Chapter 14
The Federal Reserve’s Balance Sheet
and the Money Supply Process
Brief Chapter Summary and Learning Objectives
14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 416–424)
Explain the relationship between the Fed’s balance sheet and the monetary base.
The Fed’s balance sheet lists the Fed’s assets and liabilities. There is a close connection between
the monetary base and the Fed’s balance sheet.
The monetary base is the sum of the Fed’s two major liabilities: currency in circulation and bank
reserves.
The most direct method the Fed uses to change the monetary base is open market operations,
which involve buying or selling securities, generally U.S. Treasury securities.
Though less commonly used, the Fed can also increase or decrease reserves by making discount
loans to commercial banks.
Although open market operations and discount loans both change the monetary base, the Fed has
greater control over open market operations than over discount loans.
14.2 The Simple Deposit Multiplier (pages 424–429)
Derive the equation for the simple deposit multiplier and understand what it means.
An increase in bank reserves results in rounds of bank loans, creation of checkable deposits, and
an increase in the money supply. These rounds of deposit creation multiply the initial increase
in reserves.
The simple deposit multiplier relates the initial change in reserves to the change in the money
supply and equals 1 divided by the required reserve ratio.
14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 429–439)
Explain how the behavior of banks and the nonbank public affect the money multiplier.
Increases in currency holdings or excess reserves reduce the multiple deposit creation process.
The money multiplier is the ratio of the money supply to the monetary base.
The money multiplier (m) is:
m=
(
C
D
)
+1
(
C
D
)
+rrD+
(
ER
D
)
,
where (C/D) is the currency-to-deposit ratio, (ER/D) is the excess reserves-to-deposit ratio, and
rrD is the required reserve ratio.
During the financial crisis of 2007–2009, the excess reserves-to-deposit ratio soared, causing the
money multiplier to decline by about 50%.
14 Appendix: The Money Supply Process for M2 (page 446)
Describe the money supply process for M2
Key Terms
Bank reserves Bank deposits with the Fed plus
vault cash.
Currency-to-deposit ratio (C/D) The nonbank
public’s holdings of currency, C, relative to their
holdings of checkable deposits, D.
Currency in circulation Paper money
circulating outside of the Fed.
Currency in M1: Currency held by the nonbank
public.
Discount loan A loan made by the Federal
Reserve, typically to a commercial bank.
Discount rate The interest rate the Federal
Reserve charges on discount loans.
Excess reserves Reserves that banks hold over
and above those the Fed requires them to hold.
Monetary base (or high-powered money) The
sum of bank reserves and currency in circulation.
Multiple deposit creation Part of the money
supply process in which an increase in bank
reserves results in rounds of bank loans and
creation of checkable deposits and an increase in
the money supply that is a multiple of the initial
increase in reserves.
Open market operations The Federal Reserve’s
purchases and sales of securities, usually U.S.
Treasury securities, in financial markets.
Open market purchase The Federal Reserve’s
purchase of securities, usually U.S. Treasury
securities.
Open market sale The Fed’s sale of securities,
usually Treasury securities.
Required reserve ratio The percentage of
checkable deposits that the Fed specifies that
banks must hold as reserves.
Required reserves Reserves that the Fed requires
banks to hold against demand deposits and NOW
account balances.
Simple deposit multiplier The ratio of the
amount of deposits created by banks to the amount
of new reserves.
Vault cash Currency held by banks.
Chapter Outline
Teaching Tips
Most instructors will consider this chapter to be one of the most important in the book. It integrates material
sometimes treated separately: the money supply process and the effect of changes in the Fed’s balance
sheet on the money supply process. The chapter starts with the Fed’s balance sheet (see Table 14.1 on
page 418 of the text), and then uses the balance sheet to explain the money supply process. This approach
has the advantage of keeping the Fed’s role at the center of the analysis and makes it easier for students to
keep track of the main purpose of the discussion.
Many students have difficulty understanding the deposit expansion process, so it may be a good idea to
devote significant class time to it. It can be tempting to go through the deposit expansion process fairly
quickly in order to focus on the money multiplier. However, in order to appreciate the money multiplier
material, students need to have a firm grasp of the deposit expansion process. Students should find
interesting the discussion near the end of the chapter of how the 2007-2009 financial crisis turned the
money multiplier into a money divisor.
High Times for “Gold Bugs”
Beginning in 2008, sales of gold for investment soared, causing gold to reach a record high of $1,780 per
ounce in September 2011. The motives of investors buying gold differed, but many were concerned with
the consequences of the government action during the financial crisis of 2007-2009, which they believed
would eventually lead to much higher inflation rates.
14.1 The Federal Reserve’s Balance Sheet and the Monetary Base (pages 416–424)
Learning Objective: Explain the relationship between the Fed’s balance sheet and the monetary base.
A. The Federal Reserve’s Balance Sheet
There is a close connection between the monetary base and the Fed’s balance sheet, which lists
the Fed’s assets and liabilities. The Fed’s primary assets include government securities and
discount loans, while its primary liabilities are currency in circulation and reserves.
B. The Monetary Base
The monetary base is the sum of the Fed’s two major liabilities:
1. Currency in M1, which equals currency outstanding minus vault cash.
2. Bank reserves, which equals commercial bank deposits at the Fed plus vault cash. Reserves
include required reserves and excess reserves.
C. How the Fed Changes the Monetary Base
The most direct method the Fed uses to change the monetary base is open market operations,
which involve buying or selling securities, generally U.S. Treasury securities. In an open
market purchase, the Fed buys Treasury securities and increases the monetary base by the
amount of the purchase. Similarly, the Fed can reduce the monetary base through an open
market sale of Treasury securities. T-accounts help illustrate the effect of the Fed’s actions on
the balance sheets of the banking system as a whole, the nonbank public, and the Fed. See
pages 420 – 422 of the text for an example of how open market operations can be illustrated
using T-accounts, which are essentially a simplified version of a balance sheet. Though less
commonly used, the Fed can also increase or decrease reserves by making discount loans to
commercial banks. This change in bank reserves changes the monetary base
D. Comparing Open Market Operations and Discount Loans
Although open market operations and discount loans both change the monetary base, the Fed
has greater control over open market operations than over discount loans. Economists think of
the monetary base as having two components:
1. The nonborrowed monetary base, Bnon (which the Fed controls)
2. Borrowed reserves, BR, which is another name for discount loans
Teaching Tips
Students may have heard how the Fed’s balance sheet soared during and after the financial crisis of
2007-2009 and may have seen differing explanations as to why it took place. Have students read, the
Making the Connection, “Explaining the Explosion in the Monetary Base,” which begins on page 423 of
the text. Ask students how Fed policy during that time differed from traditional policy as well as some of
the reasons for the innovative policy measures the Fed employed.
14.2 The Simple Deposit Multiplier (pages 424–429)
Learning Objective: Derive the equation for the simple deposit multiplier and understand what it
means.
A. Multiple Deposit Expansion
An open market purchase increases the excess reserves of the banking system. Normally, banks
use the excess reserves to make loans. The funds from the loan are deposited into the banking
system after being used to purchase an item. The bank that receives the new deposit holds some
of the funds in the form of required reserves and loans the rest to borrowers (households and
firms). This process continues in rounds of loans and bank deposits, resulting in an increase in
the money supply that is a multiple of the initial increase in reserves.
B. Calculating the Simple Deposit Multiplier
The simple deposit multiplier relates the initial change in reserves to the change in the money
supply and equals 1 divided by the required reserve ratio.
14.3 Banks, the Nonbank Public, and the Money Multiplier (pages 429–439)
Learning Objective: Explain how the behavior of banks and the nonbank public affect the money
multiplier.
The simple deposit multiplier assumed banks hold no excess reserves and the nonbank public does
not change its currency holdings.
A. The Effect of Increases in Currency Holdings and Increases in Excess Reserves
Because funds deposited in banks are subject to the multiple deposit creation process, while
funds held as currency are not, an increase in currency holdings relative to deposits reduces the
multiple deposit creation. In a similar way, if banks hold more excess reserves relative to
deposits, the multiple deposit creation is reduced.
B. Deriving a Realistic Money Multiplier
A realistic money multiplier links the monetary base to the money supply. The money
multiplier is the ratio of the money supply to the monetary base. The expression for the money
multiplier is:
m=
(
C
D
)
+1
(
C
D
)
+rrD+
(
ER
D
)
,
where (C/D) is the currency-to-deposit ratio, (ER/D) is the excess reserves-to-deposit ratio, and
rrD is the required reserve ratio.
Because the money supply equals the money multiplier multiplied by the monetary base, the
money supply can increase due to either an increase in the money multiplier or an increase in
the monetary base. Increases in the currency-to-deposit ratio, excess reserves-to-deposit ratio,
or required reserve ratio reduce the money multiplier, and, therefore, the money supply
(assuming no change in the monetary base).
C. The Money Supply, Money Multiplier, and the Monetary Base During and After the 2007–2009
Financial Crisis
During the financial crisis of 2007–2009, the currency-to-deposit ratio declined slightly, but the
excess reserves-to-deposit ratio soared, leading to a 50% decline in the money multiplier.
Reasons for the dramatic increase in the excess reserves-to-deposit ratio include:
1. The desire of banks for increased liquidity as they sought to rebuild their capital.
2. Tighter lending standards due to uncertainty about the credit worthiness of borrowers.
3. The introduction of interest on reserves.
Banks’ enormous holdings of excess reserves left investors, policymakers, and economists
concerned about the risk of future inflation.
Teaching Tips
As discussed throughout the chapter, the amount of excess reserves held by banks has soared in recent
years, raising concerns about future inflation. Have students read, the Making the Connection, “Did the
Fed’s Worry about Excess Reserves Cause the Recession of 1937-1938?” which begins on page 436 of
the text. Ask students about the parallels between the economic events of the 1930s and the period during
and after the financial crisis of 2007-2009. Have students discuss the concerns related to high levels of
excess reserves in the mid-1930s and the Fed’s response at that time. Ask what lessons learned can be
applied to current monetary policy.
14 Appendix: The Money Supply Process for M2 (page 446)
Learning Objective: Describe the money supply process for M2.
Many economists and policymakers pay more attention to M2 than M1. M2 includes everything in
M1 plus nontransaction accounts such as small savings and time deposit accounts (N) and money
market deposit accounts (MM). We can derive an expression for the M2 multiplier similar to the
expression we derived for the M1 multiplier. The result is:
M2multiplier=
1+
(
C
D
)
+
(
N
D
)
+
(
MM
D
)
(
C
D
)
+rrD+
(
ER
D
)
Increases in the required reserve ratio and the currency-to-deposit ratio reduce the extent of deposit
expansion, thereby reducing the M2 multiplier. An increase in the nonbank public’s preference for
nontransaction or money market–type accounts relative to checkable deposits increases the
multiplier.