Lecture 25: Monetary base

1
Lecture 25 Monetary base

• Mishkin Ch 13 part A
• page 333-341

2
Introduction

• Money supply affect interest rates and the
  overall health of the economy and thus affect us
  all.
• How money supply is determined? Who controls it?
• The money supply process.
• Deposits at banks are the largest component of
  money supply, so we first look at this.
• Monetary base and money multiplier

3
Players in the money supply process

• Central bank (Federal Reserve System)
• Banks and other depository institutions
• Depositors (individuals and institutions)
• Borrowers (individuals and institutions)
• The Fed is the most important player.

4
Feds balance sheet
Federal Reserve System Federal Reserve System
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves

• Currency in circulation money in hands of the
  public, not including those in banks.
• Reserves vault cash and commercial bank deposits
  at the Fed.
• Government securities e.g. T-bills
• Discount loans lending to commercial banks

5
Monetary base

• The Fed controls monetary base via open market
  operations and through its extension of discount
  loans to banks.
• Monetary base is about the amount of monetary
  liabilities on the Feds balance sheet.

6
Open market operations

• The primary way for the Fed to change monetary
  base is via open market operations
• Open market purchase the Fed purchases bonds ?
  increase MB
• Open market sale the Fed sells bonds ? decrease
  MB

7
Open market purchase from a bank

• Suppose the Fed buys 100 bonds from the bank
  with check.
• Net result reserves (R) have increased by 100
  currency (C) is unchanged.
• Monetary base (MB C R) has risen by 100.

Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Securities -100 Securities 100 Reserves 100
Reserves 100
8
Open market purchase from nonbank public case
one

• Suppose a person or a firm sells bonds of 100 to
  the Fed and then deposits the Feds check in a
  local bank.
• Identical result as the Fed purchases from a
  bank reserves increases 100, monetary base
  increases 100.

Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 100 Checkable deposits 100 Securities 100 Reserves 100
9
Open market purchase from nonbank public case
two

• The person/firm selling the bonds cashes the
  Feds check for currency.
• Net result reserves are unchanged currency in
  circulation increases by the amount of the open
  market purchase.
• Monetary base increases by the amount of the open
  market purchase.

Nonbank Public Nonbank Public Nonbank Public Nonbank Public Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Securities -100 Securities 100 Currency in circulation 100
Currency 100
10
Open market purchase summary

• The effect of an open market purchase on the
  monetary base always increases the base by the
  amount of the purchase.
• The effect of an open market purchase on reserves
  depends on whether the seller of the bonds keeps
  the proceeds from the sale in currency or in
  deposits.

11
Open market sale
Nonbank Public Nonbank Public Nonbank Public Nonbank Public Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Securities 100 Securities -100 Currency in circulation -100
Currency -100

• Suppose an individual buys the bonds from the Fed
  with 100 cash (currency).
• Reduces the monetary base and currency by the
  amount of the sale, reserves remain unchanged.
• If the individual buys with check, reserve
  reduces, monetary base reduces, currency
  unchanged.

12
Shifts from deposits into currency
Nonbank Public Nonbank Public Nonbank Public Nonbank Public Banking System Banking System Banking System Banking System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Checkable deposits 100 Reserves 100 Checkable deposits -100
Currency -100
Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities
Currency in circulation 100
Reserves -100
13
Discount loans
Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 100 Discount loans 100 Discount loan 100 Reserves 100
(borrowing from Fed) (borrowing from Fed)

• Suppose the Fed makes a 100 discount loan to a
  bank.
• Monetary liabilities of the Fed increases by 100
• Monetary base also increases by 100

14
Discount loans - contd
Banking System Banking System Banking System Banking System Federal Reserve System Federal Reserve System Federal Reserve System Federal Reserve System
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves -100 Discount loans -100 Discount loans -100 Reserves -100
(borrowing from Fed) (borrowing from Fed) (borrowing from Fed) (borrowing from Fed)

• Suppose the bank pays off the 100 discount loan.
• Net effect on monetary base is a reduction of
  100.
• Monetary base changes one-for-one with a change
  in the borrowings from the Federal Reserve System.

15
Other factors affecting the monetary base

• Does the Fed have complete control of the
  monetary base through its open market operations
  and discount loans?
• Float
• Treasury deposits at the Federal Reserve

16
Float

• When the Fed clears checks for banks, it often
  credits the amount of the check to a bank that
  has deposited it (increases the banks reserves)
  but only later debits (decreases the reserves of)
  the bank on which the check is drawn.
• The resulting temporary net increase in the total
  amount of reserves in the banking system (and
  hence in the monetary base) occurring from the
  Feds check-clearing process is called float.
• Float is affected by random events such as the
  weather, which affects how quickly checks are
  presented for payment, is not controlled by the
  Fed, but affects the monetary base.

17
U.S. Treasury deposits

• When the U.S. Treasury moves deposits from
  commercial banks to its account at the Fed,
  leading to a rise in Treasury deposits at the
  Fed, it causes a deposit outflow at these banks
  and thus causes reserves in the banking system
  and the monetary base to fall.
• Thus Treasury deposits at the Fed is determined
  by the U.S. Treasurys actions and affects the
  monetary base but are not fully controlled by the
  Fed.

18
Overview of the Feds ability to control the
monetary base

• Float and Treasury deposits at the Federal
  Reserve which are not in control of the Fed can
  cause short-term (a week) fluctuations in
  monetary base.
• But the Fed can offset these short-term
  fluctuations by its open market operations
  maintain its control over monetary base.