The Money Supply Process – Hubbard, Chap 17.
Key Points
1. Understand the roles of the Fed, banks, and households in the money
supply process.
2. Definition of the monetary base.
3. U.S. banking system is a fractional reserve system – permits multiple
deposit creation.
4. Deriving the simple money multiplier.
5. Modifications to money multiplier due to:
 bank behavior
 household behavior
6. Instablility in monetary aggregates – velocity.
7. Recent changes in reserve requirements – implications (article by S.
Weiner, 92).
1
I. Definitions and Accounting
Focus on the money supply – How is this defined?
Money – A Generally Accepted Medium of Exchange
But – What should we use:
Liquidity
Human
Capital
House
Savings
Accounts
Checkable
Deposits
Different Monetary Aggregates that differ in liquidity:
2
Currency
We first look at M1 – want to understand the role of


Banks   Money Supply
Households 
Fed
To understand the Fed’s role, look at simplified Balance Sheet
Assets
U.S. Govt. Securities
Discount Loans
Liabilities
Currency in circulation (C)
Reserves (R)
Reserves – deposits by banks at the Fed and vault cash.
Divide reserves into two categories:
R
RR

required reserves

ER

excess reserves
required reserves – banks must hold a fraction of their deposits as reserves –
required reserve ratio (rrr)
Important Point – required reserves are a tax on bank profits.
1
in deposits. If the interest rate
1  rrr
id
i
on deposits is d , then the cost of loans is
.
1  rrr
To obtain $1 to lend, bank needs $
The liabilities of the Fed are defined as : monetary base (B) = C + R
3
Because of balance sheet – any change in assets implies a corresponding
change in B.
Change in securities – open market operations
or
Discount Loans
4
First examine Open Market Operations – T-accounts.
Bottom line – Fed controls the size of the monetary base, public controls
composition.
Discount Window – Loans are administered by the Fed – borrowing is
discouraged. Again, convenient to divide reserves into two categories:
R
NBR


nonborrowed reserves
BR

borrowed reserves
Bank behavior can determine BR.
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