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Banking and the Money
Supply
CHAPTER
29
© 2003 South-Western/Thomson Learning
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Definitions of the Money Supply
M1
Money supply narrowly defined
Currency, including coins, held by nonbanking
public
Checkable deposits
• Deposits against which checks can be written
• Demand deposits do not earn any interest
• Other types of accounts, NOW, that carry check
writing privileges but earn interest
• Are liabilities of issuing banks which stand ready to
convert them into currency
• Are not legal tender
Travelers checks
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Circulating Currency
Primary currency circulating in the U.S.
consists of Federal Reserve notes
Issued by and are liabilities of the Federal
Reserve Banks
Redeemable for nothing other than Federal
Reserve notes  fiat money
U.S. coins are token money because
their metal value is less than their face
value
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M2 Money Supply
Includes M1, plus
Savings deposits
• earn interest but have no specific maturity date
savings deposits
Small-denomination time deposits
• also called certificates of deposit, or CDs, earn a
fixed rate of interest if held for the specified
period with premature withdrawals penalized by
loss of interest
Money market mutual funds
• carry additional restrictions
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Other Money Supply Definitions
M3 includes
M2 plus large-denomination time deposits
Less liquid than other two definitions
Exhibit 1 presents the size and relative
importance of each of the money
aggregates previously defined
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Exhibit 1: The Money Supply
7,800.4
September 2001
M3
Large
denomination
time deposits
M2
5,378.5
M1
Money market
deposit accounts
Money market
deposit accounts
Savings deposits
Savings deposits
Small
denomination
time deposits
Small
denomination
time deposits
Miscellaneous
near-moneys
Miscellaneous
near-moneys
1,178.4
Checkable deposits
Travelers checks
Checkable deposits
Travelers checks
Checkable deposits
Travelers checks
567.6
Currency
Currency
Currency
Based on monthly estimates from the Federal Reserve Board
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Financial Intermediaries
Banks serve as financial intermediaries,
or as go-betweens by bringing together
the two sides of the money market
Banks reduce the transaction costs of
channeling savings to credit worthy
borrowers
Coping with Asymmetric Information
Reducing risk through diversification
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Asymmetric Information
As lenders, banks try to identify
borrowers who are willing to pay
interest and are able to repay the loans
However, borrowers have more reliable
information about their own credit
history and financial plans than do
lenders  in the market for loans there
is asymmetric information  an
inequality in what’s known by each
party to the transaction
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Asymmetric Information
This asymmetry would not create a
problem if borrowers could be trusted
to report relevant details to lenders
Because they have experience in
evaluating applicants, banks have a
greater ability to cope with asymmetric
information and in drawing up and
enforcing contracts than would an
individual saver  savers are better off
dealing with banks
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Reducing Risk
By developing a diversified portfolio of
assets rather than lending funds to a
single borrower, banks reduce the risk
to each individual saver
A bank, in effect, lends a tiny fraction of
each saver’s deposits to each of its
many borrowers
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Starting a Bank
To obtain a charter, or the right to
operate, they must apply to the state
banking authority (state bank) or to the
U.S. Comptroller of the Currency
(national bank)
The founders invest $500,000 for shares
which become the owner’s equity or the
net worth of the bank
Part of this goes to the FED to buy
shares in their district bank  $450,000
left
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Exhibit 2: Home Bank’s Balance Sheet
Assets
Liabilities and Net Worth
Building and furniture $ 450,000
Net worth
$500,000
Total
$500,000
Stock in district Fed
Total
50,000
$500,000
Balance sheet shows a balance between the two sides of the bank’s
accounts. The left side lists the bank’s assets (any physical property or
financial claim owned by the bank) and the right side lists the bank’s
liabilities (an amount the bank owes) and their net worth
The balance sheet reflects the basic equality that Assets = Liabilities + Net
Worth
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Exhibit 3: Home Bank’s Balance Sheet
after $1,000,000 Deposit
Assets
Cash
Liabilities and Net Worth
$1,000,000
Building and furniture $450,000
Stock in district Fed
Total
Checkable deposits $1,000,000
Net worth
$500,000
50,000
$1,500,000
Total
$1,500,000
Now suppose a customer deposits $1,000,000 into a new checking account. In accepting
this, the bank promises to repay the depositor that amount  it is a liability to the bank
This deposit increases the bank’s assets and liabilities by $1,000,000
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Reserve Accounts
Recall that banks are required by the
FED to set aside, or to hold in reserve a
percentage of their checkable deposits
The dollar amount that must be held in
reserve is called required reserves
Checkable deposits multiplied by the
required reserve ratio
The required reserve ratio dictates the
minimum proportion of deposits the
bank must hold in reserve
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Reserve Accounts
The current reserve requirement is 10%
on checkable deposits
These required reserves are held either
as cash in the bank’s vault or as
deposits at the FED, but neither earns
the bank any interest
In our example, Home Bank must
therefore hold $100,000 as reserves
($1,000,000 * .10)
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Reserve Accounts
If Home Bank deposits their required
reserves with the FED, they now have
$900,000 in excess reserves held as
cash in the vault
Excess reserves have two additional
uses
They can be used to make loans, or
To purchase interest-bearing assets, such as
government bonds
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Liquidity versus Profitability
Required reserves are not meant to be
used to meet depositor requests for
funds  therefore banks often hold some
excess reserves or other assets that can
be easily converted to cash to satisfy any
unexpected demand for funds
Banks management must structure the
portfolio of assets with an eye towards
Liquidity
Profitability
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Liquidity
Liquidity is the ease with which an asset
can be converted into cash without a
significant loss of value
The most liquid asset is bank reserves,
either in the bank’s vault as cash or on
account with the FED, but reserves earn
no interest
Complete liquidity would mean holding
all its assets as cash reserves  no
difficulty meeting depositors’ demands
for funds
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Liquidity versus Profitability
However, since it holds no interestearning assets, it earns no income  no
profits
At the other extreme, if the bank uses all
its excess reserves to acquire highyielding but illiquid assets, it will run into
problems whenever withdrawals exceed
new deposits
Tradeoff between liquidity and
profitability
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Reserves
Since reserves earn no interest, banks
usually try to keep excess reserves to a
minimum
The federal funds market provides for
day-to-day lending and borrowing
among banks of excess reserves on
account at the FED
The interest rate paid on these loans is
called the federal funds rate, and it is
this rate that the FED targets as a tool
of monetary policy
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Creation of Money
Excess reserves are the raw material
the banking system employs to support
the creation of money
We will concentrate on commercial
banks because they are the largest and
most important depository institutions,
although thrifts carry out similar
functions
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Exhibit 4: Changes in Home Bank’s Balance
Sheet After Home Bank Lends You $1,000
Suppose Home Bank has already used its $900,000 in excess reserves to make loans
and buy government bonds and has no excess reserves left. Further, let’s assume there
are no excess reserves in the banking system.
Assets
Reserves At Fed
Liabilities and Net Worth
+ 1,000
Checkable deposits
+ 1,000
To start the money creation process, suppose the Fed buys a $1,000 U.S. government
bond from a securities dealer, with the transaction handled by Home Bank. The Fed
pays the dealer by crediting Home Bank’s reserve account with $1,000, so Home
Bank can increase the dealer’s checking account by $1,000.
Where did the Fed get these reserves? It makes them up – creates them out of thin
air. The securities dealer has exchanged one asset, a U.S. bond, for another asset,
checkable deposit. Since a U.S. bond is not money but checkable deposits are, the
money supply increases by $1,000 in this first round. Exhibit 4 shows the changes in
Home Bank’s balance sheet as a result of the Fed’s bond purchase.
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Exhibit 5: Changes in Home Bank’s Balance
Sheet After the Bank Makes a $900 Loan
Assets
Loans
Liabilities and Net Worth
+ 900
Checkable deposits
+ 900
Home Bank must set aside 10% of the initial deposit as required reserves  they
now have $900 in excess reserves.
Suppose you as one of Home Bank’s customers apply for a $900 loan which is
approved and the bank increases your checking account by $900. Home Bank has
converted your promise to repay, your IOU, into a $900 checkable deposit  this
action increases the money supply by $900.
The money supply has increased by a total of $1,900 to this point – the $1,000
increase in the securities dealer’s checkable deposit and now the $900 increase in
your checkable deposits.
Home Bank’s loans increase by $900 on the assets side because your IOU
becomes the bank’s asset and the liability side has increased by the same amount
because of the checkable deposit  Home Bank has created $900 in checkable
deposits based on your promise to repay your loan.
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Check Clearing
When you spend the $900, your college
promptly deposits the check into its
checking account at Merchant’s Trust
This increases the college account by $900
and sends your check to the Fed which
transfers $900 in reserves from Home
Bank’s account to Merchants Trust’s
account and then sends the check to Home
Bank, which reduces your checkable
deposits by $900
The Fed has thereby cleared your check by
setting the claim of Merchants Trust
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Exhibit 6: Change in Merchants Trust’s
Balance Sheet After an $810 Loan
Assets
Loans
Liabilities and Net Worth
+
810
Checkable deposits
+
810
Merchants Trust now has $900 more in reserves on deposit with the Fed. After
setting aside $90 in required reserves, it now has $810 in excess reserves.
Suppose they now loan this money to someone else as shown in Exhibit 6. At this point
checkable deposits in the banking system, and the money supply in the economy have
increased by a total of $2,710 ( = $1,000 + $900 + $810), all engendered by the Fed’s
original $1,000 bond purchase.
When the $810 is spent and deposited the check in an account at Fidelity Bank, Fidelity
credits the depositor’s account with $810 and sets the check to the Fed for clearance.
Fed reduces Merchants Trust reserves by $810 and increases Fidelity’s by the same
amount.
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Round Three and Beyond
Notice the pattern of deposits and loans
Each time a bank gets a fresh deposit, 10%
goes to required reserves
The rest becomes excess reserves, which
fuel new loans or other asset acquisitions
An individual bank can lend no more
than its excess reserves
When the borrower spends the amount
loaned, reserves at one bank usually
fall, but total reserves in the banking
system do not
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Round Three and Beyond
The recipient bank uses most of the new
deposit to extend more loans  more
checkable deposits
The potential expansion of checkable
deposits in the banking system equals
some multiple of the initial increase in
reserves
The example just discussed makes
certain assumptions to be noted later
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Exhibit 7: Summary
During each round, the increase in checkable deposits (1) minus the increase in
required reserves (2) equals the potential increase in loans (3). Checkable deposits
in this example can potentially increase by as much as $10,000.
Bank
Increase inRequired
Checkable Deposits
(1)
1. College Bank
Increase in
Increase in
Reserves
(2)
Loans
(3) = (1)–(2)
$ 1,000
$ 100
$ 900
2. Merchants Trust
900
90
810
3. Fidelity Bank
810
81
729
7,290
729
6,561
$10,000
$1,000
$9,000
All remaining rounds
Total
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Reserve Requirements and Money
Expansion
The multiple by which the money supply
increases as a result of an increase in the
banking system’s reserves is called the
money multiplier
The simple money multiplier equals the
reciprocal of the required reserve ratio, or
1 / r, where r is the reserve ratio
In our example the reserve ratio was
10% or 0.1  the simple money
multiplier equals 10
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Checkable Deposits / Money Supply
The formula for the multiple expansion of
checkable deposits can be written as
Change in checkable deposits (or the
money supply) = Change in reserves x 1/r
Thus, for our example, the initial deposit
of $1,000 increase in fresh reserves by the
Fed could support up to $10,000 in new
checkable deposits or the money supply
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Money Multiplier
The higher the reserve requirement, the
greater the fraction of deposits that must
be held as reserves  the smaller the
money multiplier
Reserve requirement of 20%  money
multiplier of 5
Reserve requirement of 5%  money
multiplier of 20
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Limitations on Money Expansion
Various leakages from the multiple
expansion process reduce the size of the
money multiplier. That is, we assumed
that
Banks do not let excess reserves sit idle reasonable since the profit incentive will
generally lead banks to minimize the amount of
excess reserves idle
Borrowers do something with the money seems likely, since people would not borrow
unless they had a use for funds
People do not choose to increase their cash
holdings - in fact, some amount of this may be
held as cash, which reduces the money
multiplier
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Contraction of the Money Supply
In our example, we focused on the
process whereby money was created
The process would work in reverse if the
Fed reduced bank reserves, thereby
reducing the money supply
The Fed’s sale of government bonds
reduces bank reserves, forcing banks to
recall loans or to somehow replenish
reserves and the same multiple
contraction would work
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Contraction of the Money Supply
For example, with a reserve
requirement of 10%, a $1,000 sale of
bonds would reduce the checkable
deposits and the money supply by a
maximum of $10,000
The process of reducing checkable
deposits or the money supply would be
the same as illustrated in the expansion
illustration
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Tools for Controlling Reserves
The Fed has three tools for controlling
reserves hence checkable deposits 
money supply
Conducting open market operations 
buying and selling of U.S. government
bonds
Setting the discount rate, the interest rate
the Fed charges for loans it makes to banks
Setting the required reserve ratio, which is
the minimum fraction of reserves that banks
must hold against deposits
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Open Market Operations
Open market operations refers to the
buying and selling of U.S. government
bonds in the open market
To increase the money supply, the Fed buys
U.S. bonds  open-market purchase
To reduce the money supply, the Fed sells
U.S. bonds  open-market sale
Advantage of open-market operations
Relatively easy to carry out
Require no change in laws or regulations
Can be executed in any amount
For these reasons, this is the tool of choice
by the Fed
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Federal Funds Market
Through open-market operations, the
Fed influences bank reserves and the
federal funds rate
Recall that the federal funds rate is the
interest rate banks charge one another
for borrowing excess reserves at the
Fed, typically overnight
Banks that are unable to meet their
legal reserve requirements can borrow
in the federal funds market
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Federal Funds Market
The federal funds rate serves as a good
indicator of the tightness of monetary
policy
For example, suppose the Fed buys
bonds in the open market and thereby
increases reserves in the banking
system  banks have more excess
reserves  demand for excess reserves
falls while the supply increases  the
federal funds rate declines
38
Discount Rate
Discount rate is the interest rate the Fed
charges on loans it makes to banks
Banks can borrow from the Fed when
they need reserves to satisfy their
reserve requirements
By lowering or raising the discount rate,
the Fed encourages or discourages
banks from borrowing, which alters
reserves and affects the money supply
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Discount Rate
A lower discount rate reduces the cost
of borrowing, encouraging banks to
borrow reserves from the Fed  more
bank lending  increase in the money
supply
Higher discount rate increases the cost
of borrowing reserves from the Fed 
less bank lending  reduced money
supply
40
Discount Rate
Since there is no guarantee that banks
will necessarily borrow more even if the
discount rate is reduced
That is, if business prospects look poor
and if banks view lending as risky, then
even a lower discount rate may not
entice banks to borrow from the Fed
As a result, the Fed uses the discount
rate more as a signal to financial
markets about its monetary policy than
as a tool for changing the money supply
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Reserve Requirements
Reserve requirements are the
regulations regarding the minimum
amount of reserves that banks must
hold to back up deposits  they
influence how much money the banking
system can create with each dollar of
fresh reserves
If the Fed increases the reserve
requirement, banks must hold more
reserves  a reduction in the fraction of
each dollar that can be lent out 
reduces the banking system’s ability to
create money
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Reserve Requirements
Conversely, a decrease in the reserve
requirement increases the fraction of
each dollar on deposit that can be lent
out  which increases the banking
system’s ability to create money
Reserve requirements can be changed
by a simple majority vote by the Board
of Governors
However, since even a small change in
the reserve requirement can be
disruptive, the Fed seldom employs this
tool
43