MONEY AND BANKING
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapters 16, 17, and 18, on monetary policy and multiple deposit creation
Last revised 11 May 2009.

In these notes:

I. Introducing the Federal Reserve
II.  Structure of the Fed
II.  Tools of monetary policy, in more detail
IV.  Multiple deposit creation


I. INTRODUCING THE FEDERAL RESERVE

Virtually every country has a central bank of some kind, to be the government's banker and to regulate the supply of money and credit.  The U.S. central bank is the Federal Reserve System, or the Fed.  It is a network of 12 regional Federal Reserve banks in major U.S. cities, with additional branches in a couple dozen other cities.  The Fed's greatest power is concentrated in Washington, DC, where the Federal Reserve Board of Governors, headed by the Fed Chairman (now Alan Greenspan), is located.  Today the Fed is the most powerful economic policy-making institution, and its decisions on monetary policy and interest rates are watched intently by businesses, banks, and financial markets.

The Fed is a bank, with assets and liabilities to manage, but it is totally unlike any other U.S. bank.
-- It does not accept deposits, aside from commercial banks' reserve accounts and government deposits; instead, the vast majority of the Fed's liabilities are dollar bills, a.k.a. "Federal Reserve Notes" or "Currency in circulation."  U.S. currency is the Fed's liability because the Fed is responsible for maintaining the value of that currency by keeping inflation low.
-- On the asset side, unlike commercial banks, the Fed makes almost no loans, except emergency discount loans to banks facing cash shortages.  The vast majority of the Fed's assets are government securities, which the Fed buys and sells in order to affect the supply of bank reserves and the money supply.
-- The Fed's holdings of government securities are also important in that they provide the Fed with substantial interest income, more than enough to finance the Fed's operations.  The Fed's interest expenses on the liability side are about zero, because it does not pay interest on U.S. currency.  Put those two facts together, and you get an enormously profitable bank; the Fed's charter, however, requires it to turn over all of its profits to the federal government.
-- In terms of total assets, the Fed is larger than all but a few U.S. banks.  (It was the largest as recently as the late 1990s.)

The Fed influences the supply of credit, the money supply, and interest rates mainly by manipulating the supply of bank reserves.
-- A related measure is the monetary base = currency + bank reserves.  The monetary base is a crucial monetary measure, because the money supply is a multiple of the monetary base. In addition, while the banks and their depositors and borrowers play important roles in determining the size of the money supply, the monetary base is solely under the control of the Fed.  Increases in the monetary base are typically multiplied into much larger increases in the money supply.

The Fed controls the monetary base by controlling the level of bank reserves.  The Fed controls the level of reserves through its three policy tools:

(1) changing the banks' reserve requirements (currently 10% of checking deposits must be kept as reserves)
-- The Fed rarely changes these requirements, because it's too blunt a policy instrument, in that it could lead to excessive changes in the money supply and liquidity crunches at many banks.

(2) discount loans to banks
-- These fulfill the Fed's "lender of last resort" function. While not many banks actually take out such loans, in a period of financial crisis or recession the Fed may encourage banks to do so. The discount rate is the interest rate the Fed charges on its loans to banks.  (Historically it was slightly lower than the federal funds rate, the overnight lending rate between banks, but that's no longer the case.  For example, in 2004 the discount rate was a point higher than the federal funds rate.)

* (3) OPEN MARKET OPERATIONS (buying and selling Treasury bonds from banks).
-- When the Fed buys a T bond from a bank or lends money to a bank, it increases the total of bank reserves, thereby increasing the monetary base. When the Fed sells a T bond to a bank, the bank pays the Fed by allowing the Fed to debit its reserve account, thereby decreasing the total of bank reserves and the monetary base.
-- This is by far the Fed's most commonly used policy tool, and is what the Fed uses to control the much-watched federal funds rate (the interest rate at which banks loan reserves to each other).

II. STRUCTURE OF THE FED

The Federal Reserve System is composed of the following:
* the seven members of the Federal Reserve Board of Governors in Washington, DC.
---- These are the central figures of the Fed.
---- All seven Fed governors sit on the Fed's official policy-making group, the Federal Open Market Committee (FOMC), which has 12 members altogether.
---- Each is appointed by the President of the United States (and confirmed by the Senate) to a 14-year term.  They cannot be reappointed, but most return to academia or business before their term is up, anyway.
------ The Chairman (now Ben Bernanke; was Alan Greenspan, 1987-2006) is the exception:  his term as Chairman is only 4 years and is renewable.
* 12 regional Federal Reserve Banks in major financial centers of the U.S. such as New York, Boston, and Chicago.
---- Of the regional Feds, the Federal Reserve Bank of New York is by far the most powerful. It conducts the Fed's open-market operations (buying and selling of securities so as to influence the money supply and interest rates) and its foreign-exchange transactions (designed to influence the dollar's exchange rate).  Its president is the permanent Vice-Chairman of the FOMC.
* several thousand commercial banks that belong to the Federal Reserve System.

The Federal Open Market Committee (FOMC) is the Fed's policy-making group.
* it meets every six weeks to plot the course of monetary policy
* it decides what it wants the federal funds rate to be. Open-market operations (OMO) is its tool for reaching that target.
* it has 12 members -- the seven Fed Governors, the NY Fed President, and four other regional Fed Bank Presidents
* it sets targets for the federal funds rate, which are implemented by the NY Fed as OMO decisions.

The Fed has been around since 1914, one year after Congress passed the Federal Reserve Act.  The act was prompted by the severe financial panic of 1907, which led many to conclude that the private banking system needed an outside organization to help avert future panics.  Congress gave the Fed a permanent charter, with the understanding that it would be a "lender of last resort" that could provide liquidity and credit in troubled times.
-- Although the Fed was created by the federal government, and despite the similarity of the words "Fed" and "feds," the Fed is technically not part of the government.  It is an independent, self-financing agency.  The presidents of the twelve regional Federal Reserve Banks are appointed by the banks' shareholders, not by politicians.  The seven members of the Fed's board of governors are appointed by the President of the United States and confirmed by the Senate, but they have 14-year terms, long enough to make them basically independent of the political process.
---- Still, the Fed's independence from politics is far from complete.  The chairman of the Fed has only a 4-year term, which means that every U.S. president gets to appoint a Fed chair to his liking.  On the other hand, presidents of both parties tend to appoint the same sort of people to the Fed -- respected academic or business economists who are dedicated to keeping inflation low.

The Fed has become considerably more powerful over the course of this century.  It became especially powerful in the 1980s, as Paul Volcker (who served as Fed Chairman from 1979-87) brought down inflation nearly single-handedly.  Also, rising federal budget deficits in the 1980s, and concern that they were unacceptably large, meant that fiscal policy (changing the levels of government spending and taxes so as to stimulate or slow down the economy) was no longer much of an option. Alan Greenpan, who served as Fed Chairman from 1987-2006 and presided over prosperity with low inflation, was even more revered the Volcker.  People now look first to the Fed, rather than to Congress or the White House, for action on the economy.

III. TOOLS OF MONETARY POLICY, IN MORE DETAIL

The Fed has three main policy tools, which it uses to influence the level of bank reserves and the monetary base, and through them the money supply and interest rates and the economy:
(1) changes in banks' required reserve ratio
(2) discount loans / changes in the discount rate
(3) open market operations

A. CHANGES IN BANKS' REQUIRED RESERVE RATIO (RRR)
-- The required reserve ratio (RRR) is now 10% of checking deposits.  It has been 10% ever since the early 1990s recession, when it was lowered from 12%.
---- (To be precise, the RRR is actually only 3% on a bank's first $50 million in checking deposits and then goes up to 10%.)
-- The RRR on savings account, CD's, and money-market deposit accounts is zero.
-- Changes in the RRR have large effects on money supply: increasing RRR causes decrease in m, decrease in money supply. Because this tool's effects are so powerful as to preclude "fine tuning" (making small changes in monetary policy as needed), it is the Fed's least-used policy tool.
-- A key disadvantage of changing reserve requirements as a policy tool: it is too blunt a policy instrument, since it has a dramatic effect on the money supply.  It is also not practical, due to administrative costs and the problems it creates for banks (ex.: in 1936, a doubling of bank reserve requirements hammered the banks and induced a severe recession).
-- Some people advocate lowering the RRR all the way to zero, effectively abolishing bank reserve requirements.  Why? Apart from the fact that many other industrialized countries, including Canada, have no reserve requirements, the rationale is that having to keep 10% of deposits as reserves hurts the competitiveness and profitability of American banks.  Banks only need to keep about 1-2% of checking deposits as reserves to meet deposit outflows. If the RRR were set to zero, banks would still hold some excess reserves, but could loan out more of their deposits and reap higher profits. 
---- Prior to Nov. 2008, bank reserves paid no interest.  The Fed started paying interest on reserves in Nov. 2008 and still does.  The apparent rationale, besides boosting bank profits, was to encourage banks to have more excess reserves handy (instead of, say, buying government bonds with them) so that they'd be able to make more loans when opportunities arose.

B. DISCOUNT LOANS / CHANGES IN THE DISCOUNT RATE
Discount loans: loans (of reserves) made by regional Fed banks to commercial banks.
-- An increase in discount loans increases bank reserves (and the MB) and increases the money supply
-- A decrease in discount loans decreases bank reserves (and the MB) and decreases the money supply
The Fed controls the discount rate, i.e. the interest rate at which it loans money to banks.
-- The Fed also controls the volume, or quantity, of discount loans, since its regional banks have discretion over whether to grant or deny any particular discount-loan request
-- Discount loans are the essence of the Fed's lender of last resort function.
---- They were originally envisioned as the Fed's main policy tool, back when the Fed was chartered in 1913. (More recently, OMO has overtaken discount loans in importance.) The Fed can help prevent financial and bank panics by providing reserves.

C. OPEN MARKET OPERATIONS (OMO)
In OMO, the Fed buys or sells bonds, usually from the banks, in order to affect the level of bank reserves and the federal funds rate (the interest rate at which commercial banks loan each other reserves, on an overnight basis). In turn, the money supply and other interest rates will be affected, too.
-- OMO is the Fed's most important and most-used policy tool.  When the Fed announces that it's raising or lowering its federal funds rate target, it's really embarking on OMO, since it uses OMO to affect the federal funds rate.
-- Depending on whether the Fed is trying to conduct an expansionary monetary policy or a contractionary monetary policy, it will use one of the following types of OMO:
---- (1) open-market purchases - when the Fed buys securities from banks and pays for them by crediting the banks' reserve accounts at the Fed, thus creating reserves -> reserves increase, MB increases -> money supply increases, i decreases (expansionary monetary policy).
---- (2) open-market sales - when the Fed sells securities to banks and collects payment by debiting the banks' reserve accounts at the Fed, thus destroying reserves -> reserves decrease, MB decreases -> money supply decreases, i increases (contractionary monetary policy).
-- The types of securities involved in these open market operations are Treasury bills.  They're perfect for these transactions because they're very liquid and virtually every bank has some.
-- The Federal Open Market Committee meets every six weeks to decide on what the Fed's open market operations (FOMC; note: Federal Open Market Committee, Open Market Operations).
-- The Federal Reserve Bank of New York conducts OMO, via its Trading Desk

There are two basic types of OMO (aside from the purchases-vs.-sales distinction):

(1) DYNAMIC OMO: change MB, change money supply, interest rates
---- goes with a definite shift in Fed policy (e.g., a decision to lower interest rates).  Dynamic OMO can be either expansionary or contractionary.
------ (a) EXPANSIONARY OMO: goal is to stimulate the economy and reduce unemployment.  Sequence:
Fed makes open-market purchases of bonds from banks, pays for them by crediting banks' reserve accounts at the Fed --> reserves increase, MB increases --> money supply increases, interest rates fall --> business investment and household consumption rise --> real GDP and employment rise.
------- (b) CONTRACTIONARY OMO: goal is to reduce inflation by slowing down the economy.  Sequence:
Fed makes open-market sales of bonds to banks, collects payment by debiting banks' reserve accounts at the Fed --> reserves fall, MB falls --> money supply decreases, interest rates increase --> business investment and household consumption fall --> real GDP and employment fall (or grow more slowly) --> inflation rate falls.

(2) DEFENSIVE OMO: maintain the current federal funds rate.  In a growing economy, the demand for loans and banks' demand for new reserves to loan out increase continually.  Since only the Fed can create bank reserves, it's up to the Fed to expand the supply of bank reserves to keep pace with the normal growth of the economy.  Otherwise, the federal funds rate would grow to very high levels.
---- This would also include offsetting other factors affecting bank reserves, such as the stock market crash of 1987.
---- The Fed conducts defensive OMO nearly every day.

OMO directly influences the FEDERAL FUNDS MARKET (the market where banks loan their excess reserves to each other, usually on an overnight basis), by affecting the supply of bank reserves.  The federal funds rate, which is the interest rate that banks charge each other on loans of reserves, is the equilibrium interest rate in the federal funds market, so it is determined by the intersection of the supply and demand curves for reserves.
---- Open-market purchases increase the supply of bank reserves, causing the supply curve for reserves to shift out and the federal funds rate to decrease.  In the case of expansionary OMO, the Fed conducts open-market purchases on a large scale, in order to decrease the federal funds rate.
---- Open-market sales decrease the supply of bank reserves, causing the supply curve for reserves to shift in and the federal funds rate to increase.  In the case of contractionary OMO, the Fed conducts open-market sales on a large scale, in order to increase the federal funds rate.
---- In the case of defensive OMO, the Fed tries to keep the federal funds rate constant by (1) making open-market purchases to offset an increase in banks' demand for reserves, or (2) making open-market sales to offset a decrease in banks' demand for reserves.
-- [I drew a diagram of the federal funds market in class, including how the Fed can lower it by increasing the supply of reserves (shifting the supply curve right).  I also handed out a one-page sheet about the federal funds market, including the shifts associated with the different types of OMO.]

IV. MULTIPLE DEPOSIT CREATION

Recall:  money supply = cash in circulation + bank deposits

Bank deposits, not cash, account for the vast majority of the money supply. This is the case even though cash deposits, and cash reserves, are the foundation of the banking system. The reason why the volume of bank deposits is so much larger than the total amount of cash is that banks practice FRACTIONAL RESERVE BANKING: when cash is deposited into a bank, the bank keeps only a small fraction of that cash as reserves and loans the rest of it out, at interest.
-- Fractional reserve banking is closely related to the phenomenon of MULTIPLE DEPOSIT CREATION: when cash is deposited into a bank, the bank loans out most of that money, and most of the money loaned gets redeposited into the banking system, and gets mostly loaned out again, and redeposited, and so on. The chain of deposit creation -- excess reserves (ER) being loaned out and redeposited in the banking system -- continues until the banks have basically no more excess reserves.

Multiple deposit creation can also be understood as follows: When the Fed creates an additional $1 in bank reserves, total bank deposits (and hence the money supply) increase by a multiple of that amount.
-- The multiplication of an initial change in reserves into a much larger change in bank deposits occurs because of the chain of deposit creation, in which excess reserves are loaned out and redeposited ad infinitum.

In its simplest form, the deposit-creation process involves two key assumptions:
(1) the banks loan out 100% of their excess reserves;
(2) all loans get redeposited into the banking system.

simple deposit multiplier = {ultimate change in checking deposits}/{change in bank reserves} = 1/RRR
-- If RRR = 10%, then the simple deposit multiplier, or simple money multiplier, is 10.
---- Ex.: An increase in bank reserves of $1 million would ultimately cause both checking deposits and bank loans (and the money supply) to increase by ten times that amount, or $10 million.

Multiple deposit destruction: When the Fed destroys an additional $1 in bank reserves, total bank deposits (and hence the money supply) decrease by a multiple of that amount.
-- Multiple deposit destruction is assumed to work like this: In equilibrium, banks hold no excess reserves (ER=0). When the Fed decreases the level of bank reserves (say, by selling a bond to a bank and collecting payment by debiting the bank's reserve account), the banking system will have negative excess reserves, or a reserve deficiency, and any bank with a reserve deficiency will call in loans for repayment, and their creditors will repay the loans by drawing down their checking accounts. So the volume of loans and the volume of checking deposits will shrink at the same time. Since the banks cannot create reserves themselves, the only way to restore equilibrium is for the volume of checking deposits to shrink by exactly 10 times the change in reserves.
---- Ex.: An decrease in bank reserves of $1 million would ultimately cause both checking deposits and bank loans (and the money supply) to decrease by ten times that amount, or $10 million.

The T-account framework is helpful in illustrating how the deposit-creation process works.

EXAMPLE: The Fed buys $100 in securities from the First National Bank. (The required reserve ratio for checking deposits is 10%. We will assume that First National and all other banks initially have zero excess reserves. Also assume that all loans get redeposited into checking accounts in U.S. banks.) The Fed pays for the securities by crediting First National's reserve account at the Fed with $100. We would like to know, What is the ultimate change in the money supply, after the entire chain of deposit creation has run its course?

First, the change in the Fed's balance sheet is as follows:

FEDERAL RESERVE SYSTEM
 
Assets Liabilities
Securities +$100 Banks' deposits at the Fed +$100

The initial change in First National's balance sheet is:

FIRST NATIONAL BANK
 
Assets Liabilities
Reserves    +$100
Securities    -$100

First National now has excess reserves of $100 (ER = $100).

We can fast-forward to the answer to our question -- What is the ultimate change in the money supply, after all excess reserves have been loaned out and redeposited again and again?

The answer is simply:
{Total change in money supply} = {Initial change in reserves} * {Money multiplier}
                                                     = { + $100 } * {10}
                                                     = + $1000

The simple deposit multiplier is 10, because the RRR is 10%, or .10, so, plugging that into the formula for the simple deposit multiplier, we get:

simple deposit multiplier = 1/RRR = 1/.10 = 10

Let's step back and see how that $1000 increase in the money supply comes to be. First National will loan out its excess reserves of $100. Say it loans them out to me. I use that $100 to buy something (say, $100 worth of compact discs), and the CD merchant will either deposit that $100 in the banking system or spend it himself; either way, someone will eventually deposit that $100 cash in the banking system -- if not at First National, then at some other bank. With that new deposit the (cumulative) change in the banking system's balance sheet is as follows:
 
Assets Liabilities
Reserves    + $100 Checking deposits + $100
Securities    - $100
Loans         + $100

The money supply has expanded by $100, since the money supply includes checking deposits. The money-creation process will continue because the bank that received the $100 cash deposit now has excess reserves ( = actual reserves - required reserves) of

$100 - (.10)($100) = $100 - $10 = $90.

The bank will loan out that $90 and it, too, will eventually be redeposited as cash in the banking system. Now the cumulative change in the banks' balance sheet is:
 
Assets Liabilities
Reserves  + $100 Checking deposits + $190
Securities  - $100
Loans       + $190

The banks have excess reserves of $81 ( = $100 - (.10)($190) = $100 - $19 ). They will loan them out and the money will be redeposited in the banking system, increasing checking deposits by another $81. Then 90 percent of that will be loaned out and redeposited, and 90 percent of that will be loaned out and redeposited, etc. The total increase in bank deposits (and hence in the money supply) will be:
    $100 + $90 + $81 + ($81)(.90) + ($81)(.902) + ...
=  $100 + ($100)(.90) + ($100)(.902) + ($100)(.903) + ($100)(.904) + ...

This seemingly endless sum is a geometric series, and is solvable as

                  1                       1
$100 * --------- = $100 * ----- = $100 * 10 = $1000
              1 - .90                  .10

Thus total bank deposits increase by $1000, as does the money supply. The total change in the banking system's balance sheet, when there are no more excess reserves remaining, is:
 
Assets Liabilities
Reserves   +   $100 Checking deposits + $1000
Securities   -   $100
Loans        + $1000

That $1000 increase in checking deposits all came about as the result of an initial increase in reserves of $100. Thus the total amount of deposits has expanded by a multiple (ten) of the original change in reserves.

Extra-credit question (for 1 point):
Suppose that the RRR in the above example were 5% instead of 10%.
How exactly would that last T-account be different?  (Include numbers.)

To review:
* In our example, the Fed injects $100 in reserves into the banking system, by purchasing a $100 T-bill from the First National Bank. To see how that increases the money supply, we need to keep track of the increase in checking deposits. After the Fed's purchase, First National has $100 in excess reserves. They loan those reserves out as $100 cash, and that $100 cash gets redeposited into a checking account at the bank. Then the bank has $100 in reserves again, and $90 of that is excess reserves (the remaining $10 has to be kept to meet their 10% reserve requirement on checking deposits; they can loan out 90% of any increase in cash deposits, so they loan out .90*$100 = $90). They loan out those excess reserves -- $90 cash -- and that $90 gets redeposited. They can lend out 90% of that (.90*.90*$100 = $81), and it will be redeposited. And so on.
* The sum of all these additional checking deposits is a geometric sum, as explained in the previous lecture, meaning that we have a simple formula for finding the total increase in deposits:

total increase in deposits = initial increase in deposits * (1/RRR)

* The initial increase in reserves of $100 ultimately leads to a $1000 increase in checking deposits, or a $1000 increase in the money supply. Thus the total amount of deposits has expanded by a multiple (ten) of the original change in reserves. That multiple is called the simple deposit multiplier.
     simple deposit multiplier
     = total change in deposits per dollar increase in reserves
     = 1/(1-percent loaned out) = 1/(percent not loaned out) = 1/(percent kept as reserves)
     = 1/RRR

So far we have assumed that all excess reserves are loaned out, and all loans are redeposited in full in the banking system. Neither of those assumptions (especially the second one) is very realistic. In fact, banks do hold some excess reserves, and some of the money that banks loan out is held by the public as currency. Both of those factors are "leakages" from the stream of deposit creation; and, as a result, the result that the "real world" money multiplier is considerably smaller than 10 (i.e., 1/RRR) -- it's actually about 2.