374 PREVIEW In Chapter 15, we developed a simple model of multiple deposit creation that showed how the Fed can control the level of checkable deposits by setting the required reserve ratio and the level of reserves. Unfortunately for the Fed, life isn’t that simple; control of the money supply is far more complicated. Our critique of this model indicated that decisions by depositors about their holdings of currency and by banks about their holdings of excess reserves also affect the money supply. To deal with this cri- tique, in this chapter we develop a money supply model in which depositors and banks assume their important roles. The resulting framework provides an in-depth description of the money supply process to help you understand the complexity of the Fed’s role. To simplify the analysis, we separate the development of our model into several steps. First, because the Fed can exert more precise control over the monetary base (currency in circulation plus total reserves in the banking system) than it can over total reserves alone, our model links changes in the money supply to changes in the monetary base. This link is achieved by deriving a money multiplier (a ratio that relates the change in the money supply to a given change in the monetary base). Finally, we examine the determinants of the money multiplier. Study Guide One reason for breaking the money supply model into its component parts is to help you answer questions using intuitive step-by-step logic rather than memorizing how changes in the behavior of the Fed, depositors, or banks will affect the money supply. In deriving a model of the money supply process, we focus here on a simple def- inition of money (currency plus checkable deposits), which corresponds to M1. Although broader definitions of money—particularly, M2—are frequently used in policymaking, we conduct the analysis with an M1 definition because it is less com- plicated and yet provides a basic understanding of the money supply process. Furthermore, all analyses and results using the M1 definition apply equally well to the M2 definition. A somewhat more complicated money supply model for the M2 defi- nition is developed in an appendix to this chapter, which can be viewed online at www .aw.com/mishkin. Chapter Determinants of the Money Supply 16 The Money Supply Model and the Money Multiplier Because, as we saw in Chapter 15, the Fed can control the monetary base better than it can control reserves, it makes sense to link the money supply M to the monetary base MB through a relationship such as the following: M ϭ m ϫ MB (1) The variable m is the money multiplier, which tells us how much the money supply changes for a given change in the monetary base MB. This multiplier tells us what multiple of the monetary base is transformed into the money supply. Because the money multiplier is larger than 1, the alternative name for the monetary base, high- powered money, is logical; a $1 change in the monetary base leads to more than a $1 change in the money supply. The money multiplier reflects the effect on the money supply of other factors besides the monetary base, and the following model will explain the factors that deter- mine the size of the money multiplier. Depositors’ decisions about their holdings of currency and checkable deposits are one set of factors affecting the money multiplier. Another involves the reserve requirements imposed by the Fed on the banking sys- tem. Banks’ decisions about excess reserves also affect the money multiplier. In our model of multiple deposit creation in Chapter 15, we ignored the effects on deposit creation of changes in the public’s holdings of currency and banks’ holdings of excess reserves. Now we incorporate these changes into our model of the money supply process by assuming that the desired level of currency C and excess reserves ER grows proportionally with checkable deposits D; in other words, we assume that the ratios of these items to checkable deposits are constants in equilibrium, as the braces in the following expressions indicate: c ϭ {C/D} ϭ currency ratio e ϭ {ER/D} ϭ excess reserves ratio We will now derive a formula that describes how the currency ratio desired by depositors, the excess reserves ratio desired by banks, and the required reserve ratio set by the Fed affect the multiplier m. We begin the derivation of the model of the money supply with the equation: R ϭ RR ϩ ER which states that the total amount of reserves in the banking system R equals the sum of required reserves RR and excess reserves ER. (Note that this equation corresponds to the equilibrium condition RR ϭ R in Chapter 15, where excess reserves were assumed to be zero.) The total amount of required reserves equals the required reserve ratio r times the amount of checkable deposits D: RR ϭ r ϫ D Deriving the Money Multiplier CHAPTER 16 Determinants of the Money Supply 375 Substituting r ϫ D for RR in the first equation yields an equation that links reserves in the banking system to the amount of checkable deposits and excess reserves they can support: R ϭ (r ϫ D) ϩ ER A key point here is that the Fed sets the required reserve ratio r to less than 1. Thus $1 of reserves can support more than $1 of deposits, and the multiple expansion of deposits can occur. Let’s see how this works in practice. If excess reserves are held at zero (ER ϭ 0), the required reserve ratio is set at r ϭ 0.10, and the level of checkable deposits in the banking system is $800 billion, the amount of reserves needed to support these deposits is $80 billion (ϭ 0.10 ϫ $800 billion). The $80 billion of reserves can sup- port ten times this amount in checkable deposits, just as in Chapter 15, because mul- tiple deposit creation will occur. Because the monetary base MB equals currency C plus reserves R, we can gener- ate an equation that links the amount of monetary base to the levels of checkable deposits and currency by adding currency to both sides of the equation: MB ϭ R ϩ C ϭ (r ϫ D) ϩ ER ϩ C Another way of thinking about this equation is to recognize that it reveals the amount of the monetary base needed to support the existing amounts of checkable deposits, currency, and excess reserves. An important feature of this equation is that an additional dollar of MB that arises from an additional dollar of currency does not support any additional deposits. This occurs because such an increase leads to an identical increase in the right-hand side of the equation with no change occurring in D. The currency component of MB does not lead to multiple deposit creation as the reserves component does. Put another way, an increase in the monetary base that goes into currency is not multiplied, whereas an increase that goes into supporting deposits is multiplied. Another important feature of this equation is that an additional dollar of MB that goes into excess reserves ER does not support any additional deposits or currency. The reason for this is that when a bank decides to hold excess reserves, it does not make additional loans, so these excess reserves do not lead to the creation of deposits. Therefore, if the Fed injects reserves into the banking system and they are held as excess reserves, there will be no effect on deposits or currency and hence no effect on the money supply. In other words, you can think of excess reserves as an idle com- ponent of reserves that are not being used to support any deposits (although they are important for bank liquidity management, as we saw in Chapter 9). This means that for a given level of reserves, a higher amount of excess reserves implies that the bank- ing system in effect has fewer reserves to support deposits. To derive the money multiplier formula in terms of the currency ratio c ϭ {C/D} and the excess reserves ratio e ϭ {ER/D}, we rewrite the last equation, specifying C as c ϫ D and ER as e ϫ D: MB ϭ (r ϫ D) ϩ (e ϫ D) ϩ (c ϫ D) ϭ (r ϩ e ϩ c) ϫ D We next divide both sides of the equation by the term inside the parentheses to get an expression linking checkable deposits D to the monetary base MB: (2)D ϭ 1 r ϩ e ϩ c ϫ MB 376 PART IV Central Banking and the Conduct of Monetary Policy Using the definition of the money supply as currency plus checkable deposits (M ϭ D ϩ C ) and again specifying C as c ϫ D, M ϭ D ϩ (c ϫ D) ϭ (1 ϩ c) ϫ D Substituting in this equation the expression for D from Equation 2, we have: (3) Finally, we have achieved our objective of deriving an expression in the form of our ear- lier Equation 1. As you can see, the ratio that multiplies MB is the money multiplier that tells how much the money supply changes in response to a given change in the monetary base (high-powered money). The money multiplier m is thus: (4) and it is a function of the currency ratio set by depositors c, the excess reserves ratio set by banks e, and the required reserve ratio set by the Fed r. Although the algebraic derivation we have just completed shows you how the money multiplier is constructed, you need to understand the basic intuition behind it to understand and apply the money multiplier concept without having to memorize it. In order to get a feel for what the money multiplier means, let us again construct a numerical example with realistic numbers for the following variables: r ϭ required reserve ratio ϭ 0.10 C ϭ currency in circulation ϭ $400 billion D ϭ checkable deposits ϭ $800 billion ER ϭ excess reserves ϭ $0.8 billion M ϭ money supply (M1) ϭ C ϩ D ϭ $1,200 billion From these numbers we can calculate the values for the currency ratio c and the excess reserves ratio e: The resulting value of the money multiplier is: The money multiplier of 2.5 tells us that, given the required reserve ratio of 10% on checkable deposits and the behavior of depositors as represented by c ϭ 0.5 and banks as represented by e ϭ 0.001, a $1 increase in the monetary base leads to a $2.50 increase in the money supply (M1). An important characteristic of the money multiplier is that it is less than the sim- ple deposit multiplier of 10 found in Chapter 15. The key to understanding this result m ϭ 1 ϩ 0.5 0.1 ϩ 0.001 ϩ 0.5 ϭ 1.5 0.601 ϭ 2.5 e ϭ $0.8 billion $800 billion ϭ 0.001 c ϭ $400 billion $800 billion ϭ 0.5 Intuition Behind the Money Multiplier m ϭ 1 ϩ c r ϩ e ϩ c M ϭ 1 ϩ c r ϩ e ϩ c ϫ MB CHAPTER 16 Determinants of the Money Supply 377 of our money supply model is to realize that although there is multiple expansion of deposits, there is no such expansion for currency. Thus if some portion of the increase in high-powered money finds its way into currency, this portion does not undergo multiple deposit expansion. In our analysis in Chapter 15, we did not allow for this possibility, and so the increase in reserves led to the maximum amount of mul- tiple deposit creation. However, in our current model of the money multiplier, the level of currency does increase when the monetary base MB and checkable deposits D increase because c is greater than zero. As previously stated, any increase in MB that goes into an increase in currency is not multiplied, so only part of the increase in MB is available to support checkable deposits that undergo multiple expansion. The over- all level of multiple deposit expansion must be lower, meaning that the increase in M, given an increase in MB, is smaller than the simple model in Chapter 15 indicated. 1 Factors That Determine the Money Multiplier To develop our intuition of the money multiplier even further, let us look at how this multiplier changes in response to changes in the variables in our model: c, e, and r. The “game” we are playing is a familiar one in economics: We ask what happens when one of these variables changes, leaving all other variables the same (ceteris paribus). If the required reserve ratio on checkable deposits increases while all the other vari- ables stay the same, the same level of reserves cannot support as large an amount of checkable deposits; more reserves are needed because required reserves for these checkable deposits have risen. The resulting deficiency in reserves then means that banks must contract their loans, causing a decline in deposits and hence in the money supply. The reduced money supply relative to the level of MB, which has remained unchanged, indicates that the money multiplier has declined as well. Another way to see this is to realize that when r is higher, less multiple expansion of checkable deposits occurs. With less multiple deposit expansion, the money multi- plier must fall. 2 We can verify that the foregoing analysis is correct by seeing what happens to the value of the money multiplier in our numerical example when r increases from 10% to 15% (leaving all the other variables unchanged). The money multiplier becomes: which, as we would expect, is less than 2.5. m ϭ 1 ϩ 0.5 0.15 ϩ 0.001 ϩ 0.5 ϭ 1.5 0.651 ϭ 2.3 Changes in the Required Reserve Ratio r 378 PART IV Central Banking and the Conduct of Monetary Policy 1 Another reason the money multiplier is smaller is that e is a constant fraction greater than zero, indicating that an increase in MB and D leads to higher excess reserves. The resulting higher amount of excess reserves means that the amount of reserves used to support checkable deposits will not increase as much as it otherwise would. Hence the increase in checkable deposits and the money supply will be lower, and the money multiplier will be smaller. However, because e is currently so tiny—around 0.001—the impact of this ratio on the money multi- plier is now quite small. But there have been periods when e has been much larger and so has had a more impor- tant role in lowering the money multiplier. 2 This result can be demonstrated from the Equation 4 formula as follows: When r rises, the denominator of the money multiplier rises, and therefore the money multiplier must fall. The analysis just conducted can also be applied to the case in which the required reserve ratio falls. In this case, there will be more multiple expansion for checkable deposits because the same level of reserves can now support more checkable deposits, and the money multiplier will rise. For example, if r falls from 10% to 5%, plugging this value into our money multiplier formula (leaving all the other variables unchanged) yields a money multiplier of: which is above the initial value of 2.5. We can now state the following result: The money multiplier and the money sup- ply are negatively related to the required reserve ratio r. Next, what happens to the money multiplier when depositor behavior causes c to increase with all other variables unchanged? An increase in c means that depositors are converting some of their checkable deposits into currency. As shown before, checkable deposits undergo multiple expansion while currency does not. Hence when checkable deposits are being converted into currency, there is a switch from a com- ponent of the money supply that undergoes multiple expansion to one that does not. The overall level of multiple expansion declines, and so must the multiplier. 3 This reasoning is confirmed by our numerical example, where c rises from 0.50 to 0.75. The money multiplier then falls from 2.5 to: We have now demonstrated another result: The money multiplier and the money supply are negatively related to the currency ratio c. When banks increase their holdings of excess reserves relative to checkable deposits, the banking system in effect has fewer reserves to support checkable deposits. This means that given the same level of MB, banks will contract their loans, causing a decline in the level of checkable deposits and a decline in the money supply, and the money multiplier will fall. 4 This reasoning is supported in our numerical example when e rises from 0.001 to 0.005. The money multiplier declines from 2.5 to: Note that although the excess reserves ratio has risen fivefold, there has been only a small decline in the money multiplier. This decline is small, because in recent years e m ϭ 1 ϩ 0.5 0.1 ϩ 0.005 ϩ 0.5 ϭ 1.5 0.605 ϭ 2.48 Changes in the Excess Reserves Ratio e m ϭ 1 ϩ 0.75 0.1 ϩ 0.001 ϩ 0.75 ϭ 1.75 0.851 ϭ 2.06 Changes in the Currency Ratio c m ϭ 1 ϩ 0.5 0.05 ϩ 0.001 ϩ 0.5 ϭ 1.5 0.551 ϭ 2.72 CHAPTER 16 Determinants of the Money Supply 379 3 As long as r ϩ e is less than 1 (as is the case using the realistic numbers we have used), an increase in c raises the denominator of the money multiplier proportionally by more than it raises the numerator. The increase in c causes the multiplier to fall. If you would like to know more about what explains movements in the currency ratio c, take a look at an appendix to this chapter on this topic, which can be found on this book’s web site at www.aw.com/mishkin. Another appendix to this chapter, also found on the web site, discusses how the money multiplier for M2 is determined. 4 This result can be demonstrated from the Equation 4 formula as follows: When e rises, the denominator of the money multiplier rises, and so the money multiplier must fall. has been extremely small, so changes in it have only a small impact on the money multiplier. However, there have been times, particularly during the Great Depression, when this ratio was far higher, and its movements had a substantial effect on the money supply and the money multiplier. Thus our final result is still an important one: The money multiplier and the money supply are negatively related to the excess reserves ratio e. To understand the factors that determine the level of e in the banking system, we must look at the costs and benefits to banks of holding excess reserves. When the costs of holding excess reserves rise, we would expect the level of excess reserves and hence e to fall; when the benefits of holding excess reserves rise, we would expect the level of excess reserves and e to rise. Two primary factors affect these costs and bene- fits and hence affect the excess reserves ratio: market interest rates and expected deposit outflows. Market Interest Rates. As you may recall from our analysis of bank management in Chapter 9, the cost to a bank of holding excess reserves is its opportunity cost, the interest that could have been earned on loans or securities if they had been held instead of excess reserves. For the sake of simplicity, we assume that loans and secu- rities earn the same interest rate i, which we call the market interest rate. If i increases, the opportunity cost of holding excess reserves rises, and the desired ratio of excess reserves to deposits falls. A decrease in i, conversely, will reduce the opportunity cost of excess reserves, and e will rise. The banking system’s excess reserves ratio e is neg- atively related to the market interest rate i. Another way of understanding the negative effect of market interest rates on e is to return to the theory of asset demand, which states that if the expected returns on alternative assets rise relative to the expected returns on a given asset, the demand for that asset will decrease. As the market interest rate increases, the expected return on loans and securities rises relative to the zero return on excess reserves, and the excess reserves ratio falls. Figure 1 shows us (as the theory of asset demand predicts) that there is a nega- tive relationship between the excess reserves ratio and a representative market inter- est rate, the federal funds rate. The period 1960–1981 saw an upward trend in the federal funds rate and a declining trend in e, whereas in the period 1981–2002, a decline in the federal funds rate is associated with a rise in e. The empirical evidence thus supports our analysis that the excess reserves ratio is negatively related to mar- ket interest rates. Expected Deposit Outflows. Our analysis of bank management in Chapter 9 also indi- cated that the primary benefit to a bank of holding excess reserves is that they pro- vide insurance against losses due to deposit outflows; that is, they enable the bank experiencing deposit outflows to escape the costs of calling in loans, selling securities, borrowing from the Fed or other corporations, or bank failure. If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows increase), they will want more insurance against this possibility and will increase the excess reserves ratio. Another way to put it is this: If expected deposit outflows rise, the expected benefits, and hence the expected returns for holding excess reserves, increase. As the theory of asset demand predicts, excess reserves will then rise. Conversely, a decline in expected deposit outflows will reduce the insurance benefit 380 PART IV Central Banking and the Conduct of Monetary Policy of excess reserves, and their level should fall. We have the following result: The excess reserves ratio e is positively related to expected deposit outflows. Additional Factors That Determine the Money Supply So far we have been assuming that the Fed has accurate control over the monetary base. However, whereas the amount of open market purchases or sales is completely controlled by the Fed’s placing orders with dealers in bond markets, the central bank cannot unilaterally determine, and therefore cannot perfectly predict, the amount of borrowing by banks from the Fed. The Federal Reserve sets the discount rate (inter- est rate on discount loans), and then banks make decisions about whether to borrow. The amount of discount loans, though influenced by the Fed’s setting of the discount rate, is not completely controlled by the Fed; banks’ decisions play a role, too. Therefore, we might want to split the monetary base into two components: one that the Fed can control completely and another that is less tightly controlled. The less tightly controlled component is the amount of the base that is created by discount loans from the Fed. The remainder of the base (called the nonborrowed monetary CHAPTER 16 Determinants of the Money Supply 381 FIGURE 1 The Excess Reserves Ratio e and the Interest Rate (Federal Funds Rate) Source: Federal Reserve: www.federalreserve.gov/releases/h3/hist/h3hist2.txt. 0.0 0.001 0.002 0.003 0.004 0.005 0.006 0.007 5 10 15 20 Interest Rate Excess Reserves Ratio 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 0 Excess Reserves Ratio, e Interest Rate (%) 0.008 0.009 0.010 base) is under the Fed’s control, because it results primarily from open market oper- ations. 5 The nonborrowed monetary base is formally defined as the monetary base minus discount loans from the Fed: MB n ϭ MB Ϫ DL where MB n ϭ nonborrowed monetary base MB ϭ monetary base DL ϭ discount loans from the Fed The reason for distinguishing the nonborrowed monetary base MB n from the monetary base MB is that the nonborrowed monetary base, which is tied to open mar- ket operations, is directly under the control of the Fed, whereas the monetary base, which is also influenced by discount loans from the Fed, is not. To complete the money supply model, we use MB ϭ MB n ϩ DL and rewrite the money supply model as: M ϭ m ϫ (MB n ϩ DL) (5) where the money multiplier m is defined as in Equation 4. Thus in addition to the effects on the money supply of the required reserve ratio, currency ratio, and excess reserves ratio, the expanded model stipulates that the money supply is also affected by changes in MB n and DL. Because the money multiplier is positive, Equation 5 immediately tells us that the money supply is positively related to both the nonbor- rowed monetary base and discount loans. However, it is still worth developing the intuition for these results. As shown in Chapter 15, the Fed’s open market purchases increase the nonborrowed monetary base, and its open market sales decrease it. Holding all other variables con- stant, an increase in MB n arising from an open market purchase increases the amount of the monetary base that is available to support currency and deposits, so the money supply will increase. Similarly, an open market sale that decreases MB n shrinks the amount of the monetary base available to support currency and deposits, thereby causing the money supply to decrease. We have the following result: The money supply is positively related to the non- borrowed monetary base MB n . With the nonborrowed monetary base MB n unchanged, more discount loans from the Fed provide additional reserves (and hence higher MB) to the banking system, and these are used to support more currency and deposits. As a result, the increase in DL will lead to a rise in the money supply. If banks reduce the level of their discount loans, with all other variables held constant, the amount of MB available to support currency and deposits will decline, causing the money supply to decline. Changes in Discount Loans DL from the Fed Changes in the Nonborrowed Monetary Base MB n 382 PART IV Central Banking and the Conduct of Monetary Policy 5 Actually, there are other items on the Fed’s balance sheet (discussed in the appendix on the web site) that affect the magnitude of the nonborrowed monetary base. Since their effects on the nonborrowed base relative to open market operations are both small and predictable, these other items do not present the Fed with difficulties in controlling the nonborrowed base. The result is this: The money supply is positively related to the level of discount loans DL from the Fed. However, because the Federal Reserve now (since January 2003) keeps the interest rate on discount loans (the discount rate) above market inter- est rates at which banks can borrow from each other, banks usually have little incen- tive to take out discount loans. Discount lending, DL, is thus very small except under exceptional circumstances that will be discussed in the next chapter. Overview of the Money Supply Process We now have a model of the money supply process in which all four of the players— the Federal Reserve System, depositors, banks, and borrowers from banks—directly influence the money supply. As a study aid, Table 1 charts the money supply (M1) response to the six variables discussed and gives a brief synopsis of the reasoning behind each result. Study Guide To improve your understanding of the money supply process, slowly work through the logic behind the results in Table 1 rather than just memorizing the results. Then see if you can construct your own table in which all the variables decrease rather than increase. CHAPTER 16 Determinants of the Money Supply 383 Table 1 Money Supply (M1) Response SUMMARY Change in Money Supply Player Variable Variable Response Reason Federal Reserve r ↑↓Less multiple deposit System expansion MB n ↑↑More MB to support D and C DL ↑↑More MB to support D and C Depositors c ↑↓Less multiple deposit expansion Depositors Expected ↑↓e ↑ so fewer reserves and banks deposit outflows to support D Borrowers from i ↑↑e ↓ so more reserves banks and the to support D other three players 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. [...]... sheet of the Fed and the amount of reserves The market for reserves is where the federal funds rate is determined, and this is why we turn to a supply -and- demand analysis of this market to analyze how all three tools of monetary policy affect the federal funds rate 393 394 PART IV Central Banking and the Conduct of Monetary Policy Supply and Demand in the Market for Reserves The analysis of the market... 2 The sharp increase in the ratio during World War I and the decline thereafter 3 The steepest increase in the ratio that we see in the figure, which occurs during the Great Depression years from 1930 to 1933 4 The increase in the ratio during World War II 5 The reversal in the early 1960s of the downward trend in the ratio and the rise thereafter 6 The halt in the upward trend from 1 980 to 1993 7 The. .. 1 .8 1.10 1.00 0.90 0 .80 0.70 0.60 0.50 c 0.40 0.30 1 980 1 981 1 982 1 983 1 984 1 985 1 986 1 987 1 988 1 989 1990 1991 1992 1993 1994 1995 1996 1997 19 98 1999 2000 2005 F I G U R E 3 Determinants of the Money Supply, 1 980 –2002 Percentage for each bracket indicates the annual growth rate of the series over the bracketed period Source: Federal Reserve: www.federalreserve.gov/releases CHAPTER 16 Determinants of. .. experienced the heaviest impact of bank failures in the twenties But failure of 256 banks with $ 180 million of deposits in November 1930 was followed by the failure of 532 with over $370 million of deposits in December (all figures seasonally unadjusted), the most dramatic being the failure on December 11 of the Bank of United States with over 387 388 PART IV Central Banking and the Conduct of Monetary... periods, the link between the growth rates of the nonborrowed monetary base and the money supply is not always close, primarily because the money multiplier m experiences substantial short-run swings CHAPTER 16 M1 Money Supply ($ billions) 1200 1100 1000 900 Determinants of the Money Supply M1 2.3% 80 0 11.1% 700 600 3.3% 500 13.1% 400 7.2% 300 0 1 980 1 981 1 982 1 983 1 984 1 985 1 986 1 987 1 988 1 989 1990... shown; the effects of decreases in the variables on the money multiplier would be the opposite of those indicated in the “Response” column appendix 2 to chapter 16 Expanding Behavior of the Currency Ratio The general outline of the movements of the currency ratio c since 189 2 is shown in Figure 1 As you can see, several episodes stand out: 1 The declining trend in the ratio from 189 2 until 1917, when the. .. to the analysis of the bond market we conducted in Chapter 5 We derive a demand and supply curve for reserves Then the market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the federal funds rate, the interest rate charged on the loans of these reserves Demand Curve To derive the demand curve for reserves, we need to ask what happens to the. .. members of the Monetary Affairs Division at the Board of Governors are contacted, and the New York Fed’s forecasts of reserve supply and demand are compared with the Board’s On the basis of these projections and the observed behavior of the federal funds market, the desk will formulate and propose a course of action to be taken that day, which may involve plans to add reserves to or drain reserves from the. .. throughout the economy Thus, to fully understand how the Fed’s tools are used in the conduct of monetary policy, we must understand not only their effect on the money supply, but their direct effects on the federal funds rate as well The chapter thus begins with a supply -and- demand analysis of the market for reserves to explain how the Fed’s settings for the three tools of monetary policy determine the federal... 5, the demand for loans by borrowers influences market interest rates, as does the supply of money Therefore, all four players are important in the determination of i Explaining Movements in the Money Supply, 1 980 –2002 To make the theoretical analysis of this chapter more concrete, we need to see whether the model of the money supply process developed here helps us understand recent movements of the . 0.10, and the level of checkable deposits in the banking system is $80 0 billion, the amount of reserves needed to support these deposits is $80 billion (ϭ 0.10 ϫ $80 0 billion). The $80 billion of. and historical levels of M1, M2, and M3, and other data on the money supply. CHAPTER 16 Determinants of the Money Supply 385 that have a major impact on the growth rate of the money supply. The. www.federalreserve.gov/releases. 1200 1000 400 500 600 80 0 700 900 1100 300 0 M1 Money Supply ($ billions) M1 1 980 1 981 1 982 1 983 1 984 1 985 1 986 1 987 1 988 1 989 1990 1991 1992 1994 1995 1996 1997 19 98 1999 2000 20051993 11.1% 3.3% 2.3% 13.1% 7.2% 386