Mishkin ch.14: The Money Supply Process Money = Currency + Deposits (Applies directly to M1. Analogous for M2.

)
- Deposits: created by banks&customers - Currency: created by Fed whenever banks redeem their reserves - Assume Normal conditions: interest rates >> 0. Then examine crises.

Fed has authority to impose reserve requirements: r = reserve ratio Reserves r Deposits Symbols: RrD => Deposits (1/r) Reserves D (1/r) R Objectives: 1. Show that Fed can control the monetary base Monetary Base = Currency + Reserves 2. Derive a money multiplier so that Money = Multiplier (Currency+Reserves) 3. Prepare for Fed Funds market analysis
- Introduce concept of defensive open market operations.

MB = C + R M = m (C+R)

- Show that the Fed could control other balance sheet items (e.g. reserves) equally well

[Notes on Mishkin Ch.14 - P.1]

Links between Banks and the Fed: Reserves and Discount Loans Fed Balance Sheet: Assets BR Discount loans Securities
Gold Check Float

C R

Liabilities Currency Bank reserves

Treasury Dep Foreign CB Dep

[Currency includes Treasury coins small]

Balance Sheet of the Banking System: Assets Liabilities R Reserves D Checkable Deposits Loans Other Deposits Securities BR Borrowings Linkages: Discount loans = Borrowed Reserves BR Bank deposits at Fed = Reserves R
[Notes on Mishkin Ch.14 - P.2]

Sources of Reserves: Balance Sheet Analysis Fed Assets Securities BR Discount loans
Gold Check Float Treasury Deposits Foreign CB Deposits

Fed Liabilities C R Currency Reserves

Decompose reserves: R = NBR + BR Borrowed reserves = Discount loans: must be repaid at maturity Non-borrowed reserves = from open market operations (all other sources) - Distinction is conceptual, not identified in reserve accounts - Observe R and BR, compute: NBR = R BR. - Similarly decompose MB: MBn = MB - BR = C + NBR

[Notes on Mishkin Ch.14 - P.3]

Example Initial Fed Balance Sheet Assets Securities 99 Discount Loans 1 Liabilities Currency Reserves

90 5 5 Treasury/CB Dep. - Compute: MB = ___, R = ___, MBn = ___, NBR = ___

Open Market Operation: Purchase of securities (Sale: All in Reverse)

Assets Securities - New Balance Sheet: +1 Liabilities Reserves +1

90 6 5 Treasury/CB Dep. - Compute: MB = ___, R = ___, MBn = ___, NBR = ___

Assets Securities Discount Loans

100 1

Liabilities Currency Reserves

[Notes on Mishkin Ch.14 - P.4]

Bank-initiated Federal Reserve Transactions 1. Discount Loans:

Assets Discount Loans => New Balance Sheet: +1 Liabilities Reserves +1

90 6 5 Treasury/CB Dep. - Compute: MB = ___, R = ___, MBn = ___, NBR = ___ - What if the Fed does not want R and MB to change? Question of Fed objective/response: - to control MBn or NBR: no response - to control MB or R: Sell securities (contractionary open market operation) Defensive versus Dynamic open market operations: - Dynamic = intended to change a monetary aggregate under Fed control - Defensive = to prevent changes in a monetary aggregate under Fed control
[Notes on Mishkin Ch.14 - P.5]

Assets Securities Discount Loans

99 2

Liabilities Currency Reserves

2. Currency Redemption:
Assets Liabilities Currency Reserves => New Balance Sheet: +1 1

91 4 5 Treasury/CB Dep. - Compute: MB = ___, R = ___, MBn = ___, NBR = ___ - What if the Fed does not want R to change? Need for defensive open market operations depends on Fed objective: - to control MB or MBn: no response - to control R or Rn: buy securities Combining results for BR and currency: MBn unaffected by both => Motivates Mishkins focus on MBn.

Assets Securities Discount Loans

99 1

Liabilities Currency Reserves

[Notes on Mishkin Ch.14 - P.6]

 Caution: There are disturbances that change MBn w/o Fed initiative. - Suppose Treasury or Foreign CB withdraw Fed balances. - Common examples: Shift balances to a commercial bank, spend funds, buy foreign currency against dollars. - Implication: Funds flow into the banking system => Adds to Reserves Balance sheet analysis
Assets Liabilities Reserves Treasury/CB Dep. - New Balance Sheet: +1 1

90 6 4 Treasury/CB Dep. - Compute: MB = +1 to 96, R = +1 to 6, MBn = +1 to 95, NBR = +1 to 5

Assets Securities Discount Loans

99 1

Liabilities Currency Reserves

[Notes on Mishkin Ch.14 - P.7]

Summary and Conclusions

Transaction: Effect on: O.M.O. purchase DL new Currency outflow Treasury/CB outflow

MB R MBn NBR

+ + + +

+ +
0 0

+ + + +

Conclude: If official Treasury or CB balances fluctuate, defensive open market operations are needed to stabilize any of the accounting aggregates. - Other fluctuations with similar impact: Check float, Gold account
[See Mishkins appendix to ch.13 for more details. Optional.]

- MBn is special with regard to BR and currency, but not otherwise. Fact: The Fed focuses mostly on Reserves = Supply of Fed funds.

[Notes on Mishkin Ch.14 - P.8]

The Deposit Multiplier

Simple Algebra: - Definition of required reserves: - Assumption of no excess reserves: - Definition of total reserves: => => Invert: Define: Deposit multiplier = 1/r - If r = 10%: Deposit multiplier = 10 RR = r D ER = 0 R = RR + ER R=rD D = (1/r) R

(normal case: i>0) (with equality, not )

Key assumption: No excess reserves => When Fed increases MB, banks will create deposits whenever they can: D = (1/r) R
Dont confuse the deposit multiplier with money multiplier (next topic): - Money includes currency: Different answers if customers withdraw currency. Textbook distinction between banking system and a single bank: Single bank is limited to own excess reserves, not a multiple. Outdated: Banks can borrow Fed Funds.

[Notes on Mishkin Ch.14 - P.9]

The M1 Money Multiplier Include currency and non-zero excess reserves in a simple way. Define: c = C/D = Currency-deposit ratio e = ER/D = Excess reserves-deposit ratio - Assume both ratios are constant. - Modify the derivation of the deposit multiplier. Step 1: Reserves are a fixed fraction of deposits: - Definition of total reserves: R = RR + ER - Definition of required reserves: RR = r D - Assumption about excess reserves: ER = e D => R = r D + e D = (r+e) D Step 2: Monetary base is a fixed fraction of deposits: - Definition of monetary base: MB = R + C - Assumption about currency: C=cD - Know reserve-deposit relation: MB = (r+e+c) D => Invert: D = MB/(r+e+c)
[Notes on Mishkin Ch.14 - P.10]

 Step 3: M1 is currency plus checkable deposits: M1 = C + D = (1+c) D = (1+c)/(r+e+c) MB Result: The M1 money multiplier m = (1+c)/(r+e+c) Economic reasoning: 1. Money multiplier = Ratio of M = D + C to MB = R + C. - Ratio of D to R is 1/(r+e) ~ 10. Ratio of C to C is 1. => Ratio of M to MB normally between 1 and 10. 2. If the Fed increases reserves, banks seek to expand deposits until - Bank customers withdraw currency (c) - Reserves are tied down as required reserves (r) - Reserves are held as targeted excess reserves (e) 3. Derivation: All quantities are proportional to deposits.

[Notes on Mishkin Ch.14 - P.11]

Interpretation: practical use of the multiplies If m is constant, any change in MB translates into a proportional, predictable change in M1: M1 = m MB where m = (1+c)/(r+e+c) and MB = MBn + BR - Numerator: items that make M1 larger than D - Denominator: items that absorb MB (require large MB) Quantitative Example #1 Normal Conditions: (2007 data, $bill.) - Data: C=760, D = 620, R = 64.5, BR=0.1 - Implies: M1 = 1380, MB = 824.5, MBn= 824.4, NBR= 64.4, RR=62, ER=2.5 - Ratios: c = 760/620 =1.2258, e = 0.0040, r = 0.10. 1+c 1+1.2258 2.2258 m = r+e+c = 0.1+0.004+1.2258 = 1.3298 = 1.6738 - Verify: M1 = 1. 6738 824.5 = 1380 - Lesson: $1 open market purchase/sale will raise/reduce M1 by $1.67.
[Notes on Mishkin Ch.14 - P.12]

Quantitative Example #2 Financial Crisis and Quantitative easing (Spring 2009, $bill.) - Data: C=860, D = 740, R = 765, BR = 404 - Implies: M1 = 1600, MB = 1625, MBn= 1221, NBR= 361, RR=62, ER=691 - Ratios: c = 860/740 =1.1622, e = 0.9338, r = 0.10. 1+c 1+1.1622 m = r+e+c = 0.1+0.9338+1.1622 = 2.1622 = 0.9846 2.1960 - Verify: M1 = 0.9846 1625 = 1600 - Question: Will a $1 open market sale reduce M1 by $0.98? (Depends on banks!) What if banks stop holding excess reserves? If Fed then stops lending? 1+c 1+1.1622 - For e=0, m = r+e+c = 0.1+0+1.1622 ! 1.713 , so M1 = 1.713 1625 = 2874 - For BR=0, MB = MBn= 1221, so M1 = 1.713 1221 = 2165 Scenario with MB=880 (no crisis response): M1 = 0.9846 880 = 866
------------------

Summary: TABLE 1 of Ch.14

[Notes on Mishkin Ch.14 - P.13]

Summary: Determinants of the Money Supply

(Is the Fed in control? Only through MBn. All other changes are problematic!)

[Notes on Mishkin Ch.14 - P.14]

The M2 Multiplier Why focus on M1? (M2 more difficult but practically more relevant.) Use same approach for M2. See Mishkins online Appendix14#2 - Simplified definition: M2 = D + C + T + MMF where => Conclude: - Multiplier idea works for any concept of money, if bank and customer behavior is stable, if everything is proportional to D - If the M1 and M2 multipliers are stable, Fed can easily control M1 and M2. If multipliers fluctuate, controlling the money supply is difficult. T = time and savings deposits = t D MMF = money market funds etc. = mm D m2 =(1+c+t+mm)/(r+e+c)

If m2 is constant, M2 = m2 MB, is controllable by the Fed

[Notes on Mishkin Ch.14 - P.15]

Problems with Unstable Money Multipliers For stable depositor behavior, M1 and M2 should respond proportionally to changes in MB Recall from ch.3: Growth rates of M1 and M2 diverge => Money multipliers are not constant Find: Ratios C/D, ER/D, do vary. (Optional reading: Appendix14#3) Economic Issues: 1. Asset Allocation Perspective - Monetary assets: C, D, Other-M2. 2. Bank Management Perspective - Liabilities: D, BR, Fed-Funds,.. - Assets: R, Securities, Loans,.. => Economic incentives suggest that money multipliers vary when nominal interest rates vary.

[Notes on Mishkin Ch.14 - P.16]

Case Study: The Great Depression Series of Bank Runs

[Notes on Mishkin Ch.14 - P.17]

Currency and Excess Reserve Ratios

[Note on 2008: Rise in e but stable c. FDIC has prevented bank runs!]

[Notes on Mishkin Ch.14 - P.18]

Money and the Monetary Base

Conclusion by Milton Friedman and Anna Schwartz: The Fed should have stabilized M1. Policy mistake made the Great Depression worse. General lesson: The money stock must be monitored in problem situations, e.g., during financial crises; also, in financially unstable countries.

[Notes on Mishkin Ch.14 - P.19]