Principles of Money Supply Determination

Explain how the nation's money supply is determined.

How is the nation's money supply determined? So far we have assumed that the money supply, M, is controlled directly by the central bank.

Most generally, three groups affect the money supply: the central bank, depos­itory institutions, and the public.

1. In nearly all countries the central bank is the government institution respon­sible for monetary policy.^[252] Examples of central banks are the Federal Reserve System in the United States, the European Central Bank, and the Bank of Japan.

2. Depository institutions are privately owned banks and thrift institutions (such as savings and loan associations) that accept deposits from and make loans directly to the public. We refer to depository institutions as banks, for short.

3. The public includes every person or firm (except banks) that holds money, either as currency and coin or as deposits in banks—in other words, virtually the whole private economy outside the banking system.

Let's consider a simplified example of the U.S. economy, where the currency is dollars and the central bank is the Federal Reserve (the "Fed," for short), though our discussion in this section is more general and could apply to almost any cur­rency and any central bank.

Suppose the Fed's balance sheet looks like this:

Federal Reserve Bank

On the left side of the balance sheet are the Fed's assets—what it owns or is owed.

Next, consider the balance sheets of banks in the private sector. We will com­bine all the banks together. Suppose their consolidated balance sheet looks like this:

Consolidated Balance Sheet of Banks

The banks' assets consist of vault cash of $100 (the same $100 that appears as a liability on the Fed's balance sheet), reserve deposits of $200 (the same $200 that appears as a liability on the Fed's balance sheet), plus loans of $2700 that banks have extended to the nonbank public.

Liquid assets held by banks to meet the demands for withdrawals by deposi­tors or to pay the checks drawn on depositors' accounts are called bank reserves. Bank reserves comprise currency held by banks in their vaults and deposits held by banks at the Fed, so bank reserves in this example total $300 ($100 of vault cash plus $200 of reserve deposits). Until 2008, banks in the United States did not earn any interest on their reserves: Currency held as vault cash, of course, does not earn interest, and the Fed did not pay interest on reserve deposits that banks held at the Fed. But in October 2008, the Fed began to pay interest on reserves, as we discuss in more detail in Section 14.2. When banks have creditworthy customers seeking to borrow money from them, they can generally earn more income by lending some of their assets to these borrowers rather than holding all of their assets as reserves. Because banks lend out some of their deposits, the reserves held by a bank equal only a fraction of its outstanding deposits. In our example, the reserve-deposit ratio, or reserves divided by deposits, equals 10% because reserves equal $300 and deposits equal $3000. A banking system in which the reserve-deposit ratio is less than 1 is called fractional reserve banking. The alternative to fractional reserve banking is 100% reserve banking, in which bank reserves equal 100% of deposits. Under 100% reserve banking, banks are nothing more than a safekeeping service for the public's currency. If the central bank pays zero or very low interest on reserve deposits, the only way that banks could cover their expenses and make a profit under 100% reserve banking would be to charge depositors a fee for holding their money for them (that is, to pay negative interest on deposits).

Open-Market Transactions

Suppose the Fed wanted to increase the amount of money in the economy. It could do so by buying securities from private investors in the bond market. For exam­ple, suppose that the Fed buys $100 of securities from an investor who has a bank account at Barclays Bank. The Fed receives $100 in securities from the investor and pays for these securities by increasing Barclays Bank's deposit account at the Fed by $100. Barclays Bank then increases the investor's account balance at Barclays

Bank by $100. As a result of this transaction, the securities on the left side of the Fed's balance sheet increase by $100 to $1000 and banks' reserve deposits on the right side of the Fed's balance sheet increase by $100 to $300. On the asset side of the consolidated balance sheet of banks, reserve deposits rise by $100, and on the liabilities side, deposits rise by $100 to capture the additional $100 in the inves­tor's deposit account. After all of these transactions, the Fed's and the banks' bal­ance sheets are as follows:

Federal Reserve Bank

Consolidated Balance Sheet of Banks

As the bankers examine their balance sheets, they note that their reserves (vault cash plus reserve deposits) are $400, whereas their deposits equal $3100.

Suppose that Barclays Bank lends $90 to Anne, who uses the loan to buy some goods from Paul. Paul then deposits the $90 in his bank. (We are assuming at this point that Paul wants to hold all the additional funds as bank deposits.) The $90 loan to Anne will increase the loans on the banks' balance sheet by $90 to $2790, and when Paul deposits the $90 in his bank, the banks' deposits increase by $90 to $3190. (The reserves of the banking system are not changed, as the $90 is essen­tially transferred from Anne's bank to Paul's bank.) At this point the consolidated balance sheet of all the banks is:

Consolidated Balance Sheet of Banks

The process doesn't stop here. Looking at their balance sheets after this latest round of loans and deposits, the bankers find that their reserves ($400) still exceed 10% of their deposits, or 0.10 ? $3190 = $319. So yet another round of loans and deposits of loaned funds will occur.

This process of multiple expansion of loans and deposits, in which fractional reserve banking increases an economy's loans and deposits, will stop only when the reserves of the banking system equal 10% of its deposits. The reserves of the banks always equal $400 at the end of each round,^[253] so the process will stop when total bank deposits equal $400/0.10, or $4000.

Consolidated Balance Sheet of Banks

At this final stage, the ratio of reserves to deposits equals the ratio desired by banks (10%). No further expansion of loans and deposits will occur after this point.

Notice that the purchase of $100 in securities by the Fed led to additional deposits in the banking system of $1000 and additional loans of $900. Recall (Chapter 7) that a purchase of assets by the central bank is called an open-market purchase.^[254] It increases the monetary base and thus the money supply. A sale of assets to the public by the central bank is called an open-market sale. It reduces the monetary base and the money supply. Open-market purchases and sales col­lectively are called open-market operations. Open-market operations are the most direct way for central banks to change their national money supplies.

Bank Runs

Fractional reserve banking works on the assumption that outflows and inflows of reserves will roughly balance, and in particular that a large fraction of a bank's depositors will never want to withdraw their funds at the same time. If a large number of depositors attempt to withdraw currency simultaneously (more than 10% of the bank's deposits in the example shown earlier in the section "Open Market Transactions"), the bank will run out of reserves and be unable to meet all its depositors' demands for cash.

Historically in the United States, there have been episodes in which rumors circulated that a particular bank had made some bad loans and was at risk of becoming bankrupt. On the principle of "better safe than sorry," the bank's depos­itors lined up to withdraw their money. From the depositors' perspective, with­drawal avoided the risk that the bank would fail and not be able to pay off depositors in full. A large-scale, panicky withdrawal of deposits from a bank is called a bank run. Even if the rumors about the bank's loans proved untrue, a large enough run could exhaust the bank's reserves and force it to close.^[255]

To prevent future bank runs from occurring, the Federal Deposit Insurance Corporation (FDIC) was established in 1933 to provide deposit insurance. Deposit insurance guarantees that depositors will not lose the money they hold in an insured bank account (up to some limit) even if the bank were to go bankrupt. As

a result, depositors would have no incentive to start a bank run. The FDIC obtains the funds needed to provide such insurance by charging an insurance premium to banks. Further, the Federal government effectively stands behind the FDIC, so that if in a crisis the FDIC fund were to become exhausted, the government would provide any funds needed to prevent losses to depositors on insured deposits, as it did in the late 1980s and early 1990s. As a result of deposit insurance, when the financial crisis hit in 2008,5 people poured money into banks, where their money was insured, instead of out of banks, as occurred during the Great Depression.

14.2