the Check

If the nonbank public cashes the check, the Fed has an additional $100 million of currency in circulation.

	Assets	Liabilities
Nonbank public	Securities −$100m · Currency +$100m
The Fed	Securities +$100m	Currency in circulation +$100m

Result:
R 0 · C +100 · MB +100
Money supply: M +100 (new currency held by the public)

Open Market Sale

The Fed sells $100 million of bonds to banks or the nonbank public.

Banks

	Assets	Liabilities
Banking system	Securities +$100m · Reserves −$100m
The Fed	Securities −$100m	Reserves −$100m

Result:
R −100 · C 0 · MB −100
Money supply: M 0 (the bank only swapped reserves for bonds)

Nonbank Public

	Assets	Liabilities
Nonbank public	Securities +$100m · Currency −$100m
The Fed	Securities −$100m	Currency in circulation −$100m

Result:
R 0 · C −100 · MB −100
Money supply: M −100 (currency leaves the public)

Shifts from Deposits into Currency

Depositors withdraw $100 million of currency from banks. The banking system loses $100 million of reserves, but the Fed loses nothing: its liabilities just shift from reserves to currency in circulation.

	Assets	Liabilities
Nonbank public	Checkable deposits −$100m · Currency +$100m
Banking system	Reserves −$100m	Checkable deposits −$100m
The Fed		Currency in circulation +$100m · Reserves −$100m

Result:
R −100 · C +100 · MB 0
Money supply: M 0 (deposits became currency; both are in M)

Discount Loans

The Fed lends $100 million to a bank. The Fed’s assets increase by $100 million (discount loans), and its liabilities increase by $100 million (reserves).

	Assets	Liabilities
Banking system	Reserves +$100m	Discount loans (borrowings from the Fed) +$100m
The Fed	Discount loans +$100m	Reserves +$100m

Result:
R +100 · C 0 · MB +100
Money supply: M 0 (until the bank lends the reserves out)

The bank pays back the $100 million loan.

	Assets	Liabilities
Banking system	Reserves −$100m	Discount loans (borrowings from the Fed) −$100m
The Fed	Discount loans −$100m	Reserves −$100m

Result:
R −100 · C 0 · MB −100
Money supply: M 0

The Fed’s Ability to Control the Monetary Base

We can split the monetary base into two components: one that the Fed completely controls, which we call the nonborrowed monetary base, and another that is less tightly controlled.

where = nonborrowed monetary base; BR = borrowed reserves from the Fed.

The Money Multiplier

When the Fed supplies the banking system with $1 of additional reserves, deposits increase by a multiple of the amount. Let’s first use a simple model to understand why.

Multiple Deposit Creation (Simple Model)

Suppose the required reserve ratio (rr), one of the three policy tools, is set at 10% for all banks, and no banks hold excess reserves.

The Fed conducts an open market purchase of $100 million in bonds from the nonbank public, who deposit the Fed’s check in Bank A.

With the 10% reserve requirement, Bank A keeps $10 million as reserves and can make $90 million of loans. Bank A’s T-account (which lists only the changes in its balance sheet items) will look like this:

Bank A	Assets	Liabilities
Deposit arrives	Reserves +$100m	Checkable deposits +$100m
After lending $90m	Reserves +$10m · Loans +$90m	Checkable deposits +$100m

Suppose all the money spent by the borrowers is deposited in Bank B. With the reserve requirement, Bank B can make loans totaling $81 million to borrowers.

Bank B	Assets	Liabilities
Deposit arrives	Reserves +$90m	Checkable deposits +$90m
After lending $81m	Reserves +$9m · Loans +$81m	Checkable deposits +$90m

The $81 million spent by borrowers from Bank B will be deposited in Bank C. Following the same reasoning, the total increase in deposits from the initial $100 million increase in reserves will be $1,000 million.

Bank	Increase in Deposits ($m)	Increase in Loans ($m)	Increase in Reserves ($m)
A	100.00	90.00	10.00
B	90.00	81.00	9.00
C	81.00	72.90	8.10
D	72.90	65.61	7.29
E	65.61	59.05	6.56
F	59.05	53.14	5.90
⋮	⋮	⋮	⋮
Total for all banks	1,000.00	900.00	100.00

We call this multiple the simple deposit multiplier.

where = change in total deposits; = required reserve ratio; = change in reserves

Factors That Determine the Money Supply

Money Supply Response (holding all other factors constant)

Player	Variable	Change	Money supply	Reason
The Fed	Nonborrowed monetary base,	↑	↑	More MB, so more loans and deposits
The Fed	Required reserve ratio,	↑	↓	Less multiple deposit expansion
Banks	Borrowed reserves,	↑	↑	More MB, so more loans and deposits
Banks	Excess reserves ratio,	↑	↓	Fewer loans, so less deposit creation
Depositors	Currency ratio,	↑	↓	Currency is not lent out, so less multiple deposit expansion

The Money Multiplier Formula

The simple model only considers the required reserve ratio but doesn’t take excess reserves or currency holdings into account.

The money multiplier m finally tells us what multiple of the monetary base (MB) is transformed into the money supply.

where = money multiplier; = currency ratio; = excess reserves ratio; = required reserve ratio

2008 Financial Crisis: Quantitative Easing and the Money Supply

After the 2008 financial crisis, the Fed conducted quantitative easing (QE), buying large amounts of bonds through open market purchases. The monetary base rose about fivefold, but M1 only doubled, far less than the money multiplier would suggest. Banks held most of the new reserves instead of lending them, so the excess reserves ratio rose and the multiplier fell.

	Jul 2007	Aug 2014	Change
Monetary base (MB)	$829b	$4,075b	× 4.9
M1	$1,372b	$2,803b	× 2.0
M1 multiplier ()	1.65	0.69	−58%

Source: FRED series BOGMBASE, M1SL (monthly).