Macro Notes 2: The Money Supply

2.1  Introduction and Cautions
 We are now about to examine the financial sector of the economy. In this set of notes, we explore how the financial system works. Once we understand how it works, we can demonstrate (a) that certain policy actions made by the central bank (called the Federal Reserve in this country) will change the supply of money circulating in the economy, and (b) that this change will affect interest rates.

 The purpose of monetary policy, at least in this simple model, is to affect the interest rate so that the interest rate will affect the level of planned investment Ip. Once we change Ip, the further effects work exactly like a change in government spending, G, in the income-expenditure model presented in the chapters 9 and 10.

Caution number one: that above-described set of causal links -- from the Federal Reserve to the money supply to the interest rate to the willingness of capitalists to borrow to finance capital investment -- is the only way this story works. You may be tempted to try and make other, more direct links. Resist the temptation. They will be wrong. For example there is no necessary direct link between an increase in the money supply and more spending. Anything that affects national income/output Y must come from a change in demand for goods/services, which must come from an explanation about why C, Ip, or Y will change. In our simple model, the only link between monetary matters and demand is through Ip.

Caution number two: at a more abstract level, be careful to distinguish flows from stocks. A flow is any quantity that must be measured over a period of time. Income is a flow. A stock is any quantity that is measured at a single instant in time. The money supply is a stock.

 A few more examples of stocks versus flows: the amount of orange juice I drink in a month is a flow. The amount of orange juice I have right now in my refrigerator is a stock. The amount of water that passes over Niagara Falls in an hour is a flow. The amount of water in all the world's oceans is a stock. The number of sheets of 3/4 inch plywood in the warehouse of Snavely Lumber is a stock. The number it sells in a typical day is a flow.

Caution number three: money is what you can use to buy stuff with (a more formal discussion appears below). Money is not the same thing as income. Money is not the same thing as savings. Money is not the same thing as wealth.

2.2  What is a Bank?
 Our story depends on how banks work, so we start with them. Banks take in deposits and make loans. They turn a profit by charging a higher rate of interest on loans than they pay on deposits. At any given point in time, therefore, the bank has a certain amount of deposits on its books and a certain amount of outstanding loans. We can represent this with a balance sheet, a kind of account which looks at an individual or firm's financial position at one moment in time. (Therefore, everything represented on a balance sheet is a stock, not a flow.)

 A balance sheet has two categories. Assets are what you own, Liabilities are what you owe. In the case of a bank, its most important assets are the loans it has made. What the bank owns -- a legal contract in which the borrower promises to make certain payments at certain times -- may not look very impressive, at least in comparison to the steel mills or jet planes or communications satellites that are the productive assets of non-financial firms. But they are assets nonetheless, and the art of banking lies in carefully choosing borrowers who are likely to be able to repay their loans.

 The bank's liabilities are its deposits. When you make a deposit, you are essentially lending the bank your money. This is, however, an unusual kind of loan because you can recall it at any time. When I deposit $100 at my bank, I can ask for the $100 back whenever I like. As long as I leave it with the bank it's my loan to the bank, and the bank may pay me a little bit of interest for it.

 This gives us a first simple picture of a bank. We'll call the deposits demand deposits , to emphasize that depositors can get them back on demand -- whenever they like. Here's the balance sheet so far:

                   Commercial Bank
                  ASSETS   |  LIABILITIES          
                    loans  |  demand deposits
Now you may notice a problem. When the bank makes a loan, it will generally be for some length of time. If it lends Snavely Lumber $40,000 to buy a new forklift, the loan might have a term of five years: Snavely would repay the $40,000 in five years, and pay $2,800 a year (seven percent interest) in the meantime. But the people who deposited the $40,000 that the bank lent Snavely can walk into the bank and ask for their money any time they want.

 You could go to the opposite extreme:

                   Commercial Bank
              ASSETS     |  LIABILITIES          
              reserves   |  demand deposits
In which banks simply took in money and sat on it. But this would make banking an awfully boring business, and the important intermediating function of banks -- taking in deposits and passing them on as loans -- would be impossible. How can banks make loans but at the same time reassure depositors that they can get their deposits back?

 One approach is for a bank to hold on to some of the deposits as reserves. Indeed nowadays banks are required, by government regulation, to do so. We call this "fractional reserve banking."

                   Commercial Bank
             ASSETS      |  LIABILITIES          
             loans       |  demand deposits 
        required reserves|
Suppose the required reserve ratio is ten percent: for every dollar of deposits, the bank must hold ten cents of reserves. That means that if customers holding as much as ten percent of the bank's deposits all walk in asking for their money back, the bank has enough on hand. For ordinary business, this should be plenty: on any given day some people will make deposits and some will withdraw them, and reserves of ten percent of deposits should be enough to handle most occasions when withdrawals outrun new deposits.

But the bank is not completely safe, because if, for some reason, more customers walked in it would not have enough money. Ordinarily this is unlikely to happen -- after all, people deposited money in the bank in the first place because it was convenient. But if you heard that other depositors were withdrawing their money, you might worry that the bank would run out and rush to withdraw yours too. The result can be a "run" on a bank, in which even a well-run bank can be brought to its knees because of a scramble to withdraw deposits.

 A further safeguard in almost all modern economies is a system of government provided insurance for depositors. In the United States, the Federal Deposit Insurance Corporation (FDIC) guarantees that even if your bank goes under, you will get back at least the first $100,000 that you have on deposit. This gives depositors enough confidence in the safety of their deposits that runs on banks are nowadays extremely rare.

 If we were in an accounting class, we would be careful to add another item under the liabilities column: "Net Worth" which is definitionally the difference between assets and liabilities.

Assets - Liabilities = Net Worth
But for the story we're going to tell, this extra concept just gets in the way, so we're going to ignore it. Here is our simple bank. It faces a required reserve ratio of ten percent.
                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                    loans  450|500 demand deposits 
        required reserves   50|
This bank has no excess reserves -- in banking jargon it is "fully lent." There is nothing to stop the bank from holding more reserves than it is legally required to hold. In other words this situation:
                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                    loans  420|500 demand deposits 
          excess reserves   30|
        required reserves   50|
is legally possible. Here the bank holds 80 of total reserves, of which only 50 are required. However in this situation the bank could lend more, and since it makes profits from its lending, we will assume that banks always desire to be "fully lent," and that this situation will not persist for long -- the bank will find a borrower for the 30 in excess reserves that it now holds.

 This assumption will be important below, because it means that if the bank happens to get 20 in new deposits, it will hasten to make 18 in new loans.

2.3  What is the Federal Reserve System?
 The Federal Reserve System (Fed for short) is the central bank of the United States. A central bank functions as a sort of bank for banks, as well as carrying out several other functions that we'll encounter below.

A central bank has a unique property in a modern economy: its liabilities can be used as money. The cash in your pocket is nothing more than Federal Reserve System liabilities. In that sense it represents a debt of the central bank to you, but of a peculiar kind: all you can get for the dollar that the Fed owes you is another dollar -- another Fed liability. It has no intrinsic value whatever. The only reason you bother to hold dollars is that you can buy stuff with them. But we're getting ahead of our story.

 When banks hold reserves, they can hold them in two forms: as cash (i.e. Fed liabilities in the form of paper notes) or as deposits at the Fed. Just as your deposits at a commercial bank are your asset and its liability, so your bank's deposit at the Fed is its asset and the Fed's liability.

 What will be important to our story is that the Fed can create liabilities just by writing a check, (or printing up new dollar bills).

Caution: Do not confuse the Fed with the U.S. Treasury. The Treasury has the responsibility of raising money to pay the government's bills. It does this by taxing or borrowing. It can not print money or, like the Fed, write checks whenever it pleases.

2.4  What is Money?
 Money is what you can use to buy stuff. More formally, money is anything that is universally accepted as medium of exchange in an economy.

 Since money is universally accepted as a means of payment, it acquires some additional functions. Money functions as a:

MEDIUM OF EXCHANGE or MEANS OF PAYMENT: this is the first and primary definition of money. Money is anything that is universally acceptable as a medium of exchange in an economy. What makes it money is its acceptability. If something is not universally acceptable as a medium of exchange, then it is not money.

 UNIT OF ACCOUNT: this means that since money is the universally accepted form of payment, and can thus be used as a measure of value, all transactions in an economy, and all values in an economy are usually accounted in terms of the amount of money receives in exchange for selling an item, or the amount of money one pays to receive an item. Thus, we account for the total value of all the transactions undertaken in an economy in terms of monetary units.

STORE OF VALUE: while money is not the only store of value, the fact that it is universally accepted as a means of payment allows it also to become a store of value. This means that I can sell some good or service today, and receive money for it. I can keep the money and thus "store" the value received from my sale for a while. Then, later, I can use the money to purchase a good or service.

CAUTIONS: In ordinary language, we use the term "money" very loosely. But in economics, we have to be very careful to define our terms, and to use them with care. This is because many items which are loosely referred to as "money" actually have different roles in the economy and enter the macroeconomy in different ways.
Money is not "income." We have been very careful to define aggregate income as the value of total goods and services produced in an economy. An individual's income is the value of their total earnings in input markets, received in exchange for the sale of labor, capital, land and entrepreneurship in a given period. Income is a flow, while money is a stock.

 Money is not "savings." Savings is the amount of income not consumed. It is not the "amount of money a person has." We have been very careful to define savings in terms of income and consumption, and not in terms of "money." Savings is a flow, while money is a stock.

 Money is not wealth. A person can be wealthy but that is not the same thing as "holding money," or "having money." A wealthy person, for example, may have many stocks and bonds and own much property, but may not hold much money. While both wealth and money are stocks (both are calculated as a total volume at a point in time), not all wealth is acceptable as a medium of exchange.

Now, as noted above, money primarily functions to facilitate exchange. So, why do we use money? Why not undertake exchanges directly? A barter exchange is when two people exchange goods and services directly without using money as an intermediary.

 In economies which are small, and everyone knows know everyone else, barter may work well. For example, in a small village, the farmer knows the carpenter, and agrees to give the carpenter milk every morning in exchange for a chair and a table, the butcher agrees to give meat to the cobbler in exchange for shoes, and so on. Such an economy would be a simple barter economy.

 But once you have larger and more complex economies, it is very inconvenient to try and arrange all the exchanges one needs through such mechanisms. Barter requires a double coincidence of wants. If I make shoes and want spinach, I have to find someone who has extra spinach and wants shoes in exchange. Therefore in a complex market economy, money is extremely useful.

 So far we've answered the question "what is money" mainly by pointing to what money does: facilitate exchange. But we have now done enough analysis to specify what it is that we use as money in a modern economy: certain kinds of liabilities.

The first kind of liability we use as money are liabilities of the central bank -- the Fed. The cash and coins you use daily are Fed liabilities.

 The second kind of liabilities we use as money are the liabilities of commercial banks. Suppose you have $1,000 in your checking account. That represents a debt of the bank to you (your asset and the bank's liability). Suppose you want to buy a really exciting economics book for $50. You can write a check for $50 to the bookstore. That check is a legal document that transfers $50 of the bank's liabilities to you (your asset) to the bookstore (it becomes the bookstore's asset). As long as the bookstore is sure that you really own this asset that you are trading for the book (i.e. that you have at least $50 in your checking account) it will happily accept the check.

 Why should the bookstore accept a liability of the Fulton National Bank? Suppose the bookstore has its account at Franklin bank. It will want to get Fed liabilities in exchange for the Fulton bank's liabilities (requiring Fulton Bank to pay out of its reserves) before depositing that money in its account at Franklin bank. Why does it have confidence that Fulton bank really owns $50 worth of central bank liabilities? Here is another example of the importance of deposit insurance: the bookstore happily accepts the Fulton Bank liability without doing any research into Fulton's soundness, because it knows that in the unlikely event that Fulton goes bankrupt, the Fed will step in and make good its liabilities.

 As a result of this confidence, we can use checking account deposits to pay for things. In fact cash and coins make up less than ten percent of the total payments made in this country by dollar volume.

 This convenience also means that we are willing to hold money in the form of checking deposits even if it pays little or no interest. In turn this gives banks a big advantage over, say, mutual funds. If I put money in a mutual fund (say a long-term Treasury Bond fund) it may earn seven percent interest. But I can't use the mutual fund's debt to me to buy things. Since I can use a commercial bank's debt to me to buy stuff, I'm willing to lend them money at very low or zero interest. In turn that means that the commercial bank can attract money very cheaply. Since the bank makes a profit from the difference between the interest rate it charges on loans and the interest rate it pays on deposits, this helps.

2.5  The First Tool of Monetary Policy: Changes in Reserve Requirements
Let's start with the commercial bank we set up earlier, which is "fully lent" (i.e. it has lent as much as it can, and therefore has no excess reserves).

                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                    loans  450|500 demand deposits 
        required reserves   50|
Now suppose that the reserve requirement is lowered to from ten percent to five percent. Our bank then faces the following situation:
                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                    loans  450|500 demand deposits 
          excess reserves   25|
        required reserves   25|
If it wants to make as much profit as possible it will seek once again to be "fully lent," meaning that it will lend out the 25 in excess reserves. If you would like to see, step by step, how this is done, here it is:

 Step 1. The bank locates a worthy borrower and negotiates the loan. To actually make the loan, it creates a new deposit for the borrower on the liability side, and books the loan on the asset side:

                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                old loans  450|500 demand deposits 
                 new loan   25| 25 new demand deposit
          excess reserves   25|     (for borrower)
        required reserves   25|
Step 2. But the above situation won't last longer than a day or two, because the borrower is borrowing because it needs to use the money. So the borrower then draws the loan by withdrawing the new deposit, which the bank pays by using the excess reserves. This then is the final balance sheet for our bank.
                        Commercial Bank
                 ASSETS       |      LIABILITIES          
                    loans  475|500 demand deposits 
        required reserves   25|
While this is the end of the story for one bank, it's not the end of the story for the banking system. That 25 lent to the new borrower will be used to buy something -- e.g. Snavely Lumber uses it to buy a new truck, so it ends up in the account of the truck dealer. So in another bank somewhere, there is now a new deposit of 25.

Therefore:

And so on.

 In fact, cutting the reserve requirement in half will end up doubling the money supply.

 Note than money has just been created out of thin air. Or, if you like, at the stroke of a banker's pen.

 Similarly, raising the reserve requirement would force banks to reduce lending in order to build up their reserves. This would force the above process to work in reverse, as lenders used up deposits to pay off loans.

 As you can see changes in reserve requirements have large effects on the money supply. In practice, this is very rarely used, in part because it is such a blunt instrument.

2.6  The Second Tool of Monetary Policy: The Discount Rate
Banks have another way of getting hold of reserves: then can borrow from the Fed. When a commercial bank borrows from the Fed, the Fed books a loan on the asset side of its balance sheet and a new deposit, owned by the bank, as a liability. This new deposit joins existing deposits that the commercial banks have with the Fed; all these Fed liabilities are reserve assets of the banks.

 In practice, the reason this "discount window" exists is to give banks a way of fine tuning their operations and being sure they can meet reserve requirements if they fall a bit short. But it's not considered cool to use the discount window too much, and the "frown costs" of doing so may include closer regulatory attention by the Fed to a bank's operations.

 In theory, if banks decided to borrow reserves based solely on the discount rate then changing the discount rate would make them more or less likely to do this, and hence more or less likely to make more loans. In practice, when banks do borrow from the discount window it's generally because they need to; ordinarily, especially if you want to give the impression to the Fed that you're a well-run bank, you avoid doing so. So it's not clear that changing the discount rate will have much effect at all.

2.7  The Third and Most Important Tool of Monetary Policy: Open Market Operations
 In almost every wealthy capitalist economy, open market operations are the principal means by which central banks seek to affect the money supply. Unlike changes in the reserve requirement or in the discount rate, open market operations do not require any direct interference by the Fed in bank operations. Instead, the Fed simply buys and sells an asset.

 The assets which the Fed buys and sells are government bonds -- IOUs issued at some earlier point by the U.S. Treasury. But the only reason the Fed deals in government bonds is that they are easy to buy and sell. It could conduct open-market operations just as well if it bought and sold corporate bonds, or rare stamps, or used cars, or anything else. All that matters is that when the Fed buys an asset it writes a check (a new Fed liability) and when it sells an asset someone writes a check to the Fed. When that check clears, the result is that the Fed's total liabilities have decreased.

Caution: Do not confuse the Fed with the U.S. Treasury.

If the Fed wishes to increase the supply of money, therefore, it buys an asset and in so doing writes the person it buys the asset from a check. It is the act of writing this check that first increases the supply of money. (That's why open market operations would work if the Fed bought/sold any asset.) Writing the check creates a new Fed liability, which is something that can be used as money. But the story, as we noted earlier, does not stop there. When this Fed check is deposited, the bank can lend most of it out. That new loan leads to a new deposit -- even more new money -- which leads to new lending, new deposits, and so on. The end result is that the final increase in the money supply is a lot larger than the initial check the Fed writes. In fact the smaller the required reserve ratio, the larger the additional increase (can you see why, intuitively?)

 It so happens that the final increase in the money supply, if all banks lend as much as they can, is equal to the initial increase (that first Fed check) times one over the required reserve ratio. If the required reserve ratio is five percent, the final rise in the money supply will be twenty times as big as the first Fed check.

 Somewhat confusingly, this phenomenon is called the "money multiplier." Although the underlying mathematical principle is similar. in terms of economic theory this is completely different from the government spending and tax multipliers discussed in earlier chapters.

Caution: Do not confuse the money multiplier with the government spending or tax multipliers.

Essentially the same process works in reverse, if the Fed wants to reduce the money supply. Buy selling an asset it gets someone to write a check to it. If I but a bond from the Fed for $1,000, then when my check clears, my bank must use $1,000 of reserves to pay the Fed. That lowers bank reserves and forces a reduction in lending. This process is carefully shown on page 265 of your book.

2.8  The Story so Far: How the Fed Controls the Money Supply
 So far we have learned that in a modern economy like that of the United States, money -- that which you can use to buy things with -- consists of liabilities of the Federal Reserve and liabilities of the commercial banks. You have also seen that the Federal Reserve can do various things to influence the amount of money in existence -- the supply of money.

So what? What effect does that have on anything else? We won't see the point of all this until we look at the demand for money.


©1998 S. Charusheela and Colin Danby.