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Chapter 18
The Fed, Depository
Institutions, and the
Money Supply Process
©2000 South-Western College Publishing
Open market operations
The buying and selling of
government securities by
the Fed
2
Effect of Open Market
Operations on Reserves
•When the Fed buys securities,
reserves of depository institutions
RISE
•When the Fed sells securities,
reserves of depository institutions fall
3
The Money Supply Process
Credit
Availability
Open Market Reserves Lending
Operations
Money
Supply
Deposit
Creation
Interest
Rates
Exhibit 18 - 1
4
Effect of Open Market
Operations on Reserves
Fed
Assets
(1) + $1,000 securities
purchased from the
public
Exhibit 18 - 2
Liabilities
(3) + $1,000 deposit
due HLT
5
Effect of Open Market
Operations on Reserves
Public
Assets
Liabilities
(1) - $1,000 securities
sold to the Fed
public
(2) + $1,000 deposits
in the form of checks
received from Fed and
deposited in HLT
6
Exhibit 18 - 2 cont.
Effect of Open Market
Operations on Reserves
HLT National Bank
Assets
Liabilities
(3) + $1,000 reserves (2) + $1,000 deposit
in the form of deposits by the public
by the Fed
Exhibit 18 - 2 cont.
7
Effect of Discount Loans on
Monetary Base
Fed
Assets
+ $1,000 discount loans
Exhibit 18 - 3
Liabilities
+ $1,000 deposits
due HLT
8
Effect of Discount Loans on
Monetary Base
HLT National Bank
Assets
Liabilities
+ $1,000 reserves
Exhibit 18 - 3 cont.
+ $1,000 discount loans
9
Factors that Affect the Reserves of
Depository Institutions
Factors that
increase reserves
Open Market Purchases
Increases in discount loans
Factors that
decrease reserves
Open Market Sales
Decrease in discount loans
Exhibit 18 - 4
10
Offsetting Open Market
Operations
Open market purchases or
sales to offset changes in the
monetary base from other
factors
11
Federal Reserve Float
The excess in reserves that
results from a check being
credited to one bank (or other
depository institution) before it
is debited from another
12
Total Reserves
Required reserves plus
excess reserves
Required Reserves
The amount of reserve assets
that the Fed requires a
depository institution to hold
13
Excess Reserves
Reserves over and above
those required by the Fed
14
Loan and Deposit Expansion at
HLT National Bank
Assets
Liabilities
Total reserves $1,000 Checkable deposits $1,000
Assets
Liabilities
Required reserves $100 Checkable deposits $1,000
Excess reserves $900 New checkable
Loan
$900 deposits
$900
Total
$1,900 Total
$1,900
Exhibit 18 - 5
15
What is loaned up?
When a bank has no excess
reserves left to serve as a basis
for lending
16
Transactions between HLT
National and Second National Bank
HLT National Bank
Assets
Total Reserves
$100
Loan
$900
Total $1,000
Exhibit 18 - 6
Liabilities
Checkable Deposits
$1,000
$1,000
17
Transactions between HLT
National and Second National Bank
Second National Bank
Assets
Total Reserves
$900
Total
Exhibit 18 - 6 cont.
$900
Liabilities
Checkable Deposits
$900
$900
18
Transactions of Second National
and Third National Bank
Second National Bank
Assets
Total Reserves
$90
Loans
$810
Total
$900
Exhibit 18 - 7
Liabilities
Checkable Deposits
$900
$900
19
Transactions of Second National
and Third National Bank
Third National Bank
Assets
Total Reserves
$810
Total
Exhibit 18 -7 cont.
$810
Liabilities
Checkable Deposits
$810
$810
20
Required Reserve Ratio
( rD )
The fraction of deposits that
depository institutions are
required to hold as required
reserve assets
21
Simple Money Multiplier
The reciprocal of the required
reserve ration, I/rD
22
RR = Required Reserve Assets
rD = Required Reserve Ratio
D = Deposit Liabilities
ER = Excess Reserves TR = Total Reserves
(18-1) RR = rD  D
(18-2) ER = TR  RR
(18-3) TR = RR = rD  D
(18-4) D = TR / rD (or) D = 1 / rD  TR
(18-5) L = D = 1 / rD  TR
23
Fractional Reserve
Banking System
A banking system in which
individual banks hold reserve
assets equal to a fraction of
deposit liabilities
24
The Required Reserve Ratio and
the Simple Money Multiplier
rD
.05
.10
.20
.25
.50
Exhibit 18 - 8
Simple Money Multiplier
1 / .05 = 20
1 / .10 = 10
1 / .20 = 5
1 / .25 = 4
1 / .50 = 2
25
Checkable
Deposits
$620.3
$44.9
+
+
Currency in the
Public’s hands*
$470.4
$470.4*
Reserves + Currency
in the
Public’s
hands*
= M1
= $1,090.7
= $487.3
= Monetary Base
26
* Travelers’ Checks included
Exhibit 18 -9
Monetary Base
Reserves plus currency in
the hands of the public,
denoted as MB
27
Money Multiplier
The multiple of the change
in the monetary base by
which the money supply
will change
28
Factors that Affect the Money Multiplier
An Increase in ...
c (the desired
ratio of currency
to checkable
deposits)
Caused by ...
The decision by the
public to increase their
holdings of currency
relative to deposits
The decision by the
e (the ratio of
depository institutions to
excess reserves
held to checkable hold more excess reserves
deposits)
rD (the required
reserve ratio)
Exhibit 18 -12
Results in ...
A decrease in the
money multiplier
and a decrease in
the money supply
The decision by the Fed
to increase the required
reserve ratio
29
Factors that Affect the Money Multiplier
A Decrease in ...
c (the desired
ratio of currency
to checkable
deposits)
Caused by ...
Results in ...
The decision by the public
to decrease their holdings
of currency relative to
deposits
The decision by the
e (the ratio of
depository institutions to
excess reserves
held to checkable hold fewer excess reserves
deposits)
rD (the required
reserve ratio)
An increase in
the money
multiplier and a
increase in the
money supply
The decision by the Fed to
decrease the required
reserve ratio
30
Exhibit 18 -12 cont.
Major Assets of the Fed*
1. Gold and SDRs Certificate Accounts
and other Assets in Foreign Currencies
2. Loans
3. Securities
4. Floats
*See Figure 18-13 for detailed list.
31
Repurchase Agreement
An arrangement whereby the
New York Fed agrees to buy
securities from the securities
dealers with whom it does
business regularly and the
dealers agree to repurchase the
securities on a specific day in the
near future
32
Reverse Repurchase
Agreement
An arrangement whereby the
New York Fed agrees to sell
securities with dealers with
whom it regularly does
business and the Fed agrees to
repurchase the securities on a
specific day in the near future
33
Major Liabilities of the Fed
1. Federal Reserve Notes
2. Bank Deposits
34