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					Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



                                                                                                                       Big Concepts
                                               ECON 354
                                                                               • Understanding items on the Balance Sheet for Commercial
                                Money and Banking                                banks and the Fed


                                  Professor Yamin Ahmad                        • The Bank Lending Channel of Monetary Policy

                                                                               • How changes in the instruments affects the supply of money
  Lecture 10: Money Supply                                                           Emphasis on Open Market Operations
  • Understanding the Fed’s
    Balance Sheet                                                              • Deposit Creation
  • Open Market Operations
                                                                               • Money Multiplier Process
  • Deposit Creation
                                                                               • Non Borrowed Monetary Base and Discount Loans
                                                                                   Note: These lecture notes are incomplete without having attended lectures




Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



         Banks
         Banks’ role in the money supply                                                             The Four Players
                                                                                              in the Money Supply Process
• The money supply equals currency plus
  demand (checking account) deposits:                                          1. Central bank: the Fed


                                        M = C + D                              2. Banks


• Since the money supply includes demand                                       3. Depositors
  depos ts, t e ba    g syste plays an
  deposits, the banking system p ays a
  important role.                                                              4. Borrowers from banks


   Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



                             Fed s
                         The Fed’s Policy Tools                                                 The Federal Reserve System
• Recall the Fed uses following monetary policy                                 • The Fed sets required reserve ratios, which are the
  tools:                                                                          minimum percentages of deposits that depository
                                                                                             p       g         p           p      y
                                                                                  institutions must hold as reserves.
     1.        q
            Required reserve ratios
                                                                                • The Fed does not change these ratios very often.
     2.     The discount rate
     3.     Open market operations
                                                                                • The discount rate is the interest rate at which the Fed
     4.     Term Auction Facility
                                                                                  stands ready to lend reserves to depository institutions.
     5.     Primary Dealer Credit Facility
     6
     6.     Term Securities L di Facility
            T    S     iti Lending F ilit
                                                                                • An open market operation is the purchase or sale of
                                                                                  government securities—U.S. Treasury bills and bonds—
                                                                                                                             market.
                                                                                  by the Federal Reserve System in the open market
    Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



                         Fed s
                     The Fed’s Balance Sheet                                                                Fed s
                                                                                          Understanding the Fed’s Balance
                                                                                 July 2007
                                                                                                      Sheet
  On th F d’ b l          h t the l    t d
• O the Fed’s balance sheet, th largest and most t                               Assets                                                         Liabilities
  important asset is U.S. government securities.                                 Securities                                                     Federal Reserve Notes                     $781.4 
                                                                                                  Held Outright                  $790.6         Commercial Bank Reserve Balance            $16.8 
                                                                                                         Repos                    $30.3         Liabilities related to foreign official    $42.4 
                                                                                 Loans                                                             and US Treaury Deposits
• The most important liabilities are Federal Reserve notes                                    Primary Lending                     $0.19         Other Liabilities                           $5.7 
  in circulation and banks’ deposits.                                                      (Discount Window)
                                                                                 Foreign Exchange Reserves
                                                                                 Foreign Exchange Reserves                        $20 8
                                                                                                                                  $20.8 
                                                                                 Gold                                             $11.0 
                                                                                 Other Assets                                     $27.5 
• The sum of Federal Reserve notes, coins, and banks’                            Total Assets                                    $880.4         Total Liabilities                         $846.3 

                                      base.
  deposits at the Fed is the monetary base                                       Capital ( = Total Assets ‐ Total Liabilities)             $34.1 

                                                                                 Note: Numbers are in Billions of dollars




    Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                                     Professor Yamin Ahmad, Money and Banking – ECON 354



                         Composition of Assets                                                                   Composition of Assets
                                                                                     •     Definition: Repos – short term collateralized loan in which a security
Securities:                                                                                is exchanged for cash with the agreement that both parties will
            sec rities      outright
• Fed holds securities both o tright and as part of                                        reverse the transaction on a specific f
                                                                                                    h          i                        date at an agreed upon
                                                                                                                             ifi future d               d
  repurchase agreements (repos).                                                           price
                                                                                              Kind of like an overnight mortgage, e.g. in the same way you would pledge your
                                                                                                                                           (i e                  collateral),
                                                                                               house to the bank in exchange for a loan (i.e. use the house as collateral) a
                                                                                               financial institution pledges a bond to the Fed in exchange for funds, and also
• Securities that Fed owns are comprised of US Treasury                                        promises to reverse the transaction and provide cash for the bond in the near
  bills, notes and bonds                                                                       future
                                                                                              Fed does this by FRBNY s Open Market Desk through “primary dealers”.
                                                                                                                   FRBNY’s                              primary dealers

• Prior to the crisis, securities amounted to about 90% of                           •     Use of Repurchase Agreements allow for two things:
      Fed s
  the Fed’s assets                                                                            K
                                                                                               Keeps a ffraction of the F d’ asset very short term, allowing fl ibili f the
                                                                                                             i    f h Fed’s              h           ll i flexibility for h
                                                                                               Fed to expand and contract the quantity quickly. This allows policy makers to add
                                                                                               or take away reserves from the system immediately if needs be.
                                                                                              By operating every day, the Fed is in contact with market participants daily.


    Note: These lecture notes are incomplete without having attended lectures               Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                                     Professor Yamin Ahmad, Money and Banking – ECON 354



                         Composition of Assets
                                                                                                              Composition of Liabilities
Loans
• The Discount Window serves as an avenue for banks in                                        y
                                                                                     • Currency in Circulation
  need of reserves to be able to borrow from the Fed.                                        – Approximately one-half to two-thirds is typically held
                                                                                               outside the U.S.
      Fed performs one of it’s roles as the Lender of Last Resort.


• Historically, banks have been hesitant to borrow from the                          • Commercial Bank Reserves: Banks hold reserves at
  Fed because of the stigma attached with borrowing from
                                                                                       the Fed because:
                                                                                             – The are required to do so
  the Fed.
      Banks fear that if they borrow from the Fed, other banks and financial
                                                                                             – They need them to do business so they can meet
                                                                         strength.
       institutions will draw negative conclusions about their financial strength              customer demands for withdrawals and make payments to
                                                                                                                                              p y
      Prior to the 2007-09 crisis, borrowing averaged less than $200 million
                                                                                               other banks
       per day.                                                                              – It is prudent to do so because reserves act as the bank’s
                                                                                               emergency funds in case of a disaster.
                                                                                                      g   y

    Note: These lecture notes are incomplete without having attended lectures               Note: These lecture notes are incomplete without having attended lectures
    Professor Yamin Ahmad, Money and Banking – ECON 354                                                                        Professor Yamin Ahmad, Money and Banking – ECON 354



   The Fed’s Balance Sheet In June 2009
June 2009
                                                                                                                                                       Fed s
                                                                                                                                   Key Elements of The Fed’s Balance
Assets                                                                  Liabilities                                                             Sheet
Securities Held Outright
                     g                               $1,115.8
                                                     $ ,                Federal Reserve Notes                      $
                                                                                                                   $868.8 
                           US Treasury                 $606.2           Commercial Bank Reserve Balance            $844.7                                       Federal Reserve System
                  Federal Agency Debt                    $82.0          Liabilities related to foreign official    $313.8 
                     Mortgage Backed                   $427.6              and US Treaury Deposits
Repurchase Agreements                                       $0          Other Liabilities                             $6.3 
Term Auction Credit                                  $372.54                                                                                             Assets                                                      Liabilities
Other Loans                                            $124.2 
                       Primary Lending                   $42.1 
      Asset Backed Commerical Paper                    $23.64 
                          Credit to AIG                  $43.1 
           Term Security Loan Facility
Commercial Paper Funding Facility
                                                         $15.4 
                                                      $142.6 
                                                                                                                                       Government securities                                       Currency in circulation
Maiden Lane Assets                                       $62.5                                                                                                                                     (C)
Central Bank Liquidity Swaps                           $175.7                                                                          Discount loans
Foreign Exchange Reserves                               $23.3                                                                                                                                      Reserves (R)
                                                                                                                                                                                                            ( )
Gold                                                    $11.0 

Other Assets                                            $51.4 
Total Assets                                         $2,079.0           Total Liabilities                         $2,033.5 

Capital ( = Total Assets ‐ Total Liabilities)                      $45.7 
                                                                                                                                                Base,
                                                                                                                                       Monetary Base MB = C + R
Note: Numbers are in Billions of dollars
         Note: These lecture notes are incomplete without having attended lectures                                                 Note: These lecture notes are incomplete without having attended lectures




    Professor Yamin Ahmad, Money and Banking – ECON 354                                                                        Professor Yamin Ahmad, Money and Banking – ECON 354



                                       A few preliminaries                                                                                        Bank s
                                                                                                                                       Commercial Bank’s Balance Sheet
                                                                                                                              June 2009
 • Reserves (R ): the portion of deposits that banks have
     tl t t
   not lent out.                                                                                                              Assets                                       Percent               Liabilities                              Percent

                                                                                                                              Reserves and Cash Items                      7.75                  Checkable Deposits                       69.51
                                                                                                                              Securities                                   22.26                   Nontransaction Deposits                    62.49

     bank s                     deposits,
 • A bank’s liabilities include deposits                                                                                       U.S. Government and Agency state                    10.58           Small ‐denomination Time deposits            44.74

   assets include reserves and outstanding loans.                                                                                      and local governments and                                         (<$100,000) + savings deposits

                                                                                                                                                  other securities                 11.68            Large Denomination time deposits
                                                                                                                                                                                                       g                      p               17.76
                                                                                                                                                                                                   Transactions Deposits                        7.01
 • 100-percent-reserve banking: a system in which                                                                             Loans                                        59.1                  Borrowings                               22.49
                                                                                                                                        Commerical and Industrial                  12.35
   banks hold all deposits as reserves.                                                                                                              Real Estate                   32.36         Bank Capital                             8.0
                                                                                                                                                      Consumer                      7.33
                                                                                                                                                                                    7 33
                                                                                                                                                       Interbank                    3.52
                                                                                                                                                           Other                     3.5
 • Fractional-reserve banking:
   a system in which banks hold a fraction of their deposits                                                                   Oth A t (f             l    h i l
                                                                                                                               Other Assets (for example, physical         10.9
                                                                                                                                                                           10 9
                                                                                                                                                          capital)
   as reserves.                                                                                                               Total Assets                                 100.0                 Total Liabilities                              100.0
         Note: These lecture notes are incomplete without having attended lectures                                                 Note: These lecture notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking – ECON 354                                          Professor Yamin Ahmad, Money and Banking – ECON 354




Key Elements of a Commercial Bank’s
                             Bank s                                                                 Controlling the Quantity of Money
          Balance Sheet
                                      Commercial Bank                                        • How Required Reserve Ratios Work
                                                                                                  An increase in the required reserve ratio boosts the reserves that
                                                                                                   banks must hold, decreases their lending, and decreases the
                        Assets                                                 Liabilities                     money.
                                                                                                   quantity of money


     Reserves (R)                                                  Deposits (D)              • How the Discount Rate Works
     Outstanding loans                                             …                              An increase in the discount rate raises the cost of borrowing
                                                                                                   reserves from the Fed and decreases banks’ reserves, which
     …                                                                                                                                                     money.
                                                                                                   decreases their lending and decreases the quantity of money




   Note: These lecture notes are incomplete without having attended lectures                    Note: These lecture notes are incomplete without having attended lectures




Professor Yamin Ahmad, Money and Banking – ECON 354                                          Professor Yamin Ahmad, Money and Banking – ECON 354



       Controlling the Quantity of Money                                                            Controlling the Quantity of Money

• How an Open Market Operation Works                                                         • Although the details differ, the ultimate process
     When the Fed conducts an open market operation by                                        of how an open market operation changes the
      buying a government security, it increases banks’                                        money supply is the same regardless of whether
      reserves.                                                                                the Fed conducts its transactions with a
     Banks loan the excess reserves.                                                          commercial bank or a member of the public.
     By making loans they create money
                 loans,           money.

                                                                                             • An open market operation that increases banks’
• The reverse occurs when the Fed sells a                                                                l increases the monetary b
                                                                                               reserves also i        h             base.
  government security.


   Note: These lecture notes are incomplete without having attended lectures                    Note: These lecture notes are incomplete without having attended lectures
   Professor Yamin Ahmad, Money and Banking – ECON 354                                                                        Professor Yamin Ahmad, Money and Banking – ECON 354




           Controlling the                                                                                                                       Control of Monetary Base
          Quantity of Money
                                                                                                                             Open Market Purchase From a Bank:
                                                                                                                              Manhattan Commercial                                             Federal Reserve Bank
    Figure 1 summarizes both                                                                                                  Bank                                                             of New York
       types of open market                                                                                                   Assets                           Liabilities                  Assets                           Liabilities
  operation. These are shown in                                                                                                       $100
                                                                                                                          Securities -$100                                                           $100
                                                                                                                                                                                         Securities +$100                        $100
                                                                                                                                                                                                                       Reserves +$100
   more details on the following                                                                                                                                 The Fed buys
                                                                                                                                                                 securities from a
               slides                                                                                                     Reserves +$100                         commercial bank…


                                                                                                                                                                                                                        … and pays for the
                                                                                                                                                                                                                        securities by
                                                                                                                             Result: R  $100 MB  $100
                                                                                                                             R   lt      $100,                                                                          increasing the
                                                                                                                                                                                                                        reserves of the
      Note: These lecture notes are incomplete without having attended lectures                                                  Note: These lecture notes are incomplete without having attended lectures              commercial bank




   Professor Yamin Ahmad, Money and Banking – ECON 354                                                                        Professor Yamin Ahmad, Money and Banking – ECON 354



                      Control of Monetary Base                                                                                                   Control of Monetary Base
Open Market Purchase from Public                                                                                               Open Market Purchase from Public: Cashing a
                                                                    Federal Reserve Bank                                       Check
Goldman Sachs                                                       of New York                                                                                                                  Federal Reserve Bank
     Assets                            Liabilities                      Assets                              Liabilities     Public                                                               of New York
Securities        $100
                 -$100                                           Securities            +$100        Reserves      +$100          Assets                             Liabilities                     Assets                        Liabilities
Deposits at Manhattan                                                                                                       Securities       -$100                                           Securities        +$100         Currency      +$100
Commercial Bank                                                The Fed buys securities from
                                                               Goldman Sachs, a member of the
               +$100                                           general public…
                                                                                                                                                                                                      y
                                                                                                                                                                                            The Fed buys securities from a
                                                                                                                                                                                            member of the general public…
Manhattan Commercial                                                                                                                                              … and pays for it by writing
                                                                                  … and pays for it by writing
Bank                                                                              a check that is deposited to
                                                                                                                            Currency        +$100                 a check that is cashed
     Assets                            Liabilities                                Goldman Sach’s account at
                                                                                                                                                                  either at the local bank or
                                                                                                                                                                   t F d lR              Bank
                                                                                                                                                                  at a Federal Reserve B k
                                                                                  Manhattan Commercial
Reserves +$100                 Goldman Sach’s                                                                                                                     for currency.
                                                                                  Bank and that increases
                               Deposits     +$100                                 the reserves of the
                                                                                  commercial bank
                                                                                                                                  Result: R unchanged MB  $100;
                                                                                                                                            unchanged,
                                                                  Result: R  $100, MB  $100                                     Effect on MB certain, on R uncertain
      Note: These lecture notes are incomplete without having attended lectures                                                  Note: These lecture notes are incomplete without having attended lectures
   Professor Yamin Ahmad, Money and Banking – ECON 354                                                                      Professor Yamin Ahmad, Money and Banking – ECON 354



                      Control of Monetary Base                                                                                                 Control of Monetary Base
Shifts From Deposits into Currency
                                                                    Federal Reserve Bank                                   Discount Loans:
Public: J Doe                                                       of New York
     Assets                            Liabilities                      Assets                            Liabilities       Manhattan Commercial                                             Federal Reserve Bank
Currency         $100
                -$100                                                                             Currency      +$100       Bank                                                             of New York
Deposits at Manhattan                                    J Doe takes deposits out of his
Commercial Bank                                          checking account, which lowers           Reserves      -$100      Assets                            Liabilities                  Assets              Liabilities
               -$100                                        Manhattan Commercial’s
                                                             liabilities and assets…
                                                                                                                        Reserves +$100             Discount -$100                                $100
                                                                                                                                                                                       Discount +$100      Reserves +$100
Manhattan Commercial                                                                                                                               Loan                                Loan
                                                                                  … by lowering reserves. By                                                         Commercial bank
Bank                                                                              switching from reserves to
     Assets                            Liabilities                                currency, this then
                                                                                           y,                                                                        borrows from Fed in
                                                                                  increases currency in                                                              the Discount
Reserves        -$100          J Doe’s                                            circulation.                                                                       Market…
                               Deposits           -$100


                                                                                                                           Result: R  $100 MB  $100
                                                                                                                           R   lt      $100,                                                                   this i      th
                                                                                                                                                                                                           … thi increases the
                                                                                                                                                                                                           amount of reserves
                                                          Result: R  $100, MB unchanged                                                                                                                   in the banking
      Note: These lecture notes are incomplete without having attended lectures                                                Note: These lecture notes are incomplete without having attended lectures
                                                                                                                                                                                                           system




   Professor Yamin Ahmad, Money and Banking – ECON 354                                                                      Professor Yamin Ahmad, Money and Banking – ECON 354



                                          Conclusion…                                                                               Reserves,                Base,
                                                                                                                               Bank Reserves the Monetary Base
                                                                                                                                    and the Money Multiplier
                                                                                                                           • The money multiplier is the amount by which a change
                                                                                                                             in the monetary base is multiplied to calculate the final
                                                                                                                             change in the money supply.
        Fed has a better ability to control
       monetary base (MB) than reserves (R)!                                                                               • An increase in currency held outside the banks is called
                                                                                                                                        drain
                                                                                                                             a currency drain.

                                                                                                                           • Such a drain reduces the amount of banks’ reserves,
                                                                                                                                                                banks
                                                                                                                             thereby decreasing the amount that banks can loan and
                                                                                                                             reducing the money multiplier.


      Note: These lecture notes are incomplete without having attended lectures                                                Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                                            Professor Yamin Ahmad, Money and Banking – ECON 354



        Controlling the Quantity of Money

• The money multiplier differs from the deposit
  multiplier.
                                                                                                                                      Example…
                                                                                                                            A Simpler Example
• The deposit multiplier shows how much a
  change in reserves affects deposits.
      g                        p
                                                                                                                   - An Example of Deposit Creation!
    e o ey u t p e s o s o          uc
• The money multiplier shows how much a
  change in the monetary base affects the money
  supply.

    Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                                            Professor Yamin Ahmad, Money and Banking – ECON 354



             Deposit Creation: Single Bank                                                             Deposit Creation: Banking System
Suppose the Fed bought $100 securities from Manhattan
Commercial Bank via an open market purchase.                                                   What happens next at other banks…
 • What does Manhattan Commercial do with excess
   reserves?                                                                                    Fleet Bank                                                         Bank One

                 Assets                                                    Liabilities           Assets                             Liabilities                  Assets                    Liabilities
                                                                                             Reserves        $10
                                                                                                            +$10
                                                                                                             $100
                                                                                                            +$100           Deposits +$100
                                                                                                                                      $100                   Reserves              +$9
                                                                                                                                                                                 +$90    Deposits    +$90
    Securities                       -$100                       Deposits            +$100
                                                                                             Loans            +$90                                           Loans               +$81
    R
    Reserves                         +$100

    Loans                            +$100

    Note: These lecture notes are incomplete without having attended lectures                        Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                                                  Professor Yamin Ahmad, Money and Banking – ECON 354


                                    Deposit Creation                                                                                   Deposit Creation
Creation of Deposits (assuming 10% Reserve Requirement and $100
increase in reserves)
                                                Increase in              Increase in   Increase in                   y                   $90
                                                                                                     If Fleet Bank buys securities with $ check
 Bank                                           Deposits                 Loans         Reserves
                                                                                                                             Fleet Bank
 Manhattan Commercial                                  0.00                  100.00          0.00
 Fleet Bank                                          100.00                   90.00         10.00
                                                                                                     Assets                      Liabilities
 Bank One                                              90.00                  81.00          9.00    Reserves      + $10        Deposits    + $100
 Bank A                                                81.00                  72.90          8.10
                                                                                                     Securities    + $90
 B kB
 Bank                                                  72.90
                                                       72 90                  65 61
                                                                              65.61          7 29
                                                                                             7.29
 Bank C                                                65.61                  59.05          6.56
                                                                                                     Seller deposits $90 at Bank One and process is same
 Bank D                                                59.05                  53.14          5.91
 .                                                        .                       .            .
                                                                                                                                      securities,
                                                                                                     Whether bank makes loans or buys securities get
 .                                                        .                       .            .
                                                                                                     same deposit expansion
 .                                                        .                       .            .
 Total For All Banks                                1000.00                 1000.00         100.00
      Note: These lecture notes are incomplete without having attended lectures                          Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                                                  Professor Yamin Ahmad, Money and Banking – ECON 354



                                   Deposit Multiplier                                                                                 p   p
                                                                                                               Derivation of the Simple Deposit
     Simple Deposit Multiplier                                                                                             Multiplier
                                                                                                     • Total Reserves = Required Reserves + Excess
                                                                                                       Reserves, i.e. R = RR+ER
                                              1                                                      • Assume that banks hold no excess reserves, i.e.
                                                                                                                                                ,
                                          D   R
                                              r                                                        ER=0
                                                                                                     • Then:         R  RR  r  D
     i.e. the change in reserves that arises is a multiple of                                                                                  1
          the change in deposits.                                                                                                          D  R
                                                                                                                                                r
                                                                                                                                                  1
                                                                                                                                           D     R
                                                                                                                                                  r
      Note: These lecture notes are incomplete without having attended lectures                          Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                            Professor Yamin Ahmad, Money and Banking – ECON 354




                    Deposit Creation:                                                                Critique of Simple Model
                Banking System as a Whole
                                                                                From our simple model, deposit creation stops if:
                 Banking System
  Assets               Liabilities                                              1 Proceeds from loan kept in cash
                                                                                1.
  Securities – $100    Deposits + $1000
  Reserves + $100                                                               2 Bank holds excess reserves ER
                                                                                2.                  reserves,
  Loans + $1000




    Note: These lecture notes are incomplete without having attended lectures      Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                            Professor Yamin Ahmad, Money and Banking – ECON 354



The Multiplier Effect of an Open Market                                                Controlling the Quantity of Money
               Operation                                                              Figure 2 illustrates a round in the multiplier process
• When the Fed conducts an open market                                                       following an open market operation.
                                                                                                       g      p            p
  operation, the ultimate change in the money
  supply is larger than the initiating open market
  operation.

• Banks use excess reserves from the open
  market operation to make loans so that the
  banks h      h loans are d
  b k where the l                  i d
                            deposited acquirei
  excess reserves which they, in turn, then loan.

    Note: These lecture notes are incomplete without having attended lectures      Note: These lecture notes are incomplete without having attended lectures
    Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



           Controlling the Quantity of Money                                                                   Extending the model
    Figure 3 illustrates the multiplier effect of an open market
                             operation.
                                    ti                                             What happens if:

                                                                                   • People convert loans to currency and hold
                                                                                     cash? (Currency drain)

                                                                                   • Banks hold additional reserves beyond what
                                                                                     t ey eed        o d the o of equ ed
                                                                                     they need to hold in t e form o required
                                                                                     reserves, i.e. they hold excess reserves.


       Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures




    Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354



                 Deriving The Money Multiplier                                         Deriving the Money Multiplier (cont.)
Money Multiplier:
                                                                                            g      q
                                                                                   Examining the equation for reserves:
  M = m  MB                                ;                  Monetary Base
                                                          MB = M   t    B
                                                                                      R = RR + ER      ;     R = Reserves, RR = Required
                                                                                                                               Reserves
•        Assume: ratio of currency to checkable d
         A           ti f           t h k bl deposits and
                                                       it   d                         RR = r  D       ;     D = Deposits
         ratio of excess reserves to checkable deposits are                           R = (r  D) + ER ;     ER = Excess Reserves
         constant in equilibrium
        i.e. c=C/D and e = ER/D                                                    • Note: r<1

•        Implication: Desired level of currency and excess                         Adding C to both sides
         reserves grow proportionately with checkable deposits
                                                                                     R + C = MB = (r  D) + ER + C

       Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures
 Professor Yamin Ahmad, Money and Banking – ECON 354                            Professor Yamin Ahmad, Money and Banking – ECON 354




                            R + C = MB = (r  D) + ER + C                          Deriving the Money Multiplier (cont.)
Equation above tells us three things:
                                                                                                    D  r  1  c  MB
                                                                                                            e
1. Tells us amount of MB needed support D, ER and C
                                                                                                    M  D  ( c  D )  (1  c )  D
2. An increase of $1 of MB in C, does not get multiplied,
   whilst those that go into supporting deposits (e.g.
                        multiplied
   Reserves) does get multiplied.                                                                   M  r   c c  MB
                                                                                                           1
                                                                                                             e
3. An increase of $1 of MB in ER, does not support D or C                                           where                m  r  c c
                                                                                                                               1
                                                                                                                                 e
MB          = (r  D) + (e  D) + (c D)
            = (r + e + c)  D
              (         )

    Note: These lecture notes are incomplete without having attended lectures      Note: These lecture notes are incomplete without having attended lectures




 Professor Yamin Ahmad, Money and Banking – ECON 354                            Professor Yamin Ahmad, Money and Banking – ECON 354



                                         Exercise 1…                                                                    Exercise 2…
• Suppose: r=0.2, M=$1500 billion, C=$500 billion,                                                                                                               1 c
  D=$1000 billion, ER=$1.2 billion
    $            ,    $                                                              M  m B where m 
                                                                                                                                                               r  e c
• What is the money multiplier?
                                                                                Question: Suppose households decide to hold
           Answer:
                                                                                more of their money as currency and less in the
                                                                                form of demand deposits.
                                                                                                  p
                                                                                 1. Determine impact on money supply.
• What is the value of the monetary base?                                                                         result.
                                                                                 2 Explain the intuition for your result
                                                                                 2.
           Answer:



    Note: These lecture notes are incomplete without having attended lectures      Note: These lecture notes are incomplete without having attended lectures
    Professor Yamin Ahmad, Money and Banking – ECON 354                             Professor Yamin Ahmad, Money and Banking – ECON 354




                            M  m MB  1 c  MB                                                            bank s
                                                                                      What factors influence bank’s holdings of
                                       r ec                                                   Excess Reserves?
Note
Note:
                                                                                   The banking system’s excess reserve ratio e is:
• m < 1/r because no multiple expansion for
   currency and because as D  ER 
                                                                                   • negatively related to the market interest rate, i
•        The                l    ( d th
         Th money supply, M (and the money
         multiplier, m) is negatively related to                                   • positively related to expected deposit outflows
         The required reserve ratio r
                                ratio,
         The currency ratio, c
         The excess reserve ratio, e
                                    ,

       Note: These lecture notes are incomplete without having attended lectures       Note: These lecture notes are incomplete without having attended lectures




    Professor Yamin Ahmad, Money and Banking – ECON 354



                               Excess Reserves Ratio




Determinants of e
     ,                                      ),
1. i  relative Re on ER  (opportunity cost  e 
2. Expected deposit outflows, ER insurance worth more, e 
       Note: These lecture notes are incomplete without having attended lectures

				
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