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Samenvatting - Advanced money, credit and banking
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  • Vak
  • Advanced money, credit and banking
  • Instelling
  • Erasmus Universiteit Rotterdam (EUR)

Full summary of all lectures, chapters and articles of the course Advanced money, credit and banking of the master "Financial economics", which is one of the eight master specialisation within the master Economics and Business

Voorbeeld 4 van de 43  pagina's

Document informatie

  • 13 oktober 2024
  • 43
  • 2024/2025
  • Samenvatting

Onderwerpen

  • finance
  • financial economics
  • economics and business
  • erasmus
  • advanced
  • advanced money
  • credit
  • banking
  • money

Geschreven voor

  • Erasmus Universiteit Rotterdam (EUR)
  • Financial economics
  • Advanced money, credit and banking
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Voorbeeld van de inhoud

Weeks 1 & 2
Mishkin Chapter 15: The money supply process
Movements in the money supply affect interest rates and inflation and thus affect us all.
Because of its far-reaching effects on economic activity, it is important to understand how the
money supply is determined. Who controls it? What causes it to change? In this chapter, we
start to answer these questions by providing a detailed description of the money supply
process, the mechanism that determines the level of the money supply. Because deposits
at banks are by far the largest component of the money supply, learning how these deposits
are created is the first step in understanding the money supply process.

The “cast of characters” in the money supply story is as follows:
1. The central bank—the government agency that oversees the banking system and is
responsible for the conduct of monetary policy; in the United States, the Federal
Reserve System
2. Banks (depository institutions)—the financial intermediaries that accept deposits
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.

The Fed’s balance sheet
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.

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 supply
(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, which are primarily coins) is called the monetary base. When discussing the
monetary base, we will focus only on the monetary liabilities of the Fed, because those of
the Treasury account for less than 10% of the base.
- 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 institutions is also a liability of the Fed, but is counted as part of the
reserves.
- 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).

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.
Both assets are used to provide reserves to the banking system.
- Securities. This category of assets covers the Fed’s holdings of securities issued by
the U.S. Treasury and, in unusual circumstances, 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.
- 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. These loans appear as a liability on financial 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.

Control of the monetary base
The monetary base equals currency in circulation (C) plus the total reserves (R) in the
banking system (= total liabilities). The monetary base MB can be expressed as:
𝑀𝐵 = 𝐶 + 𝑅
The Federal Reserve exercises control over the monetary base (1) through its purchases or
sales of securities in the open market, called open market operations, and (2) 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 (securities) 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, government
securities dealers who operate out of private banking institutions.

Open market sale:
Suppose the Fed purchases $100 million of bonds from a primary dealer. 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:
The effects on the Fed’s balance sheet are shown below. 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:
As you can see, the Fed’s open market purchase of $100 million
causes an expansion 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 central 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:

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 currency to buy gifts and so
withdraws $100 million in cash. The effect on the T-account of the
nonbank public is:

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

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:
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 proceeds of the loan. The effects on the balance sheets

, of the banking system and the Fed are illustrated by the following T-accounts:

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 Fed’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 monetary 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 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.

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. The amount of open market
purchases or sales is completely controlled by the Fed’s placing orders with dealers in bond
markets. The Federal Reserve sets the discount 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. The
nonborrowed monetary base is formally defined as the monetary base minus borrowings
from the Fed, which are referred to as borrowed reserves:
𝑀𝐵𝑛 = 𝑀𝐵 − 𝐵𝑅
- 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 fluctuations are
usually predictable and so can be offset through open market operations. So, the Fed is
basically accurately controlling it.

Multiple creation: a simple model
With our understanding of how the Federal Reserve controls the monetary base, we now
have the tools necessary to explain how deposits are created. When the Fed supplies the

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