The Economics of Money, Banking, and

Financial Markets
Thirteenth Edition

Chapter 14
The Money Supply Process

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Preview
• This chapter provides an overview of how commercial
banks create deposits and describes the basic principles
of the money supply creation process

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Learning Objectives (1 of 2)
14.1 List and describe the “three players” that influence the
money supply.
14.2 Classify the factors affecting the Federal Reserve’s
assets and liabilities.
14.3 Identify the factors that affect the monetary base and
discuss their effects on the Federal Reserve’s balance
sheet.
14.4 Explain and illustrate the deposit creation process
using T-accounts.

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Learning Objectives (2 of 2)
14.5 List the factors that affect the money supply.
14.6 Summarize how the “three players” can influence the
money supply.
14.7 Calculate and interpret changes in the money
multiplier.

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Three Players in the Money Supply
Process

1. The Central bank: Federal Reserve System

2. Banks: depository institutions; financial intermediaries
3. Depositors: individuals and institutions

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The Fed’s Balance Sheet
Blank

Federal Reserve System

Assets Liabilities
Securities Currency in circulation
Loans to Financial Institutions Reserves

• Liabilities
– Currency in circulation: in the hands of the public
– Reserves: bank deposits at the Fed and vault cash
• Assets
– Government securities: holdings by the Fed that affect money
supply and earn interest
– Discount loans: provide reserves to banks and earn the
discount rate
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Control of the Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system

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Open Market Purchase from a Bank
Blank Blank Blank Blank Blank

Banking Federal
System Reserve
Assets
Blank

Liabilities System
Blank Blank

Blank

Assets Liabilities
Securities −$100m
negative $100 lower m

Blank

Reserves +$100m Securities +$100m Reserves +$100m

• Net result is that reserves have increased by $100

• No change in currency
• Monetary base has risen by $100

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Open Market Purchase from the Nonbank
Public (1 of 2)
Blank Blank Blank Blank Blank

Banking Federal
System Reserve
Blank

System
Assets Liabilities Blank Blank

Assets Liabilities
Reserves +$100m Checkable
deposits Securities +$100m Reserves +$100m

• Person selling bonds to the Fed deposits the Fed’s

check in the bank
• Identical result as the purchase from a bank

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Open Market Purchase from the Nonbank
Public (2 of 2)
Blank Blank Blank Blank Blank Blank

Nonbank Federal
Public Reserve
Assets
Blank

Liabilities
Blank

System
Blank Blank

Assets Liabilities
−$100m
Blank Blank

Securities negative $100 lower m

Blank Blank Securities +$100m Currency in +$100m

Currency +$100m circulation

• The person selling the bonds cashes the Fed’s check

• Reserves are unchanged
• Currency in circulation increases by the amount of the open
market purchase
• Monetary base increases by the amount of the open market
purchase
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Open Market Purchase: Summary
• 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 always increases the monetary base by the amount
of the purchase.

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Open Market Sale
Blank Blank Blank Blank Blank Blank

Nonbank Federal
Public Reserve
Assets
Blank

Liabilities
Blank

System
Blank Blank

Blank Blank Assets Liabilities

Securities +$100m
Securities −$100m Currency in −$100m
−$100m
Blank Blank

Currency
negative $100 lower m negative $100 lower m

negative $100 lower m

circulation

• Reduces the monetary base by the amount of the sale

• Reserves remain unchanged
• The effect of open market operations on the monetary
base is much more certain than the effect on reserves.

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Shifts from Deposits into Currency
Blank Blank
Blank Blank Blank

Nonbank Public Banking

Blank
System
Assets Liabilities Blank Blank

Blank
Assets Liabilities
Checkable −$100m
−$100m −$100m
negative $100 lower m

deposits Reserves negative $100 lower m

Checkable negative $100 lower m

Blank
deposits
Currency +$100m
Blank Blank Blank

Federal Reserve System

Blank Blank

Assets Liabilities
Blank Blank

Currency in +$100m
circulation
−$100m
Blank Blank

Reserves negative $100 lower m

• Net effect on monetary liabilities is zero

• Reserves are changed by random fluctuations
• Monetary base is a relatively stable variable
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Loans to Financial Institutions
Blank Blank Blank Blank Blank Blank

Banking Federal
System Reserve
Assets
Blank

Liabilities
Blank

System
Blank Blank

Assets Liabilities
Reserves +$100m Loans +$100m
Blank Blank Blank Loans +$100m Reserves +$100m
(borrowin Blank Blank Blank

g from (borrowing
Fed) from Fed)

• Monetary liabilities of the Fed have increased by $100

• Monetary base also increases by this amount

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Other Factors That Affect the Monetary
Base

• Float
• Treasury deposits at the Federal Reserve
• Interventions in the foreign exchange market

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Overview of the Fed’s Ability to Control
the Monetary Base
• Open market operations are controlled by the Fed.
• The Fed cannot determine the amount of borrowing by
banks from the Fed.
• Split the monetary base into two components:

MBn = MB − BR

• The money supply is positively related to both the non-

borrowed monetary base MBn and to the level of
borrowed reserves, BR, from the Fed.

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Multiple Deposit Creation: A Simple
Model (1 of 2)
Deposit Creation: Single Bank
Blank Blank Blank Blank Blank Blank

First National First

Bank National
Blank Blank

Bank
Assets Liabilities Blank Blank

Assets Liabilities
−$100m
Blank Blank

Securities negative $100 lower m

Blank Blank Securities −$100m Checkable +$100m

Reserves +$100m
negative $100 lower m

deposits
Blank Blank

Reserves +$100m
• Excess reserves increase Loans +$100m
Blank Blank

• Bank loans out the excess reserves Blank Blank Blank

First National
Bank
• Creates a checking account Blank Blank

Assets Liabilities
• Borrower makes purchases Securities −$100m negative $100 lower m
Blank Blank

• The Money supply has increased

Blank Blank

Reserves +$100m

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Multiple Deposit Creation: A Simple
Model (2 of 2)
Deposit Creation: The Banking System
Blank Blank Blank Blank Blank Blank

Bank A Bank A
Blank Blank Blank Blank

Assets Liabilities Assets Liabilities

Reserves +$100m Checkable +$100m Reserves +$10 Checkable +$100m

deposits deposits
Blank Blank

Loans +$90

Blank Blank Blank Blank Blank Blank

Bank B Bank B
Blank Blank Blank Blank

Assets Liabilities Assets Liabilities

Reserves +$90 Checkabl +$90 Reserves +$9 Checkable +$90

e deposits deposits
Blank Blank

Loans +$81

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Table 1 Creation of Deposits (Assuming 10% Reserve
Requirement and a $100 Increase in Reserves)

Bank Increase in Deposits ($) Increase in Loans ($) Increase in Reserves ($)
First National 0.00 100.00 m 0.00
A 100.00 m 90.00 m 10.00 m
B 90.00 m 81.00 m 9.00 m
C 81.00 m 72.90 m 8.10 m
D 72.90 m 65.61 m 7.29 m
E 65.61 m 59.05 m 6.56 m
F 59.05 m 53.14 m 5.91 m
. . . .
. . . .
. . . .
. . . .
Total for all banks 1,000.00 m 1,000.00 m 100.00 m

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Deriving the Formula for Multiple Deposit
Creation

Assuming banks do not hold excess reserves

Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r) times the total amount of
checkable deposits (D)
Substituting
r D = R

Dividing both sides by r 1

D=  R
r

Taking the change in both sides yields 1

D =  R
r
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Critique of the Simple Model
• Holding cash stops the process
– Currency has no multiple deposit expansion
• Banks may not use all of their excess reserves to buy
securities or make loans.
• Depositors’ decisions (how much currency to hold) and
bank’s decisions (amount of excess reserves to hold)
also cause the money supply to change.

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Factors That Determine the Money
Supply (1 of 2)
• Changes in the nonborrowed monetary base MBn
– The money supply is positively related to the non-
borrowed monetary base MBn
• Changes in borrowed reserves from the Fed
– The money supply is positively related to the level of
borrowed reserves, BR, from the Fed

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Factors That Determine the Money
Supply (2 of 2)

• Changes in the required reserves ratio

• The money supply is negatively related to the required
reserve ratio.
• Changes in excess reserves
– The money supply is negatively related to the amount
of excess reserves.
• Changes in currency holdings
– The money supply is negatively related to currency
holdings.

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Overview of the Money Supply Process
Summary Table 1
Money Supply Response
Change in Money Supply
Player Variable Variable Response Reason
Federal Reserve Nonborrowed monetary 
Up arrow
 Up arrow
More MB for
System base, MBnM B sub n deposit creation
Blank

Required reserve ratio, rr 

Up arrow
Down arrow
Less multiple
deposit expansion
Banks Borrowed reserves, BR  More MB for

Up arrow Up arrow

deposit creation
Blank

Excess reserves  Less loans and


Up arrow Down arrow

deposit creation
Depositors Currency holdings  Less multiple

Up arrow Down arrow

deposit expansion
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 “Money Supply Response” column.
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The Money Multiplier
• Define money as currency plus checkable deposits: M1
• Link the money supply (M) to the monetary base (MB)
and let m be the money multiplier

M = m  MB

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Deriving the Money Multiplier (1 of 4)
• Assume that the desired holdings of currency C and
excess reserves ER grow proportionally with checkable
deposits D.
• Then,
c = C / D = currency ratio
e = ER / D = excess reserves ratio

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Deriving the Money Multiplier (2 of 4)
The total amount of reserves (R) equals the sum of
required reserves (RR) and excess reserves (ER).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = r  D
Subsituting for RR in the first equation
R = (r  D ) + ER

The Fed sets r to less than 1

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Deriving the Money Multiplier (3 of 4)
• The monetary base MB equals currency (C) plus
reserves (R):
MB = C + R = C + ( r  D ) + ER

• Equation reveals the amount of the monetary base

needed to support the existing amounts of checkable
deposits, currency, and excess reserves.

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Deriving the Money Multiplier (4 of 4)
c = {C / D }  C = c  D and
e = {ER / D }  ER = e  D
Substituting in the previous equation
MB = (r  D ) + (e  D ) + (c  D ) = (r + e + c )  D
Divide both sides by the term in parentheses
1
D=  MB
r +e+c
M = D + C and C = c  D
M = D + (c  D ) = (1 + c )  D
Substituting again
1+ c
M=  MB
r +e+c
1+ c
The money multiplier is then m=
r +e+c
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Intuition Behind the Money Multiplier
r = required reserve ratio = 0.10
C = currency in circulation = $400B
D = checkable deposits = $800B
ER = excess reserves = $0.8B
M = money supply (M1) = C + D = $1,200B
$400B
c= = 0.5
$800B
$0.8B
e= = 0.001
$800B
1 + 0.5 1.5
m= = = 2.5
0.1 + 0.001 + 0.5 0.601
This is less than the simple deposit multiplier Although there is multiple
expansion of deposits, there is no such expansion for currency
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Quantitative Easing and the Money
Supply, 2007–2017
• When the global financial crisis began in the fall of 2007, the Fed
initiated lending programs and large-scale asset-purchase
programs in an attempt to bolster the economy.
• By the fall of 2017, these purchases of securities had led to a
quintupling of the Fed’s balance sheet and a 350% increase in
the monetary base.
• When the coronavirus pandemic struck in March 2020, the
Federal Reserve again engaged in massive quantitative easing
programs to prevent a collapse of the economy. The effects on
the monetary base and the money supply displayed a similar
pattern to that which occurred when the global financial crisis
struck.

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Quantitative Easing and the Money
Supply, 2007–2014

• These lending and asset-purchase programs resulted in

a huge expansion of the monetary base and have been
given the name “quantitative easing.”
• This increase in the monetary base did not lead to an
equivalent change in the money supply because excess
reserves rose dramatically.

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 Figure 1 M1 and the Monetary Base,
2007–2020

Source: Federal Reserve Bank of St. Louis, FRED database:

[Link] ; [Link] .

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 Figure 2 Excess Reserves and Currency
Ratio, 2007–2020

Source: Federal Reserve Bank of St. Louis, FRED database:

[Link] ; [Link] ;

[Link] .

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