15 The Money Supply

Process
Learning Objectives
15.1 List and describe Preview
A
the “three players” that s we saw in Chapter 5 and will see in later chapters on monetary theory, move-
influence the money ments in the money supply affect interest rates and inflation and thus affect us
supply. all. Because of its far-reaching effects on economic activity, it is important to
15.2 Classify the factors understand how the money supply is determined. Who controls it? What causes it to
affecting the Federal change? How might control of it be improved? In this chapter, we start to answer these
Reserve’s assets and questions by providing a detailed description of the money supply process, the mecha-
liabilities. nism that determines the level of the money supply.
15.3 Identify the factors Because deposits at banks are by far the largest component of the money supply,
that affect the monetary learning how these deposits are created is the first step in understanding the money
base and discuss their supply process. This chapter provides an overview of how the banking system creates
effects on the Federal deposits and describes the basic principles of the money supply, concepts that will
Reserve’s balance sheet. form the foundation for the material presented in later chapters.
15.4 Explain and
illustrate the deposit
creation process
through T-accounts. 15.1 THREE PLAYERS IN THE MONEY
15.5 List the factors SUPPLY PROCESS
that affect the money
supply. LO 15.1 List and describe the “three players” that influence the money supply.
15.6 Summarize how The “cast of characters” in the money supply story is as follows:
the “three players” can
influence the money 1. The central bank—the government agency that oversees the banking system and is
supply. responsible for the conduct of monetary policy; in the United States, the Federal
15.7 Calculate and Reserve System
interpret changes in the 2. Banks (depository institutions)—the financial intermediaries that accept deposits
money multiplier. from individuals and institutions and make loans: commercial banks, savings and
loan associations, mutual savings banks, and credit unions
3. Depositors—individuals and institutions that hold deposits in banks
Of the three players, the central bank—the Federal Reserve System—is the most
important. The Fed’s conduct of monetary policy involves actions that affect its balance
sheet (holdings of assets and liabilities), to which we turn now.

384

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 CHAPTER 15 The Money Supply Process 385

15.2 THE FED’S BALANCE SHEET

LO 15.2 Classify the factors affecting the Federal Reserve’s assets and liabilities.

The operation of the Fed and its monetary policy involve actions that affect its balance
sheet, or its holdings of assets and liabilities. Here we discuss a simplified balance
sheet that includes just four items that are essential to our understanding of the money
supply process.1

Federal Reserve System

Assets Liabilities
Securities Currency in circulation
Loans to financial Reserves
institutions

Liabilities
The two liabilities on the balance sheet, currency in circulation and reserves, are often
referred to as the monetary liabilities of the Fed. They are an important part of the money
supply story, because increases in either or both will lead to an increase in the money sup-
ply (everything else held constant). The sum of the Fed’s monetary liabilities (currency in
circulation and reserves) and the U.S. Treasury’s monetary liabilities (Treasury currency
in circulation, primarily coins) is called the monetary base (also called high-powered
money). When discussing the monetary base, we will focus only on the monetary liabili-
ties of the Fed, because those of the Treasury account for less than 10% of the base.2
1. Currency in circulation. The Fed issues currency (those green-and-gray pieces of paper
in your wallet that say “Federal Reserve Note” at the top). Currency in circulation is
the amount of currency in the hands of the public. Currency held by depository insti-
tutions is also a liability of the Fed, but is counted as part of the reserves.
Federal Reserve notes are IOUs from the Fed to the bearer and are also liabili-
ties, but unlike most liabilities, they promise to pay back the bearer solely with
Federal Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if
you bring a $100 bill to the Federal Reserve and demand payment, you will receive
two $50s, five $20s, ten $10s, one hundred $1 bills, or some other combination of
bills that adds to $100.
People are more willing to accept IOUs from the Fed than from you or me
because Federal Reserve notes are a recognized medium of exchange; that is, they
are accepted as a means of payment and so function as money. Unfortunately,

1
A detailed discussion of the Fed’s balance sheet and the factors that affect the monetary base can be found in the
first appendix to this chapter found in MyLab Economics.
2
It is also safe to ignore the Treasury’s monetary liabilities when discussing the monetary base because legal restric-
tions prevent the Treasury from actively supplying its monetary liabilities to the economy.

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 386 PART 4 Central Banking and the Conduct of Monetary Policy

neither you nor I can convince people that our IOUs are worth anything more than
the paper they are written on.3
2. Reserves. All banks have an account at the Fed in which they hold deposits.
Reserves consist of deposits at the Fed plus currency that is physically held by
banks (called vault cash because it is stored in bank vaults). Reserves are assets for
the banks but liabilities for the Fed, because the banks can demand payment on
them at any time and the Fed is required to satisfy its obligation by paying Federal
Reserve notes. As you will see, an increase in reserves leads to an increase in the
level of deposits and hence in the money supply.
Total reserves can be divided into two categories: reserves that the Fed requires
banks to hold (required reserves) and any additional reserves the banks choose to
hold (excess reserves). For example, the Fed might require that for every dollar of
deposits at a depository institution, a certain fraction (say, 10 cents) must be held as
reserves. This fraction (10%) is called the required reserve ratio.

Assets
The two assets on the Fed’s balance sheet are important for two reasons. First, changes
in the asset items lead to changes in reserves and the monetary base, and consequently
to changes in the money supply. Second, because these assets (government securities
and Fed loans) earn higher interest rates than the liabilities (currency in circulation,
which pays no interest, and reserves), the Fed makes billions of dollars every year—its
assets earn income, and its liabilities cost practically nothing. Although it returns most
of its earnings to the federal government, the Fed does spend some of it on “worthy
causes,” such as supporting economic research.
1. Securities. This category of assets covers the Fed’s holdings of securities issued by the
U.S. Treasury and, in unusual circumstances (as will be discussed in Chapter 16),
other securities. As we will see, the primary way in which the Fed provides reserves
to the banking system is by purchasing securities, thereby increasing its holdings of
these assets. An increase in government or other securities held by the Fed leads to
an increase in the money supply.
2. Loans to financial institutions. The second way in which the Fed can provide reserves to
the banking system is by making loans to banks and other financial institutions. The
loans taken out by these institutions are referred to as discount loans, or alternatively as
borrowings from the Fed or as borrowed reserves. These loans appear as a liability on finan-
cial institutions’ balance sheets. An increase in loans to financial institutions can also
be the source of an increase in the money supply. During normal times, the Fed makes
loans only to banking institutions, and the interest rate charged to banks for these loans
is called the discount rate. (As we will discuss in Chapter 16, however, during the
2007–2009 financial crisis, the Fed made loans to other financial institutions.)
3
The currency item on our balance sheet refers only to currency in circulation—that is, the amount in the hands
of the public. Currency that has been printed by the U.S. Bureau of Engraving and Printing is not automatically
a liability of the Fed. For example, consider the importance of having $1 million of your own IOUs printed. You
give out $100 worth to other people and keep the other $999,900 in your pocket. The $999,900 of IOUs does not
make you richer or poorer and does not affect your indebtedness. You care only about the $100 of liabilities from
the $100 of circulated IOUs. The same reasoning applies to the Fed in regard to its Federal Reserve notes.
For similar reasons, the currency component of the money supply, no matter how it is defined, includes only
currency in circulation. It does not include any additional currency that is not yet in the hands of the public. The
fact that currency has been printed but is not circulating means that it is not anyone’s asset or liability and thus
cannot affect anyone’s behavior. Therefore, it makes sense not to include it in the money supply.

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 CHAPTER 15 The Money Supply Process 387

15.3 CONTROL OF THE MONETARY BASE

LO 15.3 Identify the factors that affect the monetary base and discuss their effects on
the Federal Reserve’s balance sheet.

The monetary base equals currency in circulation C plus the total reserves in banking
system R.4 The monetary base MB can be expressed as
MB = C + R
The Federal Reserve exercises control over the monetary base through its purchases
or sales of securities in the open market, called open market operations, and through
its extension of discount loans to banks.

Federal Reserve Open Market Operations

The primary way in which the Fed causes changes in the monetary base is through its
open market operations. A purchase of bonds by the Fed is called an open market
purchase, and a sale of bonds by the Fed is called an open market sale. Federal
Reserve purchases and sales of bonds are always done through primary dealers, gov-
ernment securities dealers who operate out of private banking institutions.

Open Market Purchase Suppose the Fed purchases $100 million of bonds
from a primary dealer. To understand the consequences of this transaction, we look at
T-accounts, which list only the changes that occur in balance sheet items, starting from
the initial balance sheet position.
When the primary dealer sells the $100 million of bonds to the Fed, the Fed adds
$100 million to the dealer’s deposit account at the Fed, so that reserves in the banking
system go up by $100 million. The banking system’s T-account after this transaction is

Banking System
Assets Liabilities
Securities - $100 m
Reserves + $100 m

The effects on the Fed’s balance sheet are shown next. The balance sheet shows
an increase of $100 million of securities in its assets column, along with an increase of
$100 million of reserves in its liabilities column:

Federal Reserve System

Assets Liabilities
Securities + $100 m Reserves + $100 m

4
Here, currency in circulation includes both Federal Reserve currency (Federal Reserve notes) and Treasury cur-
rency (primarily coins).

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 388 PART 4 Central Banking and the Conduct of Monetary Policy

As you can see, the Fed’s open market purchase of $100 million causes an expan-
sion of reserves in the banking system by an equal amount. Another way of seeing this
is to recognize that open market purchases of bonds expand reserves because the cen-
tral bank pays for the bonds with reserves. Because the monetary base equals currency
plus reserves, an open market purchase increases the monetary base by an amount
equal to the amount of the purchase.

Open Market Sale Similar reasoning indicates that if the Fed conducts an open
market sale of $100 million of bonds to a primary dealer, the Fed deducts $100 million
from the dealer’s deposit account, so the Fed’s reserves (liabilities) fall by $100 million
(and the monetary base falls by the same amount). The T-account is now

Federal Reserve System

Assets Liabilities
Securities - $100 m Reserves - $100 m

Shifts from Deposits into Currency

Even when the Fed does not conduct open market operations, a shift from deposits to
currency will affect the reserves in the banking system. However, such a shift will have
no effect on the monetary base. This tells us that the Fed has more control over the
monetary base than over reserves.
Let’s suppose that during the Christmas season, the public wants to hold more cur-
rency to buy gifts and so withdraws $100 million in cash. The effect on the T-account
of the nonbank public is

Nonbank Public
Assets Liabilities
Checkable deposits - $100 m
Currency + $100 m

The banking system loses $100 million of deposits and hence $100 million of reserves:

Banking System
Assets Liabilities
Reserves - $100 m Checkable deposits - $100 m

For the Fed, the public’s action means that $100 million of additional currency is
circulating in the hands of the public, while reserves in the banking system have fallen
by $100 million. The Fed’s T-account is

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 CHAPTER 15 The Money Supply Process 389

Federal Reserve System

Assets Liabilities
Currency in circulation + $100 m
Reserves - $100 m

The net effect on the monetary liabilities of the Fed is a wash; the monetary base is
unaffected by the public’s increased desire for cash. But reserves are affected. Random
fluctuations of reserves can occur as a result of random shifts into currency and out of
deposits, and vice versa. The same is not true for the monetary base, making it a more
stable variable and more controllable by the Fed.

Loans to Financial Institutions

In this chapter so far, we have seen how changes in the monetary base occur as a result
of open market operations. However, the monetary base is also affected when the Fed
makes a loan to a financial institution. When the Fed makes a $100 million loan to the
First National Bank, the bank is credited with $100 million of reserves from the pro-
ceeds of the loan. The effects on the balance sheets of the banking system and the Fed
are illustrated by the following T-accounts:

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves + $100 m Loans + $100 m Loans + $100 m Reserves + $100 m
(borrowings (borrowings
from the Fed) from the Fed)

The monetary liabilities of the Fed have now increased by $100 million, and the
monetary base, too, has increased by this amount. However, if a bank pays off a loan
from the Fed, thereby reducing its borrowings from the Fed by $100 million, the
T-accounts of the banking system and the Fed are as follows:

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves - $100 m Loans - $100 m Loans - $100 m Reserves - $100 m
(borrowings (borrowings
from the Fed) from the Fed)

The net effect on the monetary liabilities of the Fed, and hence on the monetary
base, is a reduction of $100 million. We see that the monetary base changes in a one-
to-one ratio with the change in the borrowings from the Fed.

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Other Factors That Affect the Monetary Base

So far in this chapter, it seems as though the Fed has complete control of the monetary
base through its open market operations and loans to financial institutions. However,
the world is a little bit more complicated for the Fed. Two important items that affect
the monetary base, but are not controlled by the Fed, are float and Treasury deposits at
the Fed. When the Fed clears checks for banks, it often credits the amount of the check
to a bank that has deposited it (increases the bank’s reserves) before it 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 mon-
etary base) caused by the Fed’s check-clearing process is called float. When the U.S.
Treasury moves deposits from commercial banks to its account at the Fed, leading to an
increase in Treasury deposits at the Fed, it causes a deposit outflow at these banks such
as that shown in Chapter 9, and thus causes reserves in the banking system and the
monetary base to decrease. Thus float (affected by random events such as the weather,
which influences how quickly checks are presented for payment) and Treasury deposits
at the Fed (determined by the U.S. Treasury’s actions) both affect the monetary base
but are not controlled by the Fed at all. Decisions by the U.S. Treasury to have the Fed
intervene in the foreign exchange market also affect the monetary base.

Overview of the Fed’s Ability to Control the Monetary Base

Our discussion above indicates that two primary features determine the monetary base:
open market operations and lending to financial institutions. Whereas the amount of open
market purchases or sales is completely controlled by the Fed’s placing orders with dealers
in bond markets, the central bank cannot unilaterally determine, and therefore cannot per-
fectly predict, the amount of borrowings from the Fed. The Federal Reserve sets the dis-
count rate (interest rate on loans to banks), and then banks make decisions about whether
to borrow. The amount of lending, though influenced by the Fed’s setting of the discount
rate, is not completely controlled by the Fed; banks’ decisions play a role, too.
Therefore, we might want to split the monetary base into two components: one
that the Fed can control completely and another that is less tightly controlled. The less
tightly controlled component is the amount of the base that is created by loans from the
Fed. The remainder of the base (called the nonborrowed monetary base) is under
the Fed’s control because it results primarily from open market operations.5 The non-
borrowed monetary base is formally defined as the monetary base minus borrowings
from the Fed, which are referred to as borrowed reserves:
MBn = MB - BR
where MBn = nonborrowed monetary base
MB = monetary base
BR = borrowed reserves from the Fed
Factors not controlled at all by the Fed (for example, float and Treasury deposits
with the Fed) undergo substantial short-run variations and can be important sources of
fluctuations in the monetary base over time periods as short as a week. However, these
5
Actually, other items on the Fed’s balance sheet (discussed in the first appendix to Chapter 15 located in MyLab
Economics) affect the magnitude of the nonborrowed monetary base. Because their effects on the nonborrowed
base relative to open market operations are both small and predictable, these other items do not present the Fed
with difficulties in controlling the nonborrowed base.

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 CHAPTER 15 The Money Supply Process 391

fluctuations are usually predictable and so can be offset through open market opera-
tions. Although float and Treasury deposits with the Fed undergo substantial short-
run fluctuations, which complicate control of the monetary base, they do not prevent
the Fed from accurately controlling it.

15.4 MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

LO 15.4 Explain and illustrate the deposit creation process through T-accounts.

With our understanding of how the Federal Reserve controls the monetary base and
how banks operate (Chapter 9), we now have the tools necessary to explain how
deposits are created. When the Fed supplies the banking system with $1 of additional
reserves, deposits increase by a multiple of this amount—a process called multiple
deposit creation.

Deposit Creation: The Single Bank

Suppose the $100 million open market purchase described earlier was conducted with
the First National Bank. After the Fed has bought the $100 million in bonds from the
First National Bank, the bank finds that it has an increase in reserves of $100 million.
To analyze what the bank will do with these additional reserves, assume that the bank
does not want to hold excess reserves because it earns little interest on them. We begin
the analysis with the following T-account:

First National Bank

Assets Liabilities
Securities - $100 m
Reserves + $100 m

Because the bank has no increase in its checkable deposits, required reserves
remain the same, and the bank finds that its additional $100 million of reserves means
that its excess reserves have risen by $100 million. Let’s say the bank decides to make a
loan equal in amount to the $100 million rise in excess reserves. When the bank makes
the loan, it sets up a checking account for the borrower and puts the proceeds of the
loan into this account. In this way, the bank alters its balance sheet by increasing its
liabilities with $100 million of checkable deposits and at the same time increasing its
assets with the $100 million loan. The resulting T-account looks like this:

First National Bank

Assets Liabilities
Securities - $100 m Checkable deposits + $100 m
Reserves + $100 m
Loans + $100 m

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The bank has created checkable deposits by its act of lending. Because checkable
deposits are part of the money supply, the bank’s act of lending has, in fact, created
money.
In its current balance sheet position, the First National Bank still has excess
reserves and so might want to make additional loans. However, these reserves will not
stay at the bank for very long. The borrowers took out loans not to leave $100 million
sitting idle in a checking account at the First National Bank but to purchase goods
and services from other individuals and corporations. When the borrowers make these
purchases by writing checks, the checks will be deposited at other banks, and the $100
million of reserves will leave the First National Bank. As a result, a bank cannot safely
make a loan for an amount greater than the excess reserves that it has before it
makes the loan.
The final T-account of the First National Bank is

First National Bank

Assets Liabilities
Securities - $100 m
Loans + $100 m

The increase in reserves of $100 million has been converted into additional loans
of $100 million at the First National Bank, plus an additional $100 million of deposits
that have made their way to other banks. (All the checks written on accounts at the
First National Bank are deposited in banks rather than converted into cash, because we
are assuming that the public does not want to hold any additional currency.) Now let’s
see what happens to these deposits at the other banks.

Deposit Creation: The Banking System

To simplify the analysis, let’s assume that the $100 million of deposits created by First
National Bank’s loan is deposited at Bank A and that this bank and all other banks hold
no excess reserves. Bank A’s T-account becomes

Bank A
Assets Liabilities
Reserves + $100 m Checkable deposits + $100 m

If the required reserve ratio is 10%, this bank will now find itself with a $10 mil-
lion increase in required reserves, leaving it $90 million of excess reserves. Because
Bank A (like the First National Bank) does not want to hold on to excess reserves, it will
make loans for the entire amount. Its loans and checkable deposits will then increase
by $90 million, but when the borrowers spend the $90 million of checkable deposits,
they and the reserves at Bank A will fall back down by this same amount. The net result
is that Bank A’s T-account will look like this:

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 CHAPTER 15 The Money Supply Process 393

Bank A
Assets Liabilities
Reserves + $10 m Checkable deposits + $100 m
Loans + $90 m

If the money spent by the borrowers to whom Bank A lent the $90 million is
deposited in another bank, such as Bank B, the T-account for Bank B will be

Bank B
Assets Liabilities
Reserves + $90 m Checkable deposits + $90 m

The checkable deposits in the banking system have risen by another $90 million,
for a total increase of $190 million ($100 million at Bank A plus $90 million at Bank
B). In fact, the distinction between Bank A and Bank B is not necessary to obtain the
same result on the overall expansion of deposits. If the borrowers from Bank A write
checks to someone who deposits them at Bank A, the same change in deposits occurs.
The T-accounts for Bank B would just apply to Bank A, and its checkable deposits
would increase by the total amount of $190 million.
Bank B will want to modify its balance sheet further. It must keep 10% of $90 mil-
lion ($9 million) as required reserves and has 90% of $90 million ($81 million) in excess
reserves and so can make loans of this amount. Bank B will make loans totaling $81 mil-
lion to borrowers, who spend the proceeds from the loans. Bank B’s T-account will be

Bank B
Assets Liabilities
Reserves +$ 9 m Checkable deposits + $90 m
Loans + $81 m

The $81 million spent by the borrowers from Bank B will be deposited in another
bank (Bank C). Consequently, from the initial $100 million increase of reserves in
the banking system, the total increase of checkable deposits in the system so far is
$271 million 1 = $100 m + $90 m + $81 m2.
Following the same reasoning, if all banks make loans for the full amount of their
excess reserves, further increments in checkable deposits will continue (at Banks C,
D, E, and so on), as depicted in Table 1. Therefore, the total increase in deposits from
the initial $100 increase in reserves will be $1,000 million: The increase is tenfold, the
reciprocal of the 10% (0.10) reserve requirement.

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TABLE 1 Creation of Deposits (assuming a 10% reserve requirement

and a $100 million increase in reserves)
Increase in Increase in Increase in
Bank Deposits ($) Loans ($) Reserves ($)
First National 0.00 100.00 m 0.00
A 100.00 m 90.00 m 10.00 m
B 90.00 m 81.00 m 9.00 m
C 81.00 m 72.90 m 8.10 m
D 72.90 m 65.61 m 7.29 m
E 65.61 m 59.05 m 6.56 m
F 59.05 m 53.14 m 5.91 m
. . . .
. . . .
. . . .
. . . .
Total for all banks 1,000.00 m 1,000.00 m 100.00 m

If the banks choose to invest their excess reserves in securities, the result is the
same. If Bank A had taken its excess reserves and purchased securities instead of mak-
ing loans, its T-account would have looked like this:

Bank A
Assets Liabilities
Reserves + $10 m Checkable deposits + $100 m
Securities + $90 m

When the bank buys $90 million of securities, it writes $90 million in checks to the
sellers of the securities, who in turn deposit the $90 million at a bank such as Bank B.
Bank B’s checkable deposits increase by $90 million, and the deposit expansion process
is the same as before. Whether a bank chooses to use its excess reserves to make loans
or to purchase securities, the effect on deposit expansion is the same.
You can now see the difference in deposit creation for a single bank versus the bank-
ing system as a whole. Because a single bank can create deposits equal only to the amount
of its excess reserves, it cannot by itself generate multiple deposit expansion. A single
bank cannot make loans greater in amount than its excess reserves, because the bank
will lose these reserves as the deposits created by the loan find their way to other banks.
However, the banking system as a whole can generate a multiple expansion of deposits,
because when a bank loses its excess reserves, these reserves do not leave the banking sys-
tem, even though they are lost to the individual bank. So as each bank makes a loan and
creates deposits, the reserves find their way to another bank, which uses them to make
additional loans and create additional deposits. As you have seen, this process continues
until the initial increase in reserves results in a multiple increase in deposits.

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 CHAPTER 15 The Money Supply Process 395

The multiple increase in deposits generated from an increase in the banking sys-
tem’s reserves is called the simple deposit multiplier.6 In our example, with a 10%
required reserve ratio, the simple deposit multiplier is 10. More generally, the simple
deposit multiplier equals the reciprocal of the required reserve ratio, expressed as a
fraction (for example, 10 = 1>0.10). So the formula for the multiple expansion of
deposits can be written as follows:
1
∆D = * ∆R (1)
rr
where ∆D = change in total checkable deposits in the banking system
rr = required reserve ratio (0.10 in the example)
∆R = change in reserves for the banking system ($100 million in the example)

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creation of deposits can be derived directly using alge-
bra. We obtain the same result for the relationship between a change in deposits and a
change in reserves.
Our assumption that banks do not hold on to any excess reserves means that the
total amount of required reserves in the banking system RR will equal the total reserves
in the banking system R:
RR = R
The total amount of required reserves equals the required reserve ratio rr times the total
amount of checkable deposits D:
RR = rr * D
Substituting rr * D for RR in the first equation,
rr * D = R
and dividing both sides of the preceding equation by rr gives
1
D = * R
rr
Taking the change in both sides of this equation and using delta to indicate a change gives
1
∆D = * ∆R
rr
which is the same formula for deposit creation given in Equation 1.7

6
This multiplier should not be confused with the Keynesian multiplier, which is derived through a similar step-
by-step analysis. That multiplier relates an increase in income to an increase in investment, whereas the simple
deposit multiplier relates an increase in deposits to an increase in reserves.
7
A formal derivation of this formula follows. Using the reasoning in the text, the change in checkable deposits
is $1001 = ∆R * 12 plus $90 3 = ∆R * 11 - rr24 plus $81 3 = ∆R * 11 - rr2 2 4 and so on, which can be
rewritten as
∆D = ∆R * 31 + 11 - rr2 + 11 - rr2 2 + 11 - rr2 3 + g 4
Using the formula for the sum of an infinite series found in footnote 3 of Chapter 4, this equation can be rewritten as
1 1
∆D = ∆R * = * ∆R
1 - 11 - rr2 rr

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This derivation provides us with another way of looking at the multiple creation of
deposits, because it forces us to examine the banking system as a whole rather than one
bank at a time. For the banking system as a whole, deposit creation (or contraction)
will stop only when excess reserves in the banking system are zero; that is, the banking
system will be in equilibrium when the total amount of required reserves equals the
total amount of reserves, as seen in the equation RR = R. When rr * D is substituted
for RR, the resulting equation rr * D = R tells us how high checkable deposits must
be for required reserves to equal total reserves. Accordingly, a given level of reserves
in the banking system determines the level of checkable deposits when the banking
system is in equilibrium (when ER = 0); put another way, the given level of reserves
supports a given level of checkable deposits.
In our example, the required reserve ratio is 10%. If reserves increase by $100 mil-
lion, checkable deposits must rise by $1,000 million for total required reserves also to
increase by $100 million. If the increase in checkable deposits is less than this—say,
$900 million—then the increase in required reserves of $90 million remains below
the $100 million increase in reserves, so excess reserves still exist somewhere in the
banking system. The banks holding the excess reserves will now make additional loans,
thereby creating new deposits; this process will continue until all reserves in the system
are used up, which occurs when checkable deposits rise by $1,000 million.
We can also see this by looking at the resulting T-account of the banking system as
a whole (including the First National Bank):

Banking System
Assets Liabilities
Securities - $ 100 m Checkable deposits + $1,000 m
Reserves + $ 100 m
Loans + $1,000 m

The procedure of eliminating excess reserves by loaning them out continues until
the banking system (First National Bank and Banks A, B, C, D, and so on) has made
$1,000 million of loans and created $1,000 million of deposits. In this way, $100 mil-
lion of reserves supports $1,000 million (ten times the quantity) of deposits.

Critique of the Simple Model

Our model of multiple deposit creation seems to indicate that the Federal Reserve is
able to exercise complete control over the level of checkable deposits by setting the
required reserve ratio and the level of reserves. The actual creation of deposits is much
less mechanical than the simple model indicates. If proceeds from Bank A’s $90 mil-
lion loan are not deposited but are kept in currency, nothing is deposited in Bank B
and the deposit creation process ceases. The total increase in the money supply is now
the $90 million increase in currency plus the initial $100 million of deposits created
by First National Bank’s loans, which were deposited at Bank A, for a total of only
$190 million—considerably less than the $1,000 million we calculated using the sim-
ple model above. In other words, currency does not lead to multiple deposit expansion,
whereas deposits do. Thus, if some proceeds from loans are not deposited in banks but

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 CHAPTER 15 The Money Supply Process 397

instead are used to raise the holdings of currency, less multiple expansion occurs over-
all, and the money supply does not increase by the amount predicted by our simple
model of multiple deposit creation.
Another situation ignored in our model is one in which banks do not make loans
or buy securities in the full amount of their excess reserves. If Bank A decides to hold
on to all $90 million of its excess reserves, no deposits will be made in Bank B, and this
will stop the deposit creation process. The total increase in deposits will be only $100
million, not the $1,000 million increase in our example. Hence, if banks choose to hold
on to all or some of their excess reserves, the full expansion of deposits predicted by the
simple model of multiple deposit creation again does not occur.
Our examples indicate that the Fed is not the only player whose behavior influ-
ences the level of deposits and therefore the money supply. Depositors’ decisions
regarding how much currency to hold and banks’ decisions regarding the amount of
excess reserves to hold also can cause the money supply to change.

15.5 FACTORS THAT DETERMINE THE MONEY SUPPLY

LO 15.5 List the factors that affect the money supply.

Our critique of the simple model shows how we can expand on it to discuss all the fac-
tors that affect the money supply. Let’s look at changes in each factor in turn, holding
all other factors constant.

Changes in the Nonborrowed Monetary Base, MBn

As shown earlier in the chapter, the Fed’s open market purchases increase the nonbor-
rowed monetary base, and its open market sales decrease it. Holding all other variables
constant, an increase in MBn arising from an open market purchase raises the amount of
the monetary base and reserves so that multiple deposit creation occurs and the money
supply increases. Similarly, an open market sale that reduces MBn shrinks the amount
of the monetary base and reserves, thereby causing a multiple contraction of deposits
and a decrease in the money supply. We have the following result: The money supply
is positively related to the nonborrowed monetary base MBn.

Changes in Borrowed Reserves, BR, from the Fed

An increase in loans from the Fed provides additional borrowed reserves and thereby
increases the amount of the monetary base and reserves so that multiple deposit cre-
ation occurs and the money supply expands. If banks reduce the level of their discount
loans, all other variables held constant, the monetary base and amount of reserves fall,
and the money supply decreases. The result is this: The money supply is positively
related to the level of borrowed reserves, BR, from the Fed.

Changes in the Required Reserve Ratio, rr

If the required reserve ratio on checkable deposits increases while all other variables,
such as the monetary base, stay the same, we have seen that multiple deposit expansion
is reduced and hence the money supply falls. If, in contrast, the required reserve ratio
falls, multiple deposit expansion is higher and the money supply rises.

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 398 PART 4 Central Banking and the Conduct of Monetary Policy

We now have the following result: The money supply is negatively related to the
required reserve ratio rr. In the past, the Fed sometimes used reserve requirements
to affect the size of the money supply. In recent years, however, reserve requirements
have become a less important factor in the determination of the money multiplier and
the money supply, as we shall see in the next chapter.

Changes in Excess Reserves

When banks increase their holdings of excess reserves, those reserves are no lon-
ger being used to make loans, causing multiple deposit creation to stop dead in its
tracks, resulting in less expansion of the money supply. If, however, banks choose
to hold fewer excess reserves, loans and multiple deposit creation increase, and
the money supply rises. The money supply is negatively related to the amount of
excess reserves.
Recall from Chapter 9 that the primary benefit to a bank of holding excess
reserves is that they provide insurance against losses due to deposit outflows; that
is, they enable the bank experiencing deposit outflows to escape the costs of calling
in loans, selling securities, borrowing from the Fed or other corporations, or bank
failure. If banks fear that deposit outflows are likely to increase (that is, if expected
deposit outflows increase), they will seek more insurance against this possibility, and
excess reserves will rise.

Changes in Currency Holdings

As shown before, checkable deposits undergo multiple expansion, whereas currency
does not. Hence, when checkable deposits are converted into currency, as long as the
amount of excess reserves is held constant, a switch is made from a component of the
money supply that undergoes multiple expansion to one that does not. The overall
level of multiple expansion declines, and the money supply falls. However, if cur-
rency holdings fall, a switch is made into checkable deposits that undergo multiple
deposit expansion, so the money supply rises. This analysis suggests the following
result: Holding excess reserves constant, the money supply is negatively related to
currency holdings.

15.6 OVERVIEW OF THE MONEY SUPPLY PROCESS

LO 15.6 Summarize how the “three players” can influence the money supply.

We now have a model of the money supply process in which all three of the play-
ers—the Federal Reserve System, depositors, and banks—directly influence the money
supply. As a study aid, Summary Table 1 charts the money supply responses to the five
factors discussed above and gives a brief synopsis of the reasoning behind them.
The variables are grouped by the player who is the primary influence behind the
variable. The Federal Reserve, for example, influences the money supply by controlling
the first two variables. Depositors influence the money supply through their decisions
about holdings of currency, while banks influence the money supply with their deci-
sions about borrowings from the Fed and excess reserves.

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 CHAPTER 15 The Money Supply Process 399

SUMMARY TABLE 1
Money Supply Response
Change in Money Supply
Player Variable Variable Response Reason
Federal Reserve Nonborrowed monetary c c More MB for deposit
System base, MBn creation
Required reserve ratio, rr c T Less multiple deposit
expansion
Banks Borrowed reserves, BR c c More MB for deposit
creation
Excess reserves c T Less loans and deposit
creation
Depositors Currency holdings c T Less multiple deposit
expansion
Note: Only increases (c) in the variables are shown. The effects of decreases on the money supply would be the opposite of those indicated in
the “Money Supply Response” column.

15.7 THE MONEY MULTIPLIER

LO 15.7 Calculate and interpret changes in the money multiplier.

The intuition inherent in the preceding section is sufficient for you to understand
how the money supply process works. For those of you who are more mathemati-
cally inclined, we can derive all of the above results using a concept called the money
multiplier, denoted by m, which tells us how much the money supply changes for a
given change in the monetary base. The relationship between the money supply M, the
money multiplier, and the monetary base is described by the following equation:
M = m * MB (2)
The money multiplier m tells us what multiple of the monetary base is transformed
into the money supply. Because the money multiplier is typically larger than 1, the
alternative name for the monetary base, high-powered money, is logical: A $1 change in
the monetary base typically leads to more than a $1 change in the money supply.

Deriving the Money Multiplier

Let’s assume that the desired holdings of currency C and excess reserves ER grow pro-
portionally with checkable deposits D; in other words, we assume that the ratios of
these items to checkable deposits are constants in equilibrium, as the braces in the fol-
lowing expressions indicate:

c = 5C>D6 = currency ratio

e = 5ER>D6 = excess reserves ratio

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 400 PART 4 Central Banking and the Conduct of Monetary Policy

We will now derive a formula that describes how the currency ratio desired by deposi-
tors, the excess reserves ratio desired by banks, and the required reserve ratio set by the
Fed affect the multiplier m. We begin the derivation of the model of the money supply
with the following equation:
R = RR + ER
which states that the total amount of reserves in the banking system R equals the sum
of required reserves RR and excess reserves ER. (Note that this equation corresponds to
the equilibrium condition RR = R given earlier in the chapter, where excess reserves
were assumed to be zero.)
The total amount of required reserves equals the required reserve ratio rr times the
amount of checkable deposits D:
RR = rr * D
Substituting rr * D for RR in the first equation yields an equation that links reserves in
the banking system to the amount of checkable deposits and excess reserves they can
support:
R = 1rr * D2 + ER
A key point here is that the Fed sets the required reserve ratio rr to less than 1. Thus
$1 of reserves can support more than $1 of deposits, and the multiple expansion of
deposits can occur.
Let’s see how this works in practice. If excess reserves are held at zero 1ER = 02,
the required reserve ratio is set at rr = 0.10, and the level of checkable deposits in the
banking system is $1,600 billion, then the amount of reserves needed to support these
deposits is $160 billion 1 = 0.10 * $1,600 billion2. The $160 billion of reserves can
support ten times this amount in checkable deposits because multiple deposit creation
will occur.
Because the monetary base MB equals currency C plus reserves R, we can gener-
ate an equation that links the amount of the monetary base to the levels of checkable
deposits and currency by adding currency to both sides of the preceding equation:
MB = R + C = 1rr * D2 + ER + C
Notice that this equation reveals the amount of the monetary base needed to support
the existing amounts of checkable deposits, currency, and excess reserves.
To derive the money multiplier formula in terms of the currency ratio c = 5C>D6
and the excess reserves ratio e = 5ER>D6, we rewrite the last equation, specifying C
as c * D and ER as e * D:
MB = 1rr * D2 + 1e * D2 + 1c * D2 = 1rr + e + c2 * D
We next divide both sides of the equation by the term inside the parentheses to get an
expression linking checkable deposits D to the monetary base MB:
1
D = * MB (3)
rr + e + c
Using the M1 definition of the money supply as currency plus checkable deposits
1M = D + C2 and again specifying C as c * D, we get
M = D + 1c * D2 = 11 + c2 * D

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 CHAPTER 15 The Money Supply Process 401

Substituting in this equation the expression for D from Equation 3 yields

1 + c
M = * MB (4)
rr + e + c
We have derived an expression in the form of our earlier Equation 2. As you
can see, the ratio that multiplies MB is the money multiplier, which tells how much
the money supply changes in response to a given change in the monetary base (high-
powered money). The money multiplier m is thus
1 + c
m = (5)
rr + e + c
It is a function of the currency ratio set by depositors c, the excess reserves ratio set by
banks e, and the required reserve ratio set by the Fed rr.

Intuition Behind the Money Multiplier

To get a feel for what the money multiplier means, let’s construct a numerical example
with realistic numbers for the following variables:
rr = required reserve ratio = 0.10
C = currency in circulation = $1,200 billion
D = checkable deposits = $1,600 billion
ER = excess reserves = $2,500 billion
M = money supply 1M12 = C + D = $2,800 billion
From these numbers we can calculate the values for the currency ratio c and the excess
reserves ratio e:

$1,200 billion
c = = 0.75
$1,600 billion
$2,500 billion
e = = 1.56
$1,600 billion
The resulting value of the money multiplier is
1 + 0.75 1.75
m = = = 0.73
0.1 + 1.56 + 0.75 2.41
The money multiplier of 0.73 tells us that, given the required reserve ratio of 10% on
checkable deposits and the behavior of depositors, as represented by c = 0.75, and
banks, as represented by e = 1.56, a $1 increase in the monetary base leads to a $0.73
increase in the money supply (M1).
An important characteristic of the money multiplier is that it is far less than the simple
deposit multiplier of 10 found earlier in the chapter. There are two reasons for this result.
First, although deposits undergo multiple expansion, currency does not. Thus, if some por-
tion of the increase in high-powered money finds its way into currency, this portion does
not undergo multiple deposit expansion. In our simple model earlier in the chapter, we did
not allow for this possibility, and so the increase in reserves led to the maximum amount
of multiple deposit creation. However, in our current model of the money multiplier, the

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 402 PART 4 Central Banking and the Conduct of Monetary Policy

level of currency does rise when the monetary base MB and checkable deposits D increase,
because c is greater than zero. As previously stated, any increase in MB that goes into an
increase in currency is not multiplied, so only part of the increase in MB is available to
support checkable deposits that undergo multiple expansion. The overall level of multiple
deposit expansion must be lower, meaning that the increase in M, given an increase in MB,
is smaller than indicated by the simple model earlier in the chapter.
Second, since e is positive, any increase in the monetary base and deposits leads to
higher excess reserves. When there is an increase in MB and D, the resulting increase
in excess reserves means that the amount of reserves used to support checkable depos-
its does not increase as much as it otherwise would. Hence the increase in checkable
deposits and the money supply are lower, and the money multiplier is smaller.
Prior to 2008, the excess reserves ratio e was almost always very close to zero (less
than 0.001), and so its impact on the money multiplier (Equation 5) was essentially irrel-
evant. When e is close to zero, the money multiplier is always greater than 1, and it was
around 1.6 during that period. However, as we will see in the next chapter, nonconven-
tional monetary policy during the global financial crisis, and again during the coronavirus
pandemic, caused excess reserves to skyrocket to over $2 trillion. Such an extraordinarily
large value of e caused the excess reserves factor in the money multiplier equation to
become dominant, and so the money multiplier fell to below 1, as discussed above.

Money Supply Response to Changes in the Factors

By recognizing that the monetary base is MB = MBn + BR, we can rewrite Equation 2 as
M = m * 1MBn + BR2 (6)
Now we can demonstrate algebraically all the results given in Summary Table 1,
which shows how the money supply responds to the changes in the factors.
As you can see from Equation 6, a rise in MBn or BR raises the money supply M
because the money multiplier m is always greater than zero. We can see that a rise in the
required reserve ratio rr lowers the money supply by calculating the value of the money
multiplier (using Equation 5) in our numerical example when rr increases from 10% to
15% (leaving all other variables unchanged). The money multiplier then becomes
1 + 0.75 1.75
m = = = 0.71
0.15 + 1.56 + 0.75 2.46
which, as we would expect, is less than 0.73.
Similarly, we can see that a rise in excess reserves lowers the money supply by
calculating the money multiplier when e is increased from 1.56 to 3.0. The money mul-
tiplier decreases from 0.73 to
1 + 0.75 1.75
m = = = 0.45
0.1 + 3.00 + 0.75 3.85
We can also analyze what happens in our numerical example when there is a rise
in the currency ratio c from 0.75 to 1.50. In this case, something peculiar happens.
Instead of falling, the money multiplier rises from 0.73 to
1 + 1.50 2.50
m = = = 0.78
0.1 + 1.56 + 1.50 3.20
At first glance, this result might seem counterintuitive. After all, a dollar of mon-
etary base that goes into currency only increases the money supply by one dollar,

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 CHAPTER 15 The Money Supply Process 403

whereas a dollar of monetary base that goes into deposits leads to multiple deposit
expansion that increases the money supply by a factor of 10. Thus it seems as though
the shift from deposits to currency should lower the overall amount of multiple expan-
sion and hence the money supply. This reasoning is correct, but it assumes a small
value of the excess reserves ratio. Indeed, that is the case during normal times, when
the excess reserves ratio is near zero. However, in our current situation, in which the
excess reserves ratio e is abnormally high, when a dollar moves from deposits into cur-
rency, the amount of excess reserves falls by a large amount, which releases reserves to
support more deposits, causing the money multiplier to rise.8

A P P L I C AT I O N Quantitative Easing and the Money Supply

During the Global Financial and the Coronavirus
Crises
When the global financial crisis became virulent in September 2008, the Fed initiated
lending programs and large-scale asset-purchase programs in an attempt to bolster the
economy. By the end of 2014, these lending programs and purchases of securities had
led to a 350% increase in the Fed’s balance sheet and the monetary base. Because these
lending and asset-purchase programs, discussed further in Chapter 16, resulted in a
huge expansion of the monetary base, they have been given the name “quantitative eas-
ing.” As our analysis in this chapter indicates, such a massive expansion of the mon-
etary base could potentially lead to a large expansion of the money supply. However, as
shown in Figure 1, when the monetary base increased by 350%, the M1 money supply
rose by only 100%. How can we explain this result using our money supply model?9
The answer is that despite the huge increase in the monetary base, the money sup-
ply rose by much less because the money multiplier fell by over 50%. To explain this
decline in the money multiplier, let’s look at Figure 2, which shows the currency ratio
c and the excess reserves ratio e for 2007–2020. We see that the currency ratio had a
slight downward trend, which would have raised, not lowered, the money multiplier.
Instead, we have to look to the extraordinary rise in the excess reserves ratio e, which
climbed 30-fold from September 2008 to December 2014.
What explains this substantial increase in the excess reserves ratio e from Septem-
ber 2008 to December 2014? When the Federal Reserve began to pay interest on excess
reserves in October 2008, the interest rate on these reserves was either equal to or
slightly greater than the rate at which the banks could lend them out in the federal

8
All the above results can be derived more generally from the Equation 5 formula for m as follows. When rr or e
increases, the denominator of the money multiplier increases, and therefore the money multiplier must decrease.
As long as rr + e is less than 1 (as is usually the case), an increase in c raises the denominator of the money mul-
tiplier proportionally by more than it raises the numerator. The increase in c causes the money multiplier to fall.
However, when rr + e is greater than 1 (the current situation), an increase in c raises the numerator of the money
multiplier proportionally by more than it raises the denominator, so the money multiplier rises. Recall that the
money multiplier in Equation 5 is for the M1 definition of money. The second appendix to Chapter 15 in MyLab
Economics discusses how the multiplier for M2 is determined. For more background on the currency ratio c, con-
sult the third appendix to this chapter at MyLab Economics.
9
If you would like to see a similar application of the money supply model to what happened to the money supply
during the Great Depression period from 1930 to 1933, go to the fourth appendix to Chapter 15 found in MyLab
Economics.

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 404 PART 4 Central Banking and the Conduct of Monetary Policy

Money Supply
Monetary base
($ billions)

5000

4000

3000

M1
2000

1000 Monetary Base

0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

FIGURE 1 M1 and the Monetary Base, 2007–2020

In percentage terms the money supply rose by substantially less than the monetary base during the two
quantitative easing episodes, the global financial crisis and the coronavirus pandemic.
Source: Federal Reserve Bank of St. Louis FRED database: [Link] [Link]
.[Link]/series/M1SL.

2.00

1.75
Currency ratio (c)
1.50

1.25

1.00

0.75
Excess reserves
0.50 ratio (e)

0.25

0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

FIGURE 2 Excess Reserves and Currency Ratio, 2007–2020

The currency ratio c was relatively steady during this period, whereas the excess reserves ratio e rose
sharply after quantitative easing during the global financial and coronavirus crises.
Source: Federal Reserve Bank of St. Louis FRED database: [Link] [Link]
.[Link]/series/CURRCIR; [Link]

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 CHAPTER 15 The Money Supply Process 405

funds market. Because excess reserves now had an opportunity cost close to zero, when
the Fed’s actions created far more reserves than were needed for banks to meet their
reserve requirements, banks were willing to hold any amount of these excess reserves.
Therefore, the increase in reserves from quantitative easing led to a large increase in the
excess reserves ratio e. As predicted by our money supply model, the huge increase in
e sharply lowered the money multiplier, and so the money supply did not undergo that
large an expansion from August 2008 to December 2014, despite the huge increase in
the monetary base.
When the coronavirus pandemic struck in March 2020, the Federal Reserve again
engaged in massive quantitative easing programs to prevent a collapse of the economy.
The effects on the monetary base and the money supply displayed a similar pattern to
that which occurred when the global financial crisis struck. From February 2020 to June
2020, the monetary base increased by 45%, while the money supply only increased by
a much smaller 29%. Just as in the aftermath of the global financial crisis, the increase
in excess reserves led to the excess reserves ratio rising sharply: From February 2020
to June 2020, the excess reserves ratio climbed by 33%. As predicted by our money
supply model, this increase in e led to a decline in the money multiplier, so the increase
in the monetary base again did not lead to as large an increase in the money supply. ◆

SUMMARY
1. The three players in the money supply process are deposit creation, in which banks do not hold on to
the central bank, banks (depository institutions), and excess reserves and the public holds no currency, the
depositors. multiple increase in checkable deposits (simple deposit
2. Four items in the Fed’s balance sheet are essential to multiplier) equals the reciprocal of the required reserve
our understanding of the money supply process: the ratio.
two liability items, currency in circulation and reserves, 5. The simple model of multiple deposit creation has seri-
which together make up the monetary base; and the ous deficiencies. Decisions by depositors to increase
two asset items, securities and loans to financial institu- their holdings of currency or by banks to hold excess
tions. reserves will result in a smaller expansion of deposits
3. The Federal Reserve controls the monetary base than is predicted by the simple model. All three play-
through open market operations and extensions of ers—the Fed, banks, and depositors—are important in
loans to financial institutions and has better control the determination of the money supply.
over the monetary base than over reserves. Although 6. The money supply is positively related to the nonbor-
float and Treasury deposits with the Fed undergo sub- rowed monetary base MBn, which is determined by
stantial short-run fluctuations, which complicate con- open market operations, and the level of borrowed
trol of the monetary base, they do not prevent the Fed reserves (lending) from the Fed, BR. The money sup-
from accurately controlling it. ply is negatively related to the required reserve ratio,
4. A single bank can make loans up to the amount of its rr, and excess reserves. The money supply is also
excess reserves, thereby creating an equal amount of negatively related to holdings of currency but only
deposits. The banking system can create a multiple if excess reserves do not vary much when there is a
expansion of deposits, because as each bank makes a shift between deposits and currency. The model of the
loan and creates deposits, the reserves find their way to money supply process takes into account the behavior
another bank, which uses them to make loans and cre- of all three players in the money supply process: the
ate additional deposits. In the simple model of multiple Fed through open market operations and setting of the

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 406 PART 4 Central Banking and the Conduct of Monetary Policy

required reserve ratio; banks through their decisions 7. The monetary base is linked to the money supply using
to borrow from the Federal Reserve and hold excess the concept of the money multiplier, which tells us
reserves; and depositors through their decisions about how much the money supply changes when the mon-
the holding of currency. etary base changes.

KEY TERMS
borrowed reserves, p. 390 monetary base, p. 385 open market sale, p. 387
discount rate, p. 386 money multiplier, p. 399 primary dealers, p. 387
excess reserves, p. 386 multiple deposit creation, p. 391 required reserve ratio, p. 386
float, p. 390 nonborrowed monetary base, p. 390 required reserves, p. 386
high-powered money, p. 385 open market operations, p. 387 reserves, p. 386
open market purchase, p. 387 simple deposit multiplier, p. 395

QUESTIONS
Unless otherwise noted, the following assumptions are made in all 5. If a bank sells $10 million of bonds to the Fed to pay
questions: The required reserve ratio on checkable deposits is 10%, back $10 million on the loan it owes, what is the effect
banks do not hold any excess reserves, and the public’s holdings of on the level of checkable deposits?
currency do not change. 6. If you decide to hold $100 less cash than usual and
1. Classify each of these transactions as an asset, a liability, therefore deposit $100 more cash in the bank, what
or neither for each of the “players” in the money supply effect will this have on checkable deposits in the bank-
process—the Federal Reserve, banks, and depositors. ing system if the rest of the public keeps its holdings of
a. You get a $10,000 loan from the bank to buy an currency constant?
automobile. 7. “The Fed can perfectly control the amount of reserves
b. You deposit $400 into your checking account at the in the system.” Is this statement true, false, or uncer-
local bank. tain? Explain.
c. The Fed provides an emergency loan to a bank for 8. “The Fed can perfectly control the amount of the mon-
$1,000,000. etary base, but has less control over the composition
d. A bank borrows $500,000 in overnight loans from of the monetary base.” Is this statement true, false, or
another bank. uncertain? Explain.
e. You use your debit card to purchase a meal at a res- 9. The Fed buys $100 million of bonds from the public
taurant for $100. and also lowers the required reserve ratio. What will
happen to the money supply?
2. The First National Bank receives an extra $100 of
reserves but decides not to lend out any of these 10. Describe how each of the following can affect the money
reserves. How much deposit creation takes place for the supply: (a) the central bank; (b) banks; and (c) depositors.
entire banking system? 11. “The money multiplier is necessarily greater than 1.”
3. Suppose the Fed buys $1 million of bonds from the Is this statement true, false, or uncertain? Explain your
First National Bank. If the First National Bank and all answer.
other banks use the resulting increase in reserves to 12. What effect might a financial panic have on the money
purchase securities only and not to make loans, what multiplier and the money supply? Why?
will happen to checkable deposits? 13. During the Great Depression years from 1930 to 1933,
4. If a bank depositor withdraws $1,000 of currency from both the currency ratio c and the excess reserves ratio e
an account, what happens to reserves, checkable depos- rose dramatically. What effect did these factors have on
its, and the monetary base? the money multiplier?

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 CHAPTER 15 The Money Supply Process 407

14. In October 2008, the Federal Reserve began pay- 15. The money multiplier declined significantly during
ing interest on the amount of excess reserves held by the period 1930–1933 and also during the recent
banks. How, if at all, might this affect the multiplier financial crisis of 2008–2010. Yet the M1 money sup-
process and the money supply? ply decreased by 25% in the Depression period but
increased by more than 20% during the recent financial
crisis. What explains the difference in outcomes?

APPLIED PROBLEMS
Unless otherwise noted, the following assumptions are made in all 23. Suppose the central bank of your country increases
of the applied problems: The required reserve ratio on checkable reserves by purchasing $1 million with of bonds from
deposits is 10%, banks do not hold any excess reserves, and the banks and that the banking system in your economy is
public’s holdings of currency do not change. in equilibrium. The reserve requirement is 10%. What
16. If the Fed sells $2 million of bonds to the First National will happen to the level of checkable deposits? Use
Bank, what happens to reserves and the monetary base? T-accounts to explain your answer.
Use T-accounts to explain your answer. 24. If the Fed sells $1 million of bonds and banks reduce
17. For the following operations, what happens to the their borrowings from the Fed by $1 million, predict
central bank’s and commercial bank’s reserves and what will happen to the money supply.
the monetary base? Use T-account to show changes in 25. Suppose that the required reserve ratio is 9%, currency
balances. Assume that the amount is $10 million. in circulation is $620 billion, the amount of check-
a. Central bank provides loan to commercial bank. able deposits is $950 billion, and excess reserves are
b. Central bank sells securities to commercial bank. $15 billion.
c. Commercial Bank repays the loan to Central Bank. a. Calculate the money supply, the currency deposit
ratio, the excess reserve ratio, and the money
18. If the Fed lends five banks a total of $100 million but
multiplier.
depositors withdraw $50 million and hold it as currency,
what happens to reserves and the monetary base? Use b. Suppose the central bank conducts an unusually
T-accounts to explain your answer. large open market purchase of bonds held by banks
of $1,300 billion due to a sharp contraction in the
19. Using T-accounts, show what happens to checkable
economy. Assuming the ratios you calculated in
deposits in the banking system when the Fed lends
part (a) remain the same, predict the effect on the
$1 million to the First National Bank.
money supply.
20. Using T-accounts, show what happens to checkable c. Suppose the central bank conducts the same open
deposits in the banking system when the Fed sells market purchase as in part (b), except that banks
$2 million of bonds to the First National Bank. choose to hold all of these proceeds as excess
21. If the Fed buys $1 million of bonds from the First reserves rather than loan them out, due to fear of a
National Bank, but an additional 10% of any financial crisis. Assuming that currency and deposits
deposit is held as excess reserves, what is the total remain the same, what happens to the amount of
increase in checkable deposits? (Hint: Use T-accounts excess reserves, the excess reserve ratio, the money
to show what happens at each step of the multiple supply, and the money multiplier?
expansion process.) d. Following the financial crisis in 2008, the Federal
22. If reserves in the banking system increase by $1 billion Reserve began injecting the banking system with
because the Fed lends $1 billion to financial institu- massive amounts of liquidity, and at the same
tions, and checkable deposits increase by $9 billion, time, very little lending occurred. As a result,
why isn’t the banking system in equilibrium? What will the M1 money multiplier was below 1 for most
continue to happen in the banking system until equi- of the time from October 2008 through 2011.
librium is reached? Show the T-account for the banking How does this scenario relate to your answer
system in equilibrium. to part (c)?

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 408 PART 4 Central Banking and the Conduct of Monetary Policy

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyLab Economics 2. Real-time Data Analysis Go to the St. Louis Federal
and are available for practice or instructor assignment. Reserve FRED database, and find data on the M1 Money
Stock (M1SL) and the Monetary Base (BOGMBASE).
1. Real-time Data Analysis Go to the St. Louis Federal a. Calculate the value of the money multiplier
Reserve FRED database, and find the most current data using the most recent data available and the
available on Currency (CURRNS), Total Checkable data from five years prior.
Deposits (TCDNS), and Excess Reserves (EXCSRESNS). b. Based on your answer to part (a), how
a. Calculate the value of the currency much would a $100 million open market
deposit ratio c. purchase of securities affect the M1 money
b. Calculate the value of the excess reserve supply today and five years ago?
ratio, e.
c. Assuming a required reserve ratio rr of
11%, calculate the value of the money
multiplier m.

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