382 P A R T I V |
Central Banking and the Conduct of Monetary Policy |
base) is under the FedÕs control, because it results primarily from open market operations.5 The nonborrowed monetary base is formally defined as the monetary base minus discount loans from the Fed:
|
MBn MB DL |
where |
MBn nonborrowed monetary base |
|
MB monetary base |
|
DL discount loans from the Fed |
The reason for distinguishing the nonborrowed monetary base MBn from the monetary base MB is that the nonborrowed monetary base, which is tied to open market operations, is directly under the control of the Fed, whereas the monetary base, which is also influenced by discount loans from the Fed, is not.
To complete the money supply model, we use MB MBn DL and rewrite the money supply model as:
|
M m (MBn DL) |
(5) |
|
where the money multiplier m is defined as in Equation 4. Thus in addition to the |
|
effects on the money supply of the required reserve ratio, currency ratio, and excess |
|
reserves ratio, the expanded model stipulates that the money supply is also affected |
|
by changes in MBn and DL. Because the money multiplier is positive, Equation 5 |
|
immediately tells us that the money supply is positively related to both the nonbor- |
|
rowed monetary base and discount loans. However, it is still worth developing the |
|
intuition for these results. |
|
Changes in the |
As shown in Chapter 15, the FedÕs open market purchases increase the nonborrowed |
Nonborrowed |
monetary base, and its open market sales decrease it. Holding all other variables con- |
Monetary Base |
stant, an increase in MBn arising from an open market purchase increases the amount |
MBn |
of the monetary base that is available to support currency and deposits, so the money |
supply will increase. Similarly, an open market sale that decreases MBn shrinks the amount of the monetary base available to support currency and deposits, thereby causing the money supply to decrease.
We have the following result: The money supply is positively related to the nonborrowed monetary base MBn.
Changes in
Discount
Loans DL from the Fed
With the nonborrowed monetary base MBn unchanged, more discount loans from the Fed provide additional reserves (and hence higher MB) to the banking system, and these are used to support more currency and deposits. As a result, the increase in DL will lead to a rise in the money supply. If banks reduce the level of their discount loans, with all other variables held constant, the amount of MB available to support currency and deposits will decline, causing the money supply to decline.
5Actually, there are other items on the FedÕs balance sheet (discussed in the appendix on the web site) that affect the magnitude of the nonborrowed monetary base. Since their effects on the nonborrowed base relative to open market operations are both small and predictable, these other items do not present the Fed with difficulties in controlling the nonborrowed base.
C H A P T E R 1 6 Determinants of the Money Supply 383
The result is this: The money supply is positively related to the level of discount loans DL from the Fed. However, because the Federal Reserve now (since January 2003) keeps the interest rate on discount loans (the discount rate) above market interest rates at which banks can borrow from each other, banks usually have little incentive to take out discount loans. Discount lending, DL, is thus very small except under exceptional circumstances that will be discussed in the next chapter.
Overview of the Money Supply Process
We now have a model of the money supply process in which all four of the playersÑ the Federal Reserve System, depositors, banks, and borrowers from banksÑdirectly influence the money supply. As a study aid, Table 1 charts the money supply (M1) response to the six variables discussed and gives a brief synopsis of the reasoning behind each result.
Study Guide |
To improve your understanding of the money supply process, slowly work through |
|
|
the logic behind the results in Table 1 rather than just memorizing the results. Then |
|
|
see if you can construct your own table in which all the variables decrease rather than |
|
|
increase. |
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|
|
|
S U M M A R Y
|
|
Change in |
Money Supply |
|
|
Player |
Variable |
Variable |
Response |
|
Reason |
Federal Reserve |
r |
↑ |
↓ |
Less multiple deposit |
System |
|
|
|
|
expansion |
|
MBn |
↑ |
↑ |
More MB to support |
|
|
|
|
|
D and C |
|
DL |
↑ |
↑ |
More MB to support |
|
|
|
|
|
D and C |
Depositors |
c |
↑ |
↓ |
Less multiple deposit |
|
|
|
|
|
expansion |
Depositors |
Expected |
↑ |
↓ |
e ↑ |
so fewer reserves |
and banks |
deposit outflows |
|
|
|
to support D |
Borrowers from |
i |
↑ |
↑ |
e ↓ |
so more reserves |
banks and the |
|
|
|
|
to support D |
other three players
Note: Only increases ( ↑ ) in the variables are shown. The effects of decreases on the money supply would be the opposite of those indicated in the ÒMoney Supply ResponseÓ column.
C H A P T E R 1 6 Determinants of the Money Supply 385
M1 Money |
|
Supply |
|
($ billions) |
|
1200 |
|
1100 |
|
1000 |
M1 |
900 |
|
800 |
2.3% |
|
700 |
11.1% |
|
600 |
3.3% |
500 |
13.1% |
|
400
7.2%
300
0 
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2005
F I G U R E 2 Money Supply (M1), 1980–2002
Percentage for each bracket indicates the annual growth rate of the money supply over the bracketed period.
Source: Federal Reserve: www.federalreserve.gov/releases.
that have a major impact on the growth rate of the money supply. The currency ratio c, which is also plotted in Figure 3, explains most of these movements in the money multiplier.
From January 1980 until October 1984, c is relatively constant. Unsurprisingly, there is almost no trend in the money multiplier m, so the growth rates of the money supply and the nonborrowed monetary base have similar magnitudes. The upward movement in the money multiplier from October 1984 to January 1987 is explained by the downward trend in the currency ratio. The decline in c meant that there was a shift from one component of the money supply with less multiple expansion (currency) to one with more (checkable deposits), so the money multiplier rose. In the period from January 1987 to April 1991, c underwent a substantial rise. As our money supply model predicts, the rise in c led to a fall in the money multiplier, because there was a shift from checkable deposits, with more multiple expansion, to currency, which had less. From April 1991 to December 1993, c fell somewhat. The decline in c led to a rise in the money multiplier, because there was again a shift from the currency component of the money supply with less multiple expansion to the checkable deposits component
386 P A R T I V |
Central Banking and the Conduct of Monetary Policy |
700
600
500
400
300
200
100
3.2
3.0
2.8
2.6
2.4
2.2
2.0
1.8
1.10
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
|
6.3% |
|
9.1% |
|
6.6% |
|
6.9% |
8.7% |
9.1% |
MBn + DL |
|
7.1% |
7.0% |
10.0% |
|
6.6% MBn
m
0.1%
2.0%
–4.9%
c
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2005
F I G U R E 3 Determinants of the Money Supply, 1980–2002
Percentage for each bracket indicates the annual growth rate of the series over the bracketed period.
Source: Federal Reserve: www.federalreserve.gov/releases.
C H A P T E R 1 6 Determinants of the Money Supply 387
with more. Finally, the sharp rise in c from December 1993 to December 2002 should have led to a decline in the money multiplier, because the shift into currency produces less multiple deposit expansion. As our money supply model predicts, the money multiplier did indeed fall sharply in this period, and there was a dramatic deceleration of money growth.
Although our examination of the 1980Ð2002 period indicates that factors such as changes in c can have a major impact on the money supply over short periods, we must not forget that over the entire period, the growth rate of the money supply is closely linked to the growth rate of the nonborrowed monetary base MBn. Indeed, empirical evidence suggests that more than three-fourths of the fluctuations in the money supply can be attributed to Federal Reserve open market operations, which determine MBn.
Application |
The Great Depression Bank Panics, 1930–1933 |
We can also use our money supply model to help us understand major movements in the money supply that have occurred in the past. In this application, we use the model to explain the monetary contraction that occurred during the Great Depression, the worst economic downturn in U.S. history. In Chapter 8, we discussed bank panics and saw that they could harm the economy by making asymmetric information problems more severe in credit markets, as they did during the Great Depression. Here we can see that another consequence of bank panics is that they can cause a substantial reduction in the money supply. As we will see in the chapters on monetary theory later in the book, such reductions can also cause severe damage to the economy.
Figure 4 traces the bank crisis during the Great Depression by showing the volume of deposits at failed commercial banks from 1929 to 1933. In their classic book A Monetary History of the United States, 1867Ð1960, Milton Friedman and Anna Schwartz describe the onset of the first banking crisis in late 1930 as follows:
Before October 1930, deposits of suspended [failed] commercial banks had been somewhat higher than during most of 1929 but not out of line with experience during the preceding decade. In November 1930, they were more than double the highest value recorded since the start of monthly data in 1921. A crop of bank failures, particularly in Missouri, Indiana, Illinois, Iowa, Arkansas, and North Carolina, led to widespread attempts to convert checkable and time deposits into currency, and also, to a much lesser extent, into postal savings deposits. A contagion of fear spread among depositors, starting from the agricultural areas, which had experienced the heaviest impact of bank failures in the twenties. But failure of 256 banks with $180 million of deposits in November 1930 was followed by the failure of 532 with over $370 million of deposits in December (all figures seasonally unadjusted), the most dramatic being the failure on December 11 of the Bank of United States with over
388 P A R T I V |
Central Banking and the Conduct of Monetary Policy |
F I G U R E 4 Deposits of Failed
Commercial Banks, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867Ð1960
(Princeton, N.J.: Princeton University Press, 1963), p. 309.
Deposits |
|
|
|
|
($ millions) |
|
|
|
|
500 |
|
|
|
|
400 |
|
|
|
|
300 |
|
|
|
|
200 |
|
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|
|
Start of First |
|
End of Final |
100 |
Banking |
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|
Crisis |
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Banking |
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|
Crisis |
50 |
|
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|
40 |
|
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30 |
|
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|
|
20 |
|
|
|
|
10 |
|
|
|
|
0 |
1930 |
1931 |
1932 |
1933 |
1929 |
$200 million of deposits. That failure was especially important. The Bank of United States was the largest commercial bank, as measured by volume of deposits, ever to have failed up to that time in U.S. history. Moreover, though it was just an ordinary commercial bank, the Bank of United StatesÕs name had led many at home and abroad to regard it somehow as an official bank, hence its failure constituted more of a blow to confidence than would have been administered by the fall of a bank with a less distinctive name.6
The first bank panic, from October 1930 to January 1931, is clearly visible in Figure 4 at the end of 1930, when there is a rise in the amount of deposits at failed banks. Because there was no deposit insurance at the time (the FDIC wasnÕt established until 1934), when a bank failed, depositors would receive only partial repayment of their deposits. Therefore, when banks were failing during a bank panic, depositors knew that they would be likely to suffer substantial losses on deposits and thus the expected return on deposits would be negative. The theory of asset demand predicts that with the onset of the first bank crisis, depositors would shift their holdings from checkable deposits to currency by withdrawing currency from their bank
6Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867Ð1960 (Princeton, N.J.: Princeton University Press, 1963), pp. 308Ð311.
C H A P T E R 1 6 Determinants of the Money Supply 389
accounts, and c would rise. Our earlier analysis of the excess reserves ratio suggests that the resulting surge in deposit outflows would cause the banks to protect themselves by substantially increasing their excess reserves ratio e. Both of these predictions are borne out by the data in Figure 5. During the first bank panic (October 1930ÐJanuary 1931) c began to climb. Even more striking is the behavior of e, which more than doubled from November 1930 to January 1931.
The money supply model predicts that when e and c increase, the money supply will fall. The rise in c results in a decline in the overall level of multiple deposit expansion, leading to a smaller money multiplier and a decline in the money supply, while the rise in e reduces the amount of reserves available to support deposits and also causes the money supply to fall. Thus our model predicts that the rise in e and c after the onset of the first bank crisis would result in a decline in the money supplyÑa prediction borne out by the evidence in Figure 6. The money supply declined sharply in December 1930 and January 1931 during the first bank panic.
Banking crises continued to occur from 1931 to 1933, and the pattern predicted by our model persisted: c continued to rise, and so did e. By the
Currency Ratio, |
|
|
|
Excess Reserves |
|
c |
|
|
|
Ratio, e |
|
0.40 |
|
|
|
0.08 |
|
0.35 |
|
|
End of |
0.07 |
|
|
|
Final Banking |
|
|
|
|
|
|
|
|
|
Crisis |
|
|
0.30 |
|
|
|
0.06 |
|
0.25 |
|
|
|
0.05 |
|
|
|
c |
|
|
|
0.20 |
|
|
|
0.04 |
|
0.15 |
|
|
|
0.03 |
|
0.10 |
|
Start of |
|
0.02 |
|
|
First Banking |
|
|
|
|
|
|
|
|
e |
Crisis |
|
|
|
0.05 |
|
|
0.01 |
|
|
|
|
|
0.0 |
|
|
|
0.0 |
|
1929 |
1930 |
1931 |
1932 |
1933 |
F I G U R E 5 |
Excess Reserves Ratio and Currency Ratio, 1929–1933 |
|
Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867Ð1960 (Princeton, N.J.: Princeton University Press, 1963), p. 333.
390 P A R T I V |
Central Banking and the Conduct of Monetary Policy |
Money Supply |
|
|
|
|
($ billions) |
|
|
|
|
29 |
|
|
|
|
28 |
|
|
|
|
27 |
|
|
|
|
26 |
|
|
|
|
25 |
|
|
|
|
24 |
M1 |
|
|
|
23 |
|
|
|
|
|
|
|
22 |
|
|
|
|
21 |
Start of |
|
|
|
20 |
First Banking |
|
|
|
Crisis |
|
|
|
19 |
|
|
|
|
|
End of |
|
|
|
|
|
9 |
|
|
Final Banking |
|
Monetary Base |
|
Crisis |
|
8 |
|
|
|
|
7 |
|
|
|
|
6 |
|
|
|
|
0 |
|
|
|
|
1929 |
1930 |
1931 |
1932 |
1933 |
F I G U R E 6 M1 and the Monetary Base, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867Ð1960 (Princeton, N.J.: Princeton University Press, 1963), p. 333.
end of the crises in March 1933, the money supply (M1) had declined by over 25%Ñby far the largest decline in all of American historyÑand it coincided with the nationÕs worst economic contraction (see Chapter 8). Even more remarkable is that this decline occurred despite a 20% rise in the level of the monetary baseÑwhich illustrates how important the changes in c and e during bank panics can be in the determination of the money supply. It also illustrates that the FedÕs job of conducting monetary policy can be complicated by depositor and bank behavior.
Summary
1.We developed a model to describe how the money supply is determined. First, we linked the monetary base to the money supply using the concept of the money multiplier, which tells us how much the money supply changes when there is a change in the monetary base.
2.The money supply is negatively related to the required reserve ratio r, the currency ratio c, and the excess reserves ratio e. It is positively related to the level of discount loans DL from the Fed and the nonborrowed base MBn , which is determined by Fed open market
C H A P T E R 1 6 Determinants of the Money Supply 391
operations. The money supply model therefore allows for the behavior of all four players in the money supply process: the Fed through its setting of the required reserve ratio, the discount rate, and open market operations; depositors through their decisions about the currency ratio; the banks through their decisions about
the excess reserves ratio and discount loans from the Fed; and borrowers from banks indirectly through their effect on market interest rates, which affect bank decisions regarding the excess reserves ratio and borrowings from the Fed.
Key Terms
money multiplier, p. 374 |
nonborrowed monetary base, p. 381 |
QUIZ Questions and Problems
Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó
*1. ÒThe money multiplier is necessarily greater than 1.Ó Is this statement true, false, or uncertain? Explain your answer.
2.ÒIf reserve requirements on checkable deposits were set at zero, the amount of multiple deposit expansion would go on indefinitely.Ó Is this statement true, false, or uncertain? Explain.
*3. During the Great Depression years 1930Ð1933, the currency ratio c rose dramatically. What do you think happened to the money supply? Why?
4.During the Great Depression, the excess reserves ratio e rose dramatically. What do you think happened to the money supply? Why?
*5. TravelerÕs checks have no reserve requirements and are included in the M1 measure of the money supply. When people travel during the summer and convert some of their checking account deposits into travelerÕs checks, what happens to the money supply? Why?
6.If Jane Brown closes her account at the First National Bank and uses the money instead to open a money market mutual fund account, what happens to M1? Why?
*7. Some experts have suggested that reserve requirements on checkable deposits and time deposits should be set equal because this would improve control of M2. Does this argument make sense? (Hint: Look at
the second appendix to this chapter and think about what happens when checkable deposits are converted into time deposits or vice versa.)
8.Why might the procyclical behavior of interest rates (rising during business cycle expansions and falling during recessions) lead to procyclical movements in the money supply?
Using Economic Analysis to Predict the Future
*9. The Fed buys $100 million of bonds from the public and also lowers r. What will happen to the money supply?
10.The Fed has been discussing the possibility of paying interest on excess reserves. If this occurred, what would happen to the level of e?
*11. If the Fed sells $1 million of bonds and banks reduce their discount loans by $1 million, predict what will happen to the money supply.
12.Predict what will happen to the money supply if there is a sharp rise in the currency ratio.
*13. What do you predict would happen to the money supply if expected inflation suddenly increased?
14.If the economy starts to boom and loan demand picks up, what do you predict will happen to the money supply?
*15. Milton Friedman once suggested that Federal Reserve discount lending should be abolished. Predict what would happen to the money supply if FriedmanÕs suggestion were put into practice.
