ECONOMICS 100B Professor Steven Wood
10/18/11 Lecture 16
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LECTURE: ICLICKER QUESTIONS/ANSWERS: 1.) The Fed can reduce the money supply by reducing: the monetary base. 2.) The money supply would shrink by the greatest amount if the public increased their currency holding ratio and the banks increased their excess reserve ratio. 3.) If the Fed wanted to increase the money supply without using open market operations, it could try to get the public to decrease their currency holding ratio and decrease banks’ reserve requirements. 4.) Changes in reserve requirements directly and immediately affect: the money multiplier. 5.) If banks decided to increase their holdings of excess reserves, none of the above. MONEY SUPPLY PROCESS: The money supply process is based on changes in the Fed’s balance sheet, which consists of assets and liabilities. The Fed’s assets include government securities, which are acquired through open market operations, and discount loans to depository institutions (banks). Discount loans consist of banks’ borrowings from the Fed. The rate at which
banks borrow from the Fed is known as the discount rate. On the other hand, the Fed’s liabilities include currency in circulation, which is held by the nonbank public, and reserves, which consist of bank reserves deposited at the Fed and banks’ vault cash. Whenever banks borrow from the Fed, the Fed’s assets increase. Whenever banks make deposits at the Fed, the Fed’s liabilities increase, because it must pay back the banks whenever demanded. There are two types of reserves: 1.) Required reserves: the minimum amount of reserves banks must legally hold against their deposits. This is determined by the required reserve ratio, rr, which is set by the Fed. 2.) Excess reserves: extra reserves that banks decide to hold over their required reserves. Excess reserves generally don’t earn very much money, so banks typically will minimize the amount of excess reserves they hold.
The Fed “creates” money when it acquires real assets from the public, or when the liabilities it issues are either currency in circulation or reserves in the banking system. These liabilities are known as the monetary base (the base on which the money supply is built), or high-powered money. Thus, the Monetary Base (MB) equals: currency in circulation
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(C) plus reserves in the banking system (R): MB = C+R The Fed primarily changes MB through open market operations. Recall that open market operations are when the Fed either buys or sells government securities in the open market. Open market purchases increase MB, while open market sales decrease MB. Suppose the Fed buys $100 government bonds (securities). We can see that the Fed gains $100 in assets, but also increases its liabilities by $100. Thus, the Fed’s assets and liabilities increase by the same amount.
As a result of the nonbank public’s action, the banking system’s reserves and deposits decrease by $100 each. Thus, banks’ assets and liabilities decrease by the same amount.
For the Fed, the change results in an increase of currency in circulation by $100, as well as a decrease in reserves of $100, since households moved their deposits (reserves) into currency. This means that the Fed’s mix of liabilities changes, but overall liabilities remains the same. Overall, although reserves fall, MB does not fall. Now suppose banks borrow $100 from the Fed. Banks now have $100 more...
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