Department of Economics
Saint Louis University
Professor: Rapach
Fall 2008
ECON 420
Money and Banking

Chapter Outline for “Chapter 13—Multiple Deposit Creation and the Money Supply Process,” Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, Eighth Edition (New York, N.Y.: Addison-Wesley, 2006)

FOUR PLAYERS IN THE MONEY SUPPLY PROCESS

1.      Central bank

2.      Banks (depository institutions)

3.      Depositors

4.      Borrowers

THE FED’S BALANCE SHEET

Liabilities

monetary base: sum of the Fed’s monetary liabilities (currency in circulation and reserves) and the U.S. Treasury’s monetary liabilities (Treasury currency in circulation, primarily coins)

1.      Currency in circulation: amount of currency in the hands of the public

2.      Reserves: deposits at the Fed plus currency that is physically held by banks (vault cash)

required reserves: reserves that the Fed requires banks to hold

excess reserves: any additional reserves the banks choose to hold

required reserve ratio: fraction of deposits that must be held as reserves

Assets

1.      Government securities: Fed’s holding of securities issued by the U.S. Treasury

2.      Discount loans: loans made my the Fed to the banking system

discount rate: interest rate charged banks for discount loans

CONTROL OF THE MONETARY BASE

MB = C + R

open market operations: purchases or sales of government securities in the open market by the Fed

Federal Reserve Open Market Operations

open market purchase: purchase of bonds by the Fed

open market sale: sale of bonds by the Fed

Open Market Purchases from a Bank

Open Market Purchase from the Nonbank Public

The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits.

The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the proceeds in deposits or in currency.

Open Market Sale

Shifts from Deposits into Currency

Discount Loans

Other Factors That Affect the Monetary Base

Overview of the Fed’s Ability to Control the Monetary Base

Although float and Treasury deposits with the Fed undergo substantial short-run fluctuations, which complicate control of the monetary base, they do not prevent the Fed from accurately controlling it.

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

Deposit Creation: The Single Bank

Deposit Creation: The Banking System

See Table 1

Whether a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on deposit expansion is the same

simple deposit multiplier: multiple increase in deposits generated from an increase in the banking system’s reserves

DD = (1/r) x DR

RR = R (ER = 0)

RR = r x D

r x D = R

D = (1/r) x R

Critique of the Simple Model

Questions and Problems: 1, 4, 6, 8, 10, 12