The money multiplier, reserve

and currency ratios, and

borrowed reserves

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 Recall our definition of M1 as currency in circulation
plus checkable deposits
 Recall our definition of MB as currency in circulation
plus reserves
 The Fed has greater control over MB than it does over
M1
 Checkable deposits are influenced by a number of factors that
the Fed does not have direct control over.
 We link MB and M1 together through the money
multiplier
 M1 = m*MB
 For every $1 increase in the MB, the money supply (M1) increases
by m*$1
 m is almost always greater than 1.

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 How much currency does the public hold relative to
their checkable deposits?
 We assume that the desired level of currency (C) is a
constant fraction of checkable deposits

 The currency ratio is a constant (in equilibrium) defined

as:
 c = C/D

 C can change, but only in constant proportion to D

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 What fraction of checkable deposits do banks hold in
reserve?
 Banks are required by the Fed to hold a minimum fraction in
reserve defined as the reserve requirement ratio (rr)
 Banks may choose to hold excess reserves (i.e. a fraction of
deposits held in reserve above and beyond the minimum required
by the fed).
 Let RR be the required reserves held by banks
 RR = rr*D, where rr is a parameter set by the Fed
 Let ER be the excess reserves held by banks
 ER = e*D, where e is assumed to be a constant proportion set by
banks
 Total reserves (R) = RR + ER = rr*D + e*D = (rr+e)*D
 Note that we have been assuming so far that ER=0 (i.e. the
reserve requirement is binding).

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 We define MB as currency (C) plus reserves (R)

 Using our definitions:

 MB = C + R
 MB = c*D + rr*D + e*D
 MB = (rr + e + c)*D

 Themonetary base is equal to the fraction of

deposits allocated to required reserves, excess
reserves, and currency in circulation

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 MB = (rr + e + c)*D

1
 Rearranging gives: D MB
rr  e  c
 Recall M1 = C + D = (c*D) + D = (1+c)*D

 Pluggingin our definition of D:

1 c
M1  MB
rr  e  c
1 c
 Since M1 = m*MB: m
rr  e  c
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 The money multiplier is defined as:
m = (1+c)/(rr+e+c)

 If no currency is held and banks hold no excess reserves,

then the money multiplier is simply the inverse reserve
ratio
 A 10% rr will produce a multiplier of 10
 A 20% rr will produce a multiplier of 5

 In reality, people do hold currency and banks do hold

excess reserves.

 As a result, the banking system is limited in the amount

of money it creates through fractional reserve banking
(i.e. multiple deposit creation)
 Money held as currency or in reserve is not being loaned out.
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 Suppose the desired currency ratio is 40%, the
reserve requirement is 10% and the excess
reserve ratio is 0.5%

 The money multiplier is

 m = (1+0.4)/(0.1 + 0.4 + 0.005) = 2.77
 A one dollar increase in the monetary base will lead to
a $2.77 increase in the money supply

 Note that if c = e = 0, then the money multiplier

would have been 10.
 Accounting for currency and excess reserves is
clearly important.
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 Let
c = 0.25, e = 0.001, and rr = 0.1. Compute the
money multiplier
 m = (1+0.25)/(0.1+0.001+0.25) = 3.56

 TheFed decides to increase rr to 20%. What

happens to the money multiplier (and the money
supply as a result?)
 m = 1.25/0.456 = 2.74
 A smaller multiplier means that banks create less money
through lending and therefore the money supply will
fall.

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 What happens to the money multiplier when the
desired currency ratio rises?

 Let c = 0.2, rr = 0.25, and e = 0.05

 m = (1+0.2)/(0.25+0.05+0.2) = 1.2/0.5 = 2.4

 Now suppose c rises to 0.3, while all other

variables remain constant
 m = (1+0.3)/(0.25+0.05+0.3) = 1.3/0.6 = 2.17

 Increasing
the fraction of deposits held as
currency causes the money supply to fall
 Money is being taken out of the banking system where
it could have been used to make loans.
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 Changes in the required reserve ratio r
 The money multiplier and the money supply
are negatively related to r

 Changes in the currency ratio c

 The money multiplier and the money supply
are negatively related to c

 Changes in the excess reserves ratio e

 The money multiplier and the money supply
are negatively related to the excess reserves
ratio e

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 We have assumed that the constant currency
ratio is an independent parameter for
simplicity.

A more complete analysis would examine the

factors that cause c to change.
 Changes in income/wealth
 Larger proportions of currency are held by people with low
income/wealth
 As income/wealth rises, the ratio of currency to deposits falls

 Changes in expected returns

 As the interest rate on deposits rises, c falls
 As the cost of acquiring currency falls, c rises
 Fears of bank insolvency (i.e. bank panics) cause c to rise
sharply
 Increases in illegal activity cause c to rise

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 What are the costs and benefits to banks of holding
excess reserves?
 Market Interest Rates (-)
 Every dollar held as an excess reserve has an opportunity cost
equal to the interest rate it could have earned as a bank loan
 As market interest rates rise, this opportunity costs increases and
banks hold fewer excess reserves
 e is negatively related to market interest rates
 Expected Deposit Outflows (+)
 The main benefit of holding excess reserves is that they insulate
the bank (somewhat) from sudden deposit outflows
 With excess reserves, banks do not have to call in loans, sell off
other assets, or borrow from the Fed to cover deposits being
withdrawn
 If banks think that deposit outflows will increase, they would be
wise to increase their excess reserve ratio
 e is positively related to expected deposit outflows.

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 The preceding analysis suggests that the Fed can
increase/decrease the money supply by lowering/raising
the reserve ratio.
 While the Fed used this policy tool in the past, it has become
ineffective in the past decade or so.

 The Fed allows banks to classify some of their membership

deposits at the Fed as required reserves

 Banks have found that they need to keep extra currency in ATM’s
over weekends and holidays. This currency is classified as vault
cash and counts toward required reserves

 With these two developments, banks actually hold more

reserves than the minimum required by the Fed

 If rr is not binding, then any change in rr will have little

to no effect. (only works if you significantly increase
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 Open market operations are controlled by the Fed, but the Fed
does not directly control the amount of borrowing by banks from
the Fed

 We split the monetary base into two components, the non-

borrowed monetary base (MBn) and borrowed reserves by banks
(BR)
 MBn= MB – BR  MB = MBn + BR
 M1 = m*MB = m*(MBn + BR)

 The money supply increases with both the non-borrowed base and
with borrowed reserves
 An increase in BR frees up more bank deposits for loans
 BR tends to be very small since the Fed keeps the discount rate
above the market interest rate.

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 Explains long
run movements

Explains short
run fluctuations

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 The model we have developed here can be used to explain the
sharp reduction in the money supply during the Great
Depression
 Prior to FDIC, there was no publicly provided insurance for bank
deposits
 With the Great Depression, many bank loans failed
 People worried (rightfully) that their bank did not have enough in
reserves to cover all deposits
 They rushed to their bank to withdraw their money while their was
still something left in reserve
 This sparked a series of bank panics where even financially stable
banks were affected
 These bank panics directly led to a reduction in the money
supply, even though the Fed would have actually preferred an
increase in M1 at this time
 Fears of bank insolvency caused c to rise
 Increases in expected deposit outflows caused e to rise
 The multiplier declined sharply
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