[This week's lectures mostly go with Chapter 15, with a little of Chapters 14 (the part on central bank independence) and 16 (the real-world money multiplier) thrown in.]

* This week:
I.    Central bank independence
II.   Multiple deposit creation
III. Example of multiple deposit creation
IV. The real-world money multiplier
 

I.  CENTRAL BANK INDEPENDENCE

The Fed is technically an independent agency, as opposed to being part of the government. The Fed's revenues do not come from the government but from the interest they receive on their T-bonds and discount loans to banks; in that sense they are independent. In addition, Fed members cannot be fired or recalled by the President or the Senate before their terms are up.

The Fed's independent status raises a number of important questions -- in particular, how can a democratic society allow so much economic power to be concentrated in a group of unelected economists? Fed Chairman Alan Greenspan has far more
control over the U.S. economy than does the President of the U.S., or anyone else.
-- On the other hand, the Fed isn't completely removed from the political process. The Federal Open Market Committee (FOMC) is dominated by the Board of Governors, all of whom are appointed by one politician, the President, and confirmed by at least 51 more, in the Senate. The Fed Chairman is reappointed by the President every four years. Also, the Fed must turn over any profits its banks make (mainly from interest income) to the federal government.

In addition, at least one Fed Chairman, Arthur Burns, has been criticized for short-sighted policies designed to help the incumbent President (Nixon) win re-election, at the cost of higher inflation later. The Burns-Nixon actions, in Nixon's first term (1969-73) were a classic case of a "POLITICAL BUSINESS CYCLE," whereby the Fed practices contractionary monetary policy in the first two years of the President's term, so as to lower the (actual and expected) rate of inflation, and shift the Phillips Curve down, then practices expansionary economic policy in the next two years, so as to lower unemployment and produce strong GDP growth at election time. Since expansionary monetary policies tend to produce higher inflation only after a time lag of a year or two, the higher inflation comes after the President has already won re-election, paving the way for another monetary contraction (and a repetition of the political business cycle) in the early years of the President's second term.
-- Aside from the Nixon-Burns experience, political business cycles are very rare, perhaps even non-existent, in this country.

Arguments against the Fed's independence:
* Undemocratic -- puts an awful lot of power in the hands of unelected Fed Governors. Since the Fed tends to be dominated by Wall Street and bond-market interests, it tends to pursue overly tight monetary policies, keeping interest rates high and inflation low, which serves the interests of those Wall Street stock- and bondholders. This is the classic populist critique of the Fed.
* No provision to replace bad members
* Makes it difficult to coordinate fiscal and monetary policy. In the early 1980's, for example, the Fed continued its War on Inflation, which induced a severe recession, while Congress passed a tax cut aimed at promoting economic recovery. Until the Fed took its brakes off the economy in late 1982, the tax cut had no prayer of working.
* Fed has often blundered (impotent in Great Contraction of 1929-33, allowed inflation to get out of control in late 1960's and 1970's)

Arguments for the Fed's independence:
* Politicians may lack the economic expertise of Fed bankers.
* Inflationary bias to Fed policy if controlled by politicians, who may tend to favor short-run monetary expansions that lower unemployment and raise real income in an election year.
---- We would expect political business cycles to be a lot more common in countries where the central bank is controlled by politicians.
---- The Treasury may pressure Fed to buy new T-bonds, financed by printing new money. (This is called the "inflation tax," or "monetizing the debt"). This phenomenon is very common in Third World countries.
---- Since the Fed does not have to worry about re-election, it can pursue unpopular but wise policies. The Fed's 1979-82 "War on Inflation," under Chairman Paul Volcker, is cited by some people as an example of such a policy ("short-term pain for long-term gain").
---- The tendency for politically controlled central banks to pursue inflationary policies is well illustrated by a chart in Mishkin [refer to Figure 4 of Chapter 14, on p. 388], which shows a definite pattern of higher inflation rates in 1973-88 in countries with non-independent central banks (Spain, New Zealand, Italy) as compared with countries with very independent central banks (U.S., Germany, Switzerland).

The Fed's independence today: The Fed remains highly independent, but for the most part maintains a good working relationship with Congress and the White House.
-- Paul Volcker and Alan Greenspan have gone out of their way to avoid even the appearance of doing too much to help incumbent Presidents win reelection. (Volcker, a Democrat, did nothing to help Jimmy Carter's re-election bid in 1980; likewise, Greenspan, a conservative Republican, did nothing to help George Bush's re-election bid in 1992.)
-- In the 1990s, despite the Fed's independence, Republican Alan Greenspan and Democratic President Bill Clinton enjoyed a productive working relationship.
-- In early 2001, with a Republican in the White House (George W. Bush) who was proposing a large tax cut, Greenspan spoke out in favor of cutting taxes, raising criticism from many people who said Fed officials should avoid commenting on hot-button political issues like tax cuts. That is, the critics were saying that Greenspan was compromising the Fed's independence by calling for tax cuts.
 

II. MULTIPLE DEPOSIT CREATION

[Note: A lot of my lecturing on this was extemporaneous -- i.e., not from previously written notes.  I'll write up that part soon and include it in the "ex post" version of these lectures.]

Multiple deposit creation: 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 banks lend out their excess reserves and those loans eventually get redeposited in the banking system as cash, giving the banks excess reserves once again. The chain of deposit creation -- excess reserves (ER) being loaned out and redeposited in the banking system -- continues until the banks have no more excess reserves.
-- 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 eventually get redeposited into the banking system.

Some notation:
DD = change in total checking deposits
DR = change in bank reserves

simple deposit multiplier = DD/DR = 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.

Once again, the T-account framework is helpful in illustrating how this deposit-creation process works, as we shall see.
 

III. EXAMPLE OF MULTIPLE DEPOSIT CREATION

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 at First National.) 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

(Note: The change in bank reserves would also be +$100 if the Fed had bought the securities from an individual person and paid with a check. This is because when the person deposits that check in her bank account and the check clears, the Fed credits that bank's reserve account at the Fed with an extra $100. So the bank would have +$100 in reserves and +$100 in deposits.)

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

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

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 dollars. 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.

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:

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 is completely 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 or 2.5.
 

IV.  THE REAL-WORLD MONEY MULTIPLIER

The simple money multiplier, or simple deposit multiplier, is very simple indeed.  You just calculate 1/RRR; since RRR is now 10%, then the simple money multiplier is 1/.10 = 10.  But, as noted above, it is not very realistic, since banks do hold some excess reserves (though not much) and, especially, because a sizeable fraction of money loaned out does not get redeposited into bank accounts.  (In fact, about two-thirds of the U.S. currency that's officially "in circulation" is not even held in this country; many people in other countries, especially third-world countries, hold dollars as a hedge against inflation in their own currency, since the dollar right now is a much better store of value than, say, the Russian ruble.)
-- To the extent that banks hold onto some of their excess reserves, those reserves don't get loaned out and don't get redeposited into the banking system; thus excess reserves do not increase the money supply at all.  So an excess reserves ratio (the ratio of excess reserves to checking deposits, or ER/D) above zero will cause the money multiplier to be less than 1/RRR.
-- When cash loaned out continues to be held as cash, instead of redeposited into bank accounts, those holdings of currency are still counted as part of the money supply, but there is no multiple expansion of deposits (and hence of the money supply) associated with currency. Instead, every dollar that the public holds as currency is a dollar that doesn't get redeposited in the banks and therefore is not available to be loaned out and to contribute to further expansion of the money supply.

If we dig up information on banks' actual holdings of excess reserves and the fraction of loan amounts that people hold as currency (instead of redepositing it into bank accounts), we can get a much more realistic estimate of the money multiplier. We will call that realistic estimate the real-world money multiplier, or just the money multiplier.

Why we care about the real-world money multiplier: Because the Fed needs to keep the money supply in balance with money demand -- which fluctuates a lot -- in order to keep interest rates stable.
-- [In section 820 we saw a supply-and-demand diagram of the money market, in which the Fed was trying to keep the interest rate constant. It was similar to Mishkin's Chapter 18, Figure 3, on page 461.]
The Fed does not control the money supply directly.  Instead, it controls the monetary base, which is the sum of bank reserves and currency in circulation.  Notationally:
                      monetary base = reserves + currency
                               MB          =      R       +     C

The money supply (M^s) is equal to the monetary base (MB) times the money multiplier (m):

Breaking that down into required and excess reserves (ER) and letting D = checking deposits, we get:

With just a little mathematical manipulation (done in class and in Mishkin, p. 415), we can express the money supply (M or M1) as a multiple of the monetary base:

                      1 + [C/D]
M1 = -------------------------------- * MB
           RRR + [ER/D] + [C/D]

-- (That big fraction is m, the real-world money multiplier.)

To find m, all we need are realistic numbers for C, D, ER, and RRR. We already know that RRR = .10, or 10%. Some not-completely-off-base numbers for those variables are:

C = currency held by the public = $400 billion
D = checking deposits = $800 billion
ER = excess reserves = $0.8 billion
M1 = narrowest measure of money supply = C + D = $1200 billion

Plugging those numbers into our formula for m, the money multiplier, m is:

                 1 + [400/800]                           1 + 0.5                  1.5
m = ------------------------------------- = ----------------------- = --------- = 2.496
        0.10 + [0.8/800] + [400/800]     0.1 + 0.001 + 0.5       0.601

Voila! The real-world money multiplier is roughly 2.5. [Right now, using the actual numbers for C, D, and ER in the year 2000, it's actually about 1.9 or 2.0, but this is pretty close.]

If the money multiplier changes, the Fed needs to make offsetting changes in the monetary base so as to keep the money supply stable.
-- For example, in recessions the money multiplier tends to shrink, because:
* the excess reserves ratio (ER/D) tends to rise during recessions, as banks tend to view loans as risky during recessions. In an economic slump, businesses and households may be more likely to default on their debts. So banks may hold a lot of excess reserves because they think holding onto their reserves is a lot safer than loaning them out. An example was the "credit crunch" during the 1990-92 recession.
* the currency-deposit ratio (C/D) tends to rise during recessions, as people may start to view bank deposits as risky (if their banks are in danger of failing. This was a bigger problem back before federal deposit insurance was established in 1933; it is not really a big deal today).

Historical note on the Great Depression:
C/D and ER/D both tend to increase during major recessions and depressions, because the public may view banks as unsafe and banks are more likely to be pessimistic about borrowers' creditworthiness. During the Great Contraction of 1929-33, both of those ratios skyrocketed, and the money supply fell by about 25%, the most it has ever fallen. The drop was because of the increases in those ratios, which dramatically shrunk the money multiplier. A related reason was the huge number of bank failures, caused in large part by the many runs on the bank by depositors, who were trying to covert their deposits into cash (C/D was rising). Those bank failures directly and severely reduced the level of bank deposits, the key component of M1.