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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