Money.supply

Money Supply: The Fed and the Creation and Control of Money

Overview

In this section we are going to look at how money is created, a power that over the years people have only dreamed of possessing.  While it may not be possible to turn eggs into gold, it is certainly possible to create money.  To understand the process, the key players and concepts must be identified.   First, there is the measurement of money - what it is being created.  The process is described in Diagram 1 below.  Let's start at the end - with the supply of money.  When people talk about the money supply they will be talking about M1 - the value of coins and currency held by the public outside of the banks (cash in our pockets) plus the value of our checking account balances (demand deposits).   [They may also be talking about M2 which is a broader measure of money].

The process begins with the Fed who controls the amount of currency that gets into the system.  Actually it is the mint, an arm of the US Treasury Department that prints the money and then sends it to the Federal Reserve, but that is a finer point we need not concern ourselves with at this time.  It is the Fed who puts the money into the system and the currency it supplies is called high-powered money. This is what the Fed directly controls, but it is not the money supply.  The high-powered money ends up in two places - the vaults of the banks as reserves, or the pockets of people and businesses as cash.  Given the nature of the banking system, it is the banks that actually create money.  The cash held by the banks is called reserves and these reserves are the base for banks' expansion of checking accounts. If you add the currency held by the public with the deposit (checking) accounts created by the banks, you have the money supply.  To understand the supply of money, therefore, it will be necessary to look more carefully at two institutions - the Fed and the banks. 

Diagram 1
Money Supply Process

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When examining the money supply process it is important to realize the US monetary system is in the midst of a rather lengthy evolutionary process. The US has come a long way from the use of tobacco as money in colonial times and the circulation of individual bank notes where there would be $1 note issued by First Federal National Bank circulating with $1 bank notes issued by American National Bank.  The problem for consumers was the value of a $1 note issued by First Federal National Bank would not be worth the same as $1 issued by American National Bank.  Along the way we have also struggled to find ways to eliminate the reoccurring banking crises that plagued the US - the most notable being the closing of banks during the Great Depression.

One of the major sources of difficulty in the financial system can be traced to the fact it is a fractional reserve system. The logic is quite simple - what I refer to as the Robin Hood effect. Since money has no intrinsic value, there are gains to be made from any reduction in the resources society devotes to the production and distribution of money. In the beginning - or at least where we picked up the story, gold was being transported through Sherwood Forest to finance transactions. This required people to mine the gold, refine it, and guard it during its transfer. It offered a wonderful opportunity for Robin Hood and his merry band of "liberators."

Eventually, however, someone realized the transaction could take place if the sheriff deposited the gold in a safe place - a goldsmith's vault being the most likely place - and receive a receipt from the goldsmith who promised to provide the holder of the receipt with gold when it was returned. These receipts could then circulate as money. It did not take long for the goldsmith to realize there was an opportunity for gain. At the end of each day the goldsmith would find all of the notes had not been returned so there was some gold sitting in the vaults - a simple statistical likelihood.

The temptation was too great and the goldsmith decided to get into the lending business. Knowing there was extra gold in the vaults at the end of the day, the goldsmith took a chance and distributed new notes promising to repay the note's holder gold. So now we had a goldsmith with 100 ounces of gold while there were people with notes promising to pay 200 ounces of gold.

The system that has just been outlined is called a fractional reserve system and it is a key piece in the money supply process.   The system can be represented by Diagram 2 below.  We start on the left-side with the Fed's supply of high-powered money which is held either as currency by the public or reserves by the banks. The banks are told that if they create demand deposits they will be required to hold in their vault some cash as required reserves.  These banks may also hold some excess reserves, cash they do not use to create demand deposits - just some extra cash "hanging around" in the vault.  The banks' ability to create money from the cash is seen in the positive slope of the demand deposit line - a small amount of reserves becomes a bigger amount of demand deposits.  Excess reserves, meanwhile, do not appear in the money supply so any increase in excess reserves will lower the supply of money. 

Diagram 2
Money Multiplier

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Three important features of the system are:

Given the importance of money and the potential conflict between profits and safety, the government has become involved in the regulation of the banking system.  The goal of the government is to avoid the banking panics that have plagued this country since the earliest days, the types of panics that contributed to the depth and duration of the Great Depression.  The four important aspects of bank regulation are:

The Fed

The Federal Reserve System (Fed) is the central bank of the United States - the equivalent of the Bank of Sweden, Bank of England, and the Bank of France which were established in 1656, 1694, and 1800.  The Fed represents the United States' third try at establishing a central bank. The first came in 1790 and the second in 1816 - each lasting twenty years. Between 1836 and the establishment of the Federal Reserve in 1914, the US was without a central bank.

In fact there are twelve Federal Reserve Banks - one for each of the twelve Federal Reserve Districts. The reason for the twelve banks is the long-standing aversion Americans had for the concentration of financial power.  By dividing the country into twelve smaller regions, the Fed would be more accountable to the interests of the people in a particular region.  If you were in Rhode Island, you were more likely to be able to influence policy by lobbying the regional Federal Reserve bank than you could a national system located in Washington, D.C.   Rhode Island is in the first district which includes almost all of New England and has its bank in Boston. The structure of the system is described in Diagram 3 below. The President of the United States, with Senate approval, appoints the seven members of the Board of Governors. Each Federal Reserve Bank has a president who is elected by the banks that are members of the system in that region.

The seven members of the Board of Governors and five bank presidents - one being the president of the New York City bank and the other four being rotating presidents of the remaining eleven banks  - form the Federal Open Market Committee (FOMC).  This is the group most responsible for setting monetary policy in the United States.  It is the meetings of this group that grab the headlines as the financial press attempts to anticipate the Fed's moves.  In 1998, for example, the business press was filled with stories centered on the Fed and its decisions regarding interest rates as it tried to help guide the economy through the Asian crisis by lowering interest rates.  Would the Fed lower rates to protect the economy from the Asian crisis?  Would the Fed raise interest rates to eliminate any inflationary pressure in the economy?  These questions were all directed at the decisions of the FOMC. 

Diagram 3
Structure of the Federal Reserve

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In this section we will be examining the tools the Fed can use to achieve its policy goals. Here we will learn what the Fed could do if it did want to increase interest rates or increase the money supply.  Before examining the tools, however, we need to look at what it is the tools are used to accomplish.  Below you have the Fed's function in its own words.

    Today, the Federal Reserve's duties fall into four general areas:

    1. Conducting the nation's monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices

    2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers (Federal Reserve Regulations)

    3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

    4. Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments system.

In this section we will be focusing our attention on the first of these function - the ability of the Fed to control the money supply.  For some additional information on the Fed and other central banks, you might want to check out the following:

Banks and Money Creation

Banks have played a central role in the money supply process and to understand the supply process we will need to examine the 'books' of banks.  By studying these financial statements we will be able to see how the banks can affect the money supply and how the FED can affect the banks.  To understand how banks create money we need to begin with a simple balance sheet for the ACM bank.  The assets banks are allowed to own are restricted by the Fed - a response to the devastating impact of the stock market crash of 1929 on the banking system.  In our simple example we will assume the bank's assets consist of cash (reserves), loans, and government securities. Banks will hold government securities and loans because they earn interest - you pay interest on car loans and the government pays interest on its loans which are the bonds (securities). Banks will also hold cash as reserves which earns no interest so you would expect banks pursuing a profit to make every effort to minimize their holdings of cash.  In the example below, the bank's assets total $5,500,000.

The banks' primary liabilities are the balances on the checking and savings accounts held by their customers. In the example below, the ACM bank's liabilities total $5,000,000 which gives it a net worth of $500,000. As we go through our example you will note that despite changes in the assets and liabilities, the two sides of the balance sheet will be equal.

You will also note there is a link between the two sides based on the Fed's regulation of the banks. Specifically, the Fed sets the required reserve rate for the banks specifying the amount of cash a bank must keep on hand to back the demand deposits (checking accounts). In this example we are assuming the Fed is requiring the bank to hold 20 percent of the amount of its deposit accounts as cash (reserves). To "support" the $5,000,000 in checking account balances, the bank will be required to hold $1,000,000 as required reserves. Given  this is all of the cash the bank has, there are no excess reserves.

Stage 1: ACM's Initial Balance Sheet

ACM's "Books:" Initial Situation

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposit $5,000,000
  Actual $1,000,000 Saving deposit $0
    Required $1,000,000 Net Worth $500,000
    Excess $0 *    
Loans $4,000,000    
Total $5,500,000 Total $5,500,000

* If banks have inadequate reserves (excess reserves < 0) then they can borrow money to satisfy the necessary reserve requirements. They can borrow from the Federal Reserve at the discount window or from other banks in the federal funds market.

Stage 2: ACM's books after a $100,000 infusion of cash

It is now time to see what happens when Mary walks into ACM with $100,00 in cash (where they get the extra cash is another story for another time). The bank will take Mary's $100,000 and add it to its assets, but it will send Mary away with an extra $100,000 in her checking account. Because the checking deposits have risen by $100,000, the bank will be required to hold 20 percent of this amount as additional reserves.  The $20,000 increase in required reserves will bring required reserves to $1,020,000 so the bank now has $80,000 in excess reserves - assets it will be making no money on. This sets the stage for the next stage when the bank undertakes policies to rid itself of the excess reserves. You can see double-entry accounting has resulted in an increase of $100,000 on both sides of the balance sheet.

ACM's "Books:" After $100,000 Deposit

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposits $5,100,000
  Actual $1,100,000 Saving deposits $0
    Required $1,020,000 Net Worth $500,000
    Excess $80,000    
Loans $4,000,000    
Total $5,600,000 Total $5,600,000

Stage 3: ACM's books after elimination of excess reserves

The bank will now attempt to transform the $80,000 into income earning assets.   In this example we assume the bank loans out the $80,000 so the loan balance increases by $80,000 and the level of reserves falls by an equal amount. The bank is now left with $1,020,000 in cash, precisely what it is required to hold, so excess reserves have been reduced to $0. But what has happened to the $80,000? Someone has the cash and we can expect they will deposit it in a bank - bank KAB will receive a deposit of $80,000 which is where we will pick up the story in Stage 4.

ACM's "Books:" After Eliminating Excess Reserves

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposits $5,100,000
  Actual $1,020,000 Saving deposits $0
    Required $1,020,000 Net Worth $500,000
    Excess $0    
Loans $4,080,000    
Total $5,600,000 Total $5,600,000

Stage 4: KAB's books after deposit $80,000

We are now back where we started - with an infusion of $80,000 into a bank - a new bank called KAB. The bank's assets rise to $80,000 in cash which is offset by an $80,000 entry in the checking account balance. You can expect this bank will follow the same procedure to rid itself of excess reserves - it is required to hold 20 percent of the $80,000 as cash so it has excess reserves of $64,000.

KAB's "Books:" After $80,000 Deposit

Assets   Liabilities  
Securities $0    
Reserves   Checking deposits $80,000
  Actual $80,000 Saving deposits $0
    Required $16,000 Net Worth $0
    Excess $64,000    
Loans $0    
Total $80,000 Total $80,000

Stage 5: KAB's books after elimination of excess reserves

The bank will now attempt to transform the $64,000 into income earning assets. In this example we have assumed the bank loans out the $64,000 so the loan balance increases by $64,000 and the level of reserves falls by an equal amount. The bank is now left with $16,000 in cash which is precisely what it is required to hold so the level of excess reserves has been reduced to $0. But what has happened to the $64,000? Someone has the cash and we can expect they will deposit it in a bank - bank MRM will receive a deposit of $64,000 which is where we will drop the story and move quickly to our conclusion.

ACM's "Books:" After Eliminating Excess Reserves

Assets   Liabilities  
Securities $0    
Reserves   Checking deposits $80,000
  Actual $16,000 Saving deposits $0
    Required $16,000 Net Worth $0
    Excess $0    
Loans $64,000    
Total $80,000 Total $80,000

Conclusion: Money creation in banking system

It's now time to retrace the flow of $s through the banking system. Below you will find the changes we could expect in the balance sheets of the banking system's banks. In bank ACM where the process began, the bank's loans increased by $80,000, its cash by $20,000, and its checking account balances by $100,000. Bank KAB, meanwhile, will see its Loans increase by $64,000, its required reserves increase by $16,000 and its checking account balances by $80,000.  The $64,000 loan made by KAB will be deposited into an account at bank MRM where 20 percent ($12,800) will be kept as reserves against checking balances of $64,000 and 80 percent ($51,200) will be loaned out which will find its way into bank AJM.

Following the Money: A Scorecard

Bank ACM      
Reserves $20,000 Checking account $100,000
Loans $80,000    
Bank KAB      
Reserves $16,000 Checking account $80,000
Loans $64,000    
Bank MRM      
Reserves $12,800 Checking account $64,000
Loans $51,200    
Bank AJM      
Reserves $10,240 Checking account $51,200
Loans $40,960    
Bank LRG      
Reserves $8,192 Checking account $40,960
Loans $32,768    

To see the cumulative effect, we can simple reorganize the table above and create a Composite of the Banking System table to show the changes in reserves, deposits, and loans in each of the banks. What we see is that the $100,000 cash deposit has been transformed into bank reserves of $100,000, deposits of $500,000, and loans of $400,000. Because the deposit balances are part of the money supply, we have seen a $100,000 increase in cash has produced a $500,000 increase in the money supply

Composite of the Banking System

  Reserves Deposits Loans
Bank ACM $20,000 $100,000 $80,000
Bank KAB $36,000 $80,000 $64,000
Bank MRM $48,800 $64,000 $51,200
Bank AJM $59,040 $51,200 $40,960
Bank LRG $67,232 $40,960 $32,768
Bank FTS $73,786 $32,768 $26,214
...      
Total $100,000 $500,000 $400,000

Because of the fractional reserve system, banks can multiply the high-powered money that the Fed puts into the system.  In this example there are no excess reserves and the banks will take a $100,000 increase in high-powered money and transform it into a $500,000 increase in demand deposits so the money multiplier would be 5.  We are now ready to put the pieces together - the Fed and the banks.  It is time to look at how the Fed can influence the money supply

Fed's Control of the Money Supply

The money supply contains coins and currency in the hands of the public, controlled by FED, and deposits accounts controlled by the interaction of the households and firms that use money and the banks that create money. At this point we have discussed the structure of the Fed and the money creation process in the banking system. It is now time to put the two together to see how the Fed can alter the money supply.

The money supply (M1) can be increased if the coins and currency in circulation increase or the checking account balances (demand deposit) increase. There are four ways that this can happen. 

  1. required reserve rate is lowered: The Fed can lower required reserve rate which raises the multiplier effect of high powered money (cash). The cash stays in the banks and each dollar can support more loans/demand deposits. In our example, it the required reserves went from 20 percent to 10 percent, bank ACM would only need to hold $10,000 in reserves for the initial injection of $100,000.  The other $90,000 would be loaned out so at each stage in the multiplier chain, the banks would be loaning out more funds and the eventual increase in the money supply would be larger.
  2. discount interest rate decreases: The Fed can lower the discount rate and lower the costs for banks holding low excess reserves which will lower the excess reserve rate.  If the Fed lowers the discount rate, or sets a lower federal funds target, this can be accomplished if the Fed injects funds into the system which will drive down the price of those funds - interest rates.  To see how it could increase the level of cash in the system, we can turn to the next Fed tool - open market operations. 
  3. publics' holding of cash changes: The Fed can raise confidence in banking system which will lower public's desire for holding cash. If you look at the high-powered money the Fed can inject into the system, a dollar in the hands of an individual is simply a dollar of money supply.  A dollar in reserves at the banks, however, can support some multiple expansion of checking accounts.  For example, when the required reserve rate was 10 percent, the $100,000 cash injection the system ultimately resulted in a $500,000 increase in checking account balances.  Thus if the Fed can move dollars from people's pockets to banks, this will increase the money supply.  In the Great Depression, one of the real problems was people lost confidence in the banks and took their cash out of the banks, a pattern that caused the money supply to decrease.  When people want cash, the reserves in the banks fall which creates a bigger drop in demand deposits.  The result is a net decrease in the money supply.  For this reason you would expect every Christmas season the money supply would decrease as consumers want to hold more cash.  To offset this the Fed will need to get more cash into the system.  The same will happen as the Fed attempts to offset the public's hoarding of money at the turn of the millennium.  
  4. open market purchases: this is the Fed's primary tool of monetary policy.  The Fed can buy or sell government securities.  Let's look at the situation when the Fed wants to increase the money supply.  The Fed will contact its broker and announce it wants to buy $100,000 of government securities.  To make life easy we will assume the securities the Fed buys are sold by Herschel Perot who deposits the cash in his bank - ACM National Bank.  The original balance sheet of the bank appears below.

ACM National Bank's Initial Balance Sheet

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposit $5,000,000
Actual $1,000,000 Saving deposit $0
Required $1,000,000 Net Worth $500,000
Excess $0 *    
Loans $4,000,000    
Total $5,500,000 Total $5,500,000

After the Fed purchase of the bonds from Mr. Perot and his deposit of the cash into his bank, ACM National Bank's balance sheet is:

ACM National Bank's books after a $100,000 infusion of cash

Assets   Liabilities  
Securities $500,000    
Reserves   Checking deposits $5,100,000
Actual $1,100,000 Saving deposits $0
Required $1,020,000 Net Worth $500,000
Excess $80,000    
Loans $4,000,000    
Total $5,600,000 Total $5,600,000

This should look very familiar.  It is in fact the first two stages of the money creation process that we examined earlier and you will recall the results.  The increase of $100,000 cash into the system will result in an increase in the money supply of $500,000.  Now you know why the Fed uses this policy to manage the money supply.  If the Fed wants to increase the money supply it will buy government securities, while if  it wants to decrease the money supply it will sell government securities. 

Although all of the above are policy tools of the FED, Open Market Operations tend to be the favored tool. Their popularity stems from the fact that the decisions are reversible, flexible, and timely.  The Fed's tools are summarized in Diagram 4 below.

Diagram 4
Fed Policy Tools

Tools Goal: Increase Money Supply Goal: Decrease Money Supply
Discount rate lower raise
Required reserve rate lower raise
Open market operations but securities sell securities

 

If the FED increases the money supply, then this would show up as an outward shift in the money supply curve in the money market. The outward shift could be accomplished by a reduction in the discount rate, open market purchases, or lower required reserve rates.

Increase in Money Supply

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It's now time to turn our attention to what impact the change in the money supply and interest rates  has on the economy - what we will call the monetary transmission mechanism.

For those with some algebra skills and would like to look at the situation one more time - this time with the help of some simple algebra, you can check out  An algebraic perspective.