• <b>United States Federal Reserve</b>

Money and Banking


5. Money Supply and Deposit Multipliers


In this section we learn how a central bank influences the money supply. We learn the difference between the monetary base and the quantity of money in the economy, and also two measures for the quantity of money. We learn in this section how quantity of money depends on deposit multipliers that can lead to expansions or contractions in the money supply, depending on the fraction of reserves held by banks, the ratio of consumers' currency to checking deposits, and the ratio of consumers savings to checking deposits.


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Open Market Operations

In this introductory Pencast on money supply, we learn how the Federal Reserve can change the quantity of money through open market operations. An open market operation is a transaction of the Federal Reserve with financial institutions in the private market, where the Federal Reserve buys or sells a financial asset in exchange for money. These transactions are taken willingly and voluntarily by the private financial institutions, so the Fed is intervening in the open market, but not imposing rules or restrictions. Still, the intervention changes the money supply. Before discussing the process, we introduce two measures of money supply. [Play Pencast]


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Money Supply Process

Here we show the distinction between the monetary base and the total money supply. We find that when the Federal Reserve conducts an open market operation of some given size, while the change in the monetary base is the same size as the open market operation, the change in the total money supply is larger. [Play Pencast]


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Money Supply Multiplier

In the last Pencast, we showed that a open market operation leads to a larger change in the money supply than in the monetary base. In this Pencast, we learn some math to find out how much larger is the money supply than the monetary base. In fact, we derive an explicit formula for the money supply multiplier, which is equal to the ratio of the money supply to the monetary base. [Play Pencast]


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General Money Supply Multiplier

In the last Pencast, we derived a formula the money supply multiplier, and showed how it is inversely related to the required reserve ratio. That formula for the multiplier was a special case though, as it assumed that consumers hold no currency, and that banks hold no reserves in excess of what is required. In this Pencast, we derive a more general money multiplier where we allow for the possibilities that consumers hold currency and banks hold excess reserves. [Play Pencast]


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Excess Reserves and Money Supply

In the last Pencast, we showed mathematically that the size of the money supply multiplier depends on the fraction of deposits that banks hold in excess reserves, which is also called the excess reserves ratio. Since the money supply multiplier depends on the excess reserve ratio, so does money supply. In this Pencast, we show what happens to the multiplier and to money supply when banks choose to hold more excess reserves. We finish the Pencast with a description of how this affects the equilibrium in the market for money, and what monetary policy might do to counteract the effect. This scenario was particularly relevant in the United States during the Great Recession and the subsequent slow recovery. In late 2008 and early 2009, and again in 2011, banks in the United States significantly increased the quantity of excess reserves that they held. [Play Pencast]


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Mathematical Result for Currency in the Multiplier

We now turn to what affect the quantity of consumers' currency holdings has on the multiplier. The mathematics for this is not as straight forward as with the effect from excess reserves, so we spend time on this Pencast showing what effect an increase in the currency ratio (defined as the ratio of consumers' currency holdings to checking deposits) has on the money supply multiplier. [Play Pencast]


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Currency and the Money Supply

Given our knowledge of how the currency ratio affects the money supply multiplier (previous Pencast), we show how an increase in the currency ratio affects the money supply and the equilibrium in the market for money. [Play Pencast]


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Required Reserve Ratio and Money Supply

In this Pencast, we show what happens to the multiplier and to money supply when the Federal Reserve mandates a change in the required reserve ratio. We show how this affects the equilibrium in the market for money. While we make a simplifying assumption for the required reserve ratio, for the sake of mathematical simplicity, we discuss what the real required reserve laws are for banking institutions in the United States. [Play Pencast]


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M2 Money Supply Multiplier

The previous Pencasts regarding the money supply multiplier focused on the M1 definition of money supply. That is, money defined as only currency plus checkable deposits, which are assets that are legally recognized as means of payment. In this Pencast, we derive a money supply multiplier for M2 money supply, which also includes deposits in savings accounts, certificates of deposits, and money market mutual funds. [Play Pencast]


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Checkable vs Savings Deposits

Banks have different rules to follow regarding holding reserves for checking deposits versus savings deposits, so a change in consumers' composition of deposits affects the M2 multiplier. We show what happens to the multiplier, the M2 money supply, and the money market equilibrium when consumers decide to hold more of their financial wealth in savings deposits versus checking deposits. [Play Pencast]


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