MS PROCESS - the mechanism that determines the money supply, the implementation of monetary policy.  It is important to understand the MS Process to understand exactly how open market operations (OMOs) change the money supply, and thereby affect the economy (int. rates, inflation, output, employment, dollar, etc.).  The majority (60-70%) of money (M1) is in what form? ___________________  Therefore, we want to understand how the banking system creates ___________ , and in the process, creates money.

FOUR PLAYERS IN THE MS PROCESS:
1. FRB (central bank) - most important player since they ultimately control the supply of money in the economy.
2. Commercial banks (depository institutions that accept deposits and make loans).
3. Depositors - bank customers (individuals, companies and institutions holding bank deposits - checking and savings accounts).
4. Borrowers from banks - individuals and companies who borrow money from banks.
 

FED'S BALANCE SHEET AND THE MONETARY BASE:

Monetary policy works by affecting the FRS's balance sheet, see page 392.

Assets of FRS - Almost 90% of assets are Treasury securities, almost $500B worth!!  Where did the Fed get all those Treasury bills, bonds, notes???

Liabilities of FRS - Two main liabilities of FRS are:

1.  Currency in Circulation (C), cash in the hands of the public, outside the banking system, currently about $528B.  Currency is really like a Govt. Bond, Fed Reserve Note, but pays 0 interest.  It is a liability of the issuing agency, because a $100 bill could be redeemed for 5 twenties or 10 tens, etc.  Or if it is worn out, banks can redeem it for a new $100 bill.  A Fed Reserve Note is an IOU that can be paid off with other IOUs.

2. Bank Reserves (R), which are in the form of either: a) commercial bank deposits at a FRB, or b) vault cash at commercial banks, both of which are used to meet reserve requirements established by FOMC.  Bank Reserves are currently about $15.5B.  Reserves are a liability of the Fed, an asset for commercial banks.

Total Reserves (R) = Required Reserves (RR, mandatory by FOMC) + Excess Reserves (ER, banks voluntary holdings of excess reserves).

Required reserves (RR) are equal to D (deposits) x required reserve ratio (r_D), which is set by FOMC:   RR = r_D  x  D

These two liabilities of the FRS are called the MONETARY BASE (MB) = Currency in circulation + Bank reserves.  Also called High-powered Money, or M0. High-powered because an increase in the MB leads to a multiple increase in the MS (M1 or M2).

MB = C (currency in hands of public) + R (reserves of banking system).

FRS directly controls the monetary base by increasing or decreasing Treasury securities and thereby increasing or decreasing bank reserves and/or currency.  If they purchase a Tbill for $100, it increases Assets by $100 and Liabilities by $100.  By increasing bank reserves by $100, the MS is increased.  Exactly How and by how much?
 

CONTROL OF THE MONETARY BASE (MB)

OMOs always affect MB, one to one. A $100 OMO always increases MB by $100 (OMO = dMB, where d = change).  However, whether the OMO increases R or C (dMB = dR + dC) depends on the public's willingness to hold cash, which depends on MD.

Also, when the Fed increases the monetary base (MB) by supplying the banking system with $1 of additional reserves, deposits (D) and M1 increase by a multiple greater than 1, a process called multiple deposit creation.

When the Fed wants to increase the MS, it engages in an open market purchase of Treasury securities from the public and adds TBills to its portfolio.  For contractionary (restrictive) policy, it engages in an open market sale of Treasury securities from its $500B portfolio to the public.

Illustration of Open Market Operations, 3 Scenarios:

1. Fed buys TBond from Bank.  OMO - Fed implements expansionary monetary policy and purchases $100 Tbond from Bank A.  Bank A gives Fed a $100 TBond, Fed writes a check to Bank A for $100.  When the check clears at the Fed, the Fed increase the Bank's reserves by $100.  See T-accounts on pages 396-397 for Bank and FRS.

Bank A has exchanged $100 Treasury security for $100 Reserves, page 396.  Fed has a new $100 Tbond, an increase in Assets, and bank reserves (liab. for FRS) also increase by $100.  (OMO = $100 = dR = dMB).

2. Fed buys a TBond from the non bank public, and the person makes a bank deposit.  A person gives the $100 TBond to the Fed in exchange for a $100 check issued by the FRS, and the person deposits the check from FRS into a bank, and the net effect on the economy is exactly the same, see page 397.
(OMO = $100 = dR = dMB and dC = 0)

3. Fed Buys $100 TBond from public, and they cash the check for $100 in currency.  In that case (page 398), the investor has exchanged a $100 security (TBond) for $100 in cash.  The FRS has increased its assets by $100 (new TBond) and increased its liabilities by $100 (increased currency in circulation).   The bank has given out $100 in vault cash to the person who cashed the FRS check (R = -$100), but get an increase in reserves (R=+$100) from the FRS check, for their account at the Fed.  Bank reserves remain unaffected, net effect is 0 for bank reserves (R).  In this case: OMO = $100 = dC = dMB, the dR = 0.
 
 

Summary:

1. The effect of an expansionary OMO depends on whether the seller a) deposits the FRS check in a checking account or b) cashes the FRS check for currency.

2. If seller of TBonds cashes the check from FRB, OMO has no effect on Reserves (dR = 0), only affects currency (OMO = dC).  Currency increases by amount of OMO.

3. If seller deposits check from FRB, reserves increase by amount of OMO (OMO = dR).  No change in Currency (dC = 0).

4. The effect on the MB is ALWAYS the same, equal to OMO (OMO = dMB).

5. The effect of OMO on MB is certain, the effect of OMO on Reserves (R) and currency (C) is NOT.

6. The effect of an OMO on M1 is uncertain, depends on how much of the OMO stays inside the banking system as R, how much is outside the banking system as C.
 

MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

Assume that FRS conducts OMO of $100, buys TBond from an investor, investor deposits $100 into his/her bank.  Deposits (D) increase by $100 and Reserves (R) increase by $100 when check clears from Bank A to FRS.

Assume that the Required Reserve Ratio (r_D) on Deposits (D) is 10%.

Bank A has $100 of new deposits, so it is required to hold $10 as Required Reserves (RR).  Bank A makes a loan for _______, increases deposits by $90 for borrower's account.  Assume customer buys a car and check gets cashed at Bank B.  As check clears, bank reserves decrease by $90 at Bank A, leaving it with $10 Reserves, $90 loan and $100 D.  Bank A fully loaned out and is now satisfied.

T Accounts - Bank A:
 
 
 
 

Bank B now has $90 of reserves, $90 of D.  It only needs $9 of reserves (RR), lends out the additional $81.  Creates a new loan of $81 and a new deposit (D) of $81 for loan customer.  When check clears, it ends up with R=$9, L=$81 and DD=$90.

T Accounts Bank B:
 
 
 
 

This process keeps going - additional loans result in banks having excess reserves, which get loaned out and become excess reserves at the next bank.  If 1) all banks are fully loaned out, no excess reserves (ER) and 2) nobody holds any additional cash (C), the total increase in Deposits (D) and the MS (M) is $1000.

T-Account for ALL BANKS:
 
 
 
 
 
 

See page 405.  A $100 OMO turned into $1000 of new deposits (D) and new M1 (M = C + D), and therefore the simple deposit multiplier (SDM) is 10x.

      SDM  =    1        =    1       =  10x
                         r_{D                 .10}
 

SDM is equal to 10x, which means that for every $1 OMO (dMB = dR), deposits (D) will increase by $10, there is a 10x deposit multiplier effect.  And because M = C + D, the money supply will increase by the amount of the increase in deposits, $10.

Note: If a bank decides to use its excess reserves to buy a Tbill, the result is the same. Assume that Bank A bought a $90 Tbill instead of making a $90 loan. The process would be the same because the bank would write a check for $90, which would get deposited at another bank, Bank B, and increases Bank B's reserves by $90. Whether excess reserves are used for making loans or buying securities, the deposit expansion is the same.
 

The simple deposit multiplier (SDM) process is:

        dD =      1       x  dR
                         r_D

where dD = change in checkable bank deposits (D)
          r_D = required reserve ratio
         dR = change in Reserves (R)
 

Our simple multiple deposit creation process depends on two factors to get the full potential deposit expansion of the SDM on D and M, e.g. 10X:

1. Banks hold NO excess reserves (ER)
2. No additional cash (C) is held by the public

Anywhere along the process, somebody could take part or all of the loan in cash (C), which would mean that the ultimate effect on D and M would LESS THAN the SDM (10x).   SDM really show the potential MAXIMUM effect that an OMO can have on deposits (D) and the money supply (M).  In reality, because a) banks hold some excess reserves and b) because people do demand currency, the actual effect on D and M never reaches the SDM effect.

POINT: Fed directly controls the MB, but can't directly control M1.  M1 is influenced by public's behavior (cash demand) and bank's behavior (holding excess reserves).

Two extreme cases:

1. First person in OMO process cashes the check from FRS.  Net result: $100 OMO increases C by $100 and increases M1 by $100.  No multiplier effect at all, but the OMO is expansionary, increases M1 on a one-to-one basis ($100 OMO = dC = $100 = dM).

2. No additional cash is demanded at any stage of the process.  Then the full potential deposit multiplier effect occurs (SDM), as long as all the deposits stay in the banking system.

The actual effect of an OMO on M would lie between the two extreme cases above (between 1 and SDM).  In the example above, that would mean between 1 (all cash) and 10x (no cash).

Note: if r_D is lowered (raised), M1 goes up (down).  For expansionary monetary policy, lower reserve requirement.  For contractionary monetary policy, raise reserve requirement.

Example:  If r_D is lowered from .10 to .05, the SDM increases to 1 / .05 or 20x (from the previous 10x).  Banks now have excess reserves, they start making loans, which creates additional deposits (D), which increases the money supply (M).  If r_D is raised from .10 to .20, the SDM decreases to 1 / .20 or 5x (from the previous 10x).  Banks now don't have enough reserves, they need to start selling or reducing loans and securities, which decreases deposits (D), which decreases the money supply (M).

POINT: Reserve requirements are not used very often for monetary policy, they are typically set and left in place for years at a time.