Chapter 14 The Money Supply Process

14.1 The Central Bank’s Balance Sheet

Ultimately the money supply is determined by the interaction of four groups: commercial banks and other depositories, depositors, borrowers, and the central bank. Like any bank, the central bank’s balance sheet is composed of assets and liabilities. Its assets are similar to those of common banks and include government securitiesStudents sometimes become confused about this because they think the central bank is the government. At most, it is part of the government, and not the part that issues the bonds. Sometimes, as in the case of the BUS and SBUS, it is not part of the government at all. and discount loans. The former provide the central bank with income and a liquid asset that it can easily and cheaply buy and sell to alter its balance sheet. The latter are generally loans made to commercial banks. So far, so good. The central bank’s liabilities, however, differ fundamentally from those of common banks. Its most important liabilities are currency in circulation and reserves.

Yes, currency and reserves. You may recall from Chapter 9 "Bank Management" that those are the assets of commercial banks. In fact, for everyone but the central bank, the central bank’s notes, Federal Reserve notes (FRN) in the United States, are assets, things owned. But for the central bank, its notes are things owed (liabilities), just like your promissory note (IOU) would be your liability, but it would be an asset for the note’s holder or owner. Similarly, commercial banks own their deposits in the Fed (reserves), which the Fed, of course, owes to the commercial banks. So reserves are commercial bank assets but central bank liabilities.

Currency in circulation (C) and reserves (R) compose the monetary baseThe most basic, powerful types of money in a given monetary system, that is, gold and silver under the gold standard, FRN, and reserves (Federal Reserve deposits) today. (MB, aka high-powered money), the most basic building blocks of the money supply. Basically, MB = C + R, an equation you’ll want to internalize. In the United States, C includes FRN and coins issued by the U.S. Treasury. We can ignore the latter because it is a relatively small percentage of the MB, and the Treasury cannot legally manage the volume of coinage in circulation in an active fashion, but rather only meets the demand for each denomination: .01, .05, .10, .25, .50, and 1.00 coins. (The Fed also supplies the $1.00 unit, and for some reason Americans prefer $1 notes to coins. In most countries, coins fill demand for the single currency unit denomination.) C includes only FRN and coins in the hands of nonbanks. Any FRN in banks is called vault cash and is included in R, which also includes bank deposits with the Fed. Reserves are of two types: those required or mandated by the central bank (RR), and any additional or excess reserves (ER) that banks wish to hold. The latter are usually small, but they can grow substantially during panics like that of September–October 2008.

Central banks, of course, are highly profitable institutions because their assets earn interest but their liabilities are costless, or nearly so. Therefore, they have no gap problems, and liquidity management is a snap because they can always print more notes or create more reserves. Central banks anachronistically own prodigious quantities of gold, but some have begun to sell off their holdings because they no longer convert their notes into gold or anything else for that matter.http://news.goldseek.com/GoldSeek/1177619058.php Gold is no longer part of the MB but is rather just a commodity with an unusually high value-to-weight ratio.

14.2 Open Market Operations

We are now ready to understand how the central bank influences the money supply (MS) with the aid of the T-accounts we first encountered in Chapter 9 "Bank Management". Central banks like the Fed influence the MS via the MB. They control their monetary liabilities, MB, by buying and selling securities, a process called open market operations. If a central bank wants to increase the MB, it need only buy a security. (Any asset will do, but securities, especially government bonds, are generally best because there is little default risk, liquidity is high, and they pay interest.) If a central bank bought a $10,000 bond from a bank, the following would occur:

The banking system would lose $10,000 worth of securities but gain $10,000 of reserves (probably a credit in its account with the central bank but, as noted above, FRN or other forms of cash also count as reserves).

The central bank would gain $10,000 of securities essentially by creating $10,000 of reserves. Notice that the item transferred, securities, has opposite signs, negative for the banking system and positive for the central bank. That makes good sense if you think about it because one party is selling (giving up) and the other is buying (receiving). Note also that the central bank’s liability has the same sign as the banking system’s asset. That too makes sense because, as noted above, the central bank’s liabilities are everyone else’s assets. So if the central bank’s liabilities increase or decrease, everyone else’s assets should do likewise.

If the central bank happens to buy a bond from the public (any nonbank), and that entity deposits the proceeds in its bank, precisely the same outcome would occur, though via a slightly more circuitous route:

If the nonbank seller of the security keeps the proceeds as cash (FRN), however, the outcome is slightly different:

Note that in either case, however, the MB increases by the amount of the purchase because either C or R increases by the amount of the purchase. Keep in mind that currency in circulation means cash (like FRN) no longer in the central bank. An IOU in the hands of its maker is no liability; cash in the hands of its issuer is not a liability. So although the money existed physically before Some Dude sold his bond, it did not exist economically as money until it left its papa (mama?), the central bank. If the transaction were reversed and Some Dude bought a bond from the central bank with currency, the notes he paid would cease to be money, and currency in circulation would decrease by $10,000.

In fact, whenever the central bank sells an asset, the exact opposite of the above T-accounts occurs: the MB shrinks because C (and/or R) decreases along with the central bank’s securities holdings, and banks or the nonbank public own more securities but less C or R.

The nonbank public can influence the relative share of C and R but not the MB. Say that you had $55.50 in your bank account but wanted $30 in cash to take your significant other to the carnival. Your T-account would look like the following because you turned $30 of deposits into $30 of FRN:

Your bank’s T-account would look like the following because it lost $30 of deposits and $30 of reserves, the $30 you walked off with:

The central bank’s T-account would look like the following because the nonbank public (you!) would hold $30 and your bank’s reserves would decrease accordingly (as noted above):

The central bank can also control the monetary base by making loans to banks and receiving their loan repayments. A loan increases the MB and a repayment decreases it. A $1 million loan and repayment a week later looks like this:

Take time now to practice deciphering the effects of open market operations and central bank loans and repayments via T-accounts in Exercise 1. You’ll be glad you did.

14.3 A Simple Model of Multiple Deposit Creation

As shown above, the central bank pretty much controls the size of the monetary base. (The check clearing process and the government’s banking activities can cause some short-term flutter, but generally the central bank can anticipate such fluctuations and respond accordingly.) That does not mean, however, that the central bank controls the money supply, which, if you recall from Chapter 3 "Money", consists of more than just MB. (M1, for example, also includes checkable deposits.) The reason is that each $1 (or €1, etc.) of additional MB creates some multiple > 1 of new deposits in a process called multiple deposit creation.

Suppose the central bank buys $1 million of securities from Some Bank. We know that the following will occur:

Some Bank suddenly has $1 million in excess reserves. (Its deposits are unchanged, but it has $1 million more in cash.) What will the bank do? Likely what banks do best: make loans. So its T-account will be the following:

Recall from Chapter 9 "Bank Management" that deposits are created in the process of making the loan. The bank has effectively increased M1 by $1 million. The borrower will not leave the proceeds of the loan in the bank for long but instead will use it, within the guidelines set by the loan’s covenants, to make payments. As the deposits flow out of Some Bank, its excess reserves decline until finally Some Bank has essentially swapped securities for loans:

But now there is another $1 million of checkable deposits out there and they rarely rest. Suppose, for simplicity’s sake, they all end up at Another Bank. Its T-account would be the following:

If the required reserve ratio (rr) is 10 percent, Another Bank can, and likely will, use those deposits to fund a loan, making its T-account:

That loan will also eventually be paid out to others and deposited into other banks, which in turn will lend 90 percent of them (1 − rr) to other borrowers. Even if a bank decides to invest in securities instead of loans, as long as it buys the bonds from anyone but the central bank, the multiple deposit creation expansion will continue, as in Figure 14.1 "Multiple deposit creation, with an increase in reserves of $1 million, if rr = .10".

Figure 14.1 Multiple deposit creation, with an increase in reserves of $1 million, if rr = .10

Notice that the increase in deposits is the same as the increase in loans from the previous bank. The increase in reserves is the increase in deposits times the required reserve ratio of .10, and the increase in loans is the increase in deposits times the remainder, .90. Rather than working through this rather clunky process every time, you can calculate the effects of increasing reserves with the so-called simple deposit multiplier formula:

where:

∆D = change in deposits

∆R = change in reserves

Rr = required reserve ratio

Practice calculating the simple deposit multiplier in Exercise 2.

Pretty easy, eh? Too bad the simple deposit multiplier isn’t very accurate. It provides an upper bound to the deposit creation process. The model simply isn’t very realistic. Sometimes banks hold excess reserves, and people sometimes prefer to hold cash instead of deposits, thereby stopping the multiple deposit creation process cold. That is why, at the beginning of the chapter, we said that depositors, borrowers, and banks were also important players in the money supply determination process. In the next chapter, we’ll take their decisions into account.

14.4 Suggested Reading

Hummel, William. Money: What It Is, How It Works 2nd ed. Bloomington, IN: iUniverse, 2006.

Mayes, David, and Jan Toporowski. Open Market Operations and Financial Markets. New York: Routledge, 2007.