8.5 The Money Supply Process and Interest Rate Determination

© 1999-2020, Douglas A.Ruby (06-15-2020)

Money can be narrowly defined as anything that may be used for purchasing goods and services or more broadly to include anything of value that may be used for trade.

Changes to the the money stock in an aggregate economy can occur for any of several reasons:

To best understand how these changes occur, it is useful to look at the basic components of the balance sheets of the non-bank public, the commercial banks, and the central bank (i.e., the Federal Reserve):

Non-Bank Public
Assets Liabilities
C = $2,000
DD = $5,000
TD = $0

L = $3,000

Commercial Banks
Assets Liabilities
rR = $500
xR = $500
L = $3,000
S = $1,000

DD = $5,000
TD = $0

The Federal Reserve
Assets Liabilities
S = $2,000 C = $2,000
R = $1,000

In the above example, C represents currency in circulation -- an asset of the non-bank public and a liability of the central bank. DD refers to demand deposits, TD to time deposits -- assets of the non-bank public and an liabilities of commercial banks. rR (required reserves), xR (excess reserves), and their sum R represent reserves and are non-income producing assets of the commercial banks and a liability of the central bank respectively. L refers to loans outstanding -- a liability of the non-bank public a and an income-producing asset for the commercial banks. Finally S is a reference to securities, specifically government securities (treasuries), that are liabilities of the Federal Government.

8.5.1 The M1 Money Multiplier

If we focus on M1, we find that this measure represents he main liquid financial assets of the non-bank public. In a similar manner we can define the monetary base B (also known as high-powered money), as the main liabilities of central bank. If we relate these two measures to one-another, we can define a link between the two, known as the money multiplier This is accomplished as follows:

M1 = C + DD
M1 = [1 + (C/DD)] x (DD)

B = R + C = [rd + (xR/DD) + (C/DD)] x (DD) and

R = rR + xR

where rd represents the reserve requirement on demand deposits. Rearranging, we can write:

DD = B / [rd + (xR/DD) + (C/DD)]
M1 = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]} x B
MS = M1 = mm x (B)
mm = {[1 + (C/DD)] / [rd + (xR/DD) + (C/DD)]}

This money multiplier represents the ability of a fractional-reserve banking system to create money within the economy, that is, for each dollar of reserves; the money supply is some multiple of that value.

Increasing the reserve requirements (rd) will reduce the value of the money multiplier and thus when holding the monetary base constant, reduce the money supply. Increases to the excess reserve-demand deposit ratio 'xR/DD' (pessimism among bank management) will have a similar affect on the money supply. Finally, changes in the currency-demand deposit ratio 'C/DD' will directly affect the money multiplier -- holding more cash in relative terms will reduce the money supply.

8.5.2 Open market operations

Open market operations, which represent one policy tool available to central banks, will affect the monetary base. If the central bank chooses to pursue an expansionary monetary policy, they would begin to buy government securities from the commercial banks (1). Payment for these securities would be in the form of reserves credited to the commercial bank's account with the central bank. Thus there is a change in the composition of assets within the commercial bank's balance sheet -- a change that lead to fewer income producing assets (securities) and more non-income producing assets (excess Reserves). Banks will attempt to convert some or all of these excess reserves to new loans by lowering the interest rate that they charge on these loans (2).

Non-Bank Public
Assets Liabilities
DD ↑ (3)

L ↑ (2)
Commercial Banking System
Assets Liabilities
xR ↑ (1), ↓ (2)
L ↑ (2)
S ↓ (1)

DD ↑ (3)
The Federal Reserve
Assets Liabilities

S ↑ (1)
R ↑ (1)

As the non-bank public takes out these new loans, they convert these funds into new deposits at the same or other banks in the commercial banking system (3). Demand deposits expand as does the money supply. Thus this particular type of open market operations (buying securities) leads to more reserves, expansion in the money supply, lower interest rates and new loans to support investment spending.

Contractionary monetary policy would do just the opposite. The central bank would sell government securities to the commercial banks, removing reserves from the system, causing these banks to curtail their loan activity and raising the interest rates charged on loans.

8.5.3 The Federal Reserve System and Central Banking

The Federal Reserve System, the central bank of the United States, was created by an act of Congress in 1913. Originally, the 'Fed' was designed as a decentralized Central Bank with 12 District banks located throughout the U.S. and the Board of Governors 'BOG' located in Washington D.C. However, over time the development and direction of monetary policy has migrated from these District banks to the BOG.

Also by design, the Fed is both a quasi-public / quasi-private institution. Public in that the 7 members of the BOG are appointed by the President to staggered single 14 year terms and confirmed by Congress. Private in that the assets of the Fed are privately owned through stock owned by commercial banks as ownership shared in their local District bank.

The Federal Reserve System

The Fed is a system composed of roughly 3x000 member commercial banks (nationally chartered banks must be a member of the Federal Reserve System - State chartered banks have the option of joining), 12 District Banks and 25 Branch District Banks, the seven-member Board of Governors and a twelve member (the 7 Governors, 4 District Bank presidents serving on a rotating basis, and the President of the N.Y. District Bank) Federal Open Market Committee - the FOMC. It is the FOMC that is responsible for providing directives guiding Open Market Operations.

The Fed has four main responsibilities:

Sometimes these responsibilities are complementary but more often one goal is in conflict with another. Inflation fighting can sometimes come at the expense of economic growth. Injecting liquidity into the banking system in times of crisis can also lead to future inflationary pressure in the economy.

The above responsibilities can often be thought of as primary goals. The Fed will work to achieve certain goals by influencing different intermediate targets. These targets include: interest rates (specifically the Federal Funds rate), Money supply targets (M1 or M2), or a particular exchange rate. These targets are affected through three tools of monetary policy.

The Minneapolis Fed.

Open market operations as described above is the most common tool used in the implementation of monetary policy. For example, if the goal is to fight inflation, the Fed will set a target of a higher Federal Funds rate (the directive will be to buy and, more likely, sell securities on the open market to achieve this target rate). A higher Federal Funds rate will be an indication of less liquidity in the banking system and thus higher interest rates charged by these banks to their customers.

With higher borrowing rates, certain investment projects will become less profitable and thus investment spending will decline. With the reduction in this investment spending, aggregate expenditure (Nominal GDP) should also decline. Less spending in the demand-side of the economy should eliminate any upward pressure on prices that may exist.

8.5.4 Equilibrium in Financial Markets

The functional form for money demand (as derived from the Inventory Theoretic Model) is:

Md = f [Y , i ]
(+) (-)

In equilibrium,

Md = M/P

where M/P represents the purchasing power of available money balances (the money supply). Holding the price level constant (no supply-side constraints), changes in purchasing power will only result via changes in the money supply. Additionally, if the price level is unchanging then changes to nominal measures of income are the same as changes to real income measures.

An increase in the Money Supply (Real money balances) shifts the MS function to the right. This is often a deliberate policy action (via open-market operations) intended to stimulate aggregate demand.

An Increase in the Money Supply

The result is an Excess Supply of Money within the commercial banking system (specifically excess reserves and thus loanable reserves) such that interest rates charged to their borrowing customers and on overnight loans to other commercial banks (the Federal Funds Rate) will fall. This is shown in the figure above.

An Increase in Income

An increase in Income 'Y' leads to an outward shift in Money Demand 'Md (due the the need to support a greater level of transactions). This shift leads to an Excess Demand for Money where individuals will begin to make portfolio adjustments (selling bonds and securities thus Pbonds ↓, ψ bonds) putting upward pressure on the whole structure of nominal interest rates. This is shown in the figure above.

Interest rates thus act as a barometer of changing expectations, reaction to new information about economic events and of changes in monetary policy. In addition interest rates provide the linkage between financial markets and the real economy.

Changes in the money supply, the buying and selling of financial assets in secondary markets, or the issue and acquisition of financial assets in primary markets all affect returns to lenders and more importantly the cost of borrowing. It is these borrowing costs that affect investment spending decisions and thus real economic activity.

Concepts for Review:
  • Board of Governors
  • Branch District Banks
  • Commercial Banks
  • Contractionary Monetary Policy
  • Currency
  • Currency-Demand Deposit Ratio
  • Demand Deposits
  • Discount Rate
  • District Banks
  • Excess Reserves
  • Excess Demand for Money
  • Excess Supply of Money
  • Expansionary Monetary Policy
  • Federal Open Market Committee
  • Federal Reserve System
  • Lender of Last Resort
  • Loans
  • Monetary Base
  • Money
  • Money Demand
  • Money Multiplier
  • Money Stock
  • Money Supply
  • Non-bank Public
  • Open Market Operations
  • Required Reserves
  • Reserve Requirement
  • Reserves (total reserves)
  • Securities
  • Time Deposits

Top of page related: Money Supply Process previous: the Portfolio Model Macroeconomic Theory
© 1999-2020, Douglas A.Ruby (05-20-2020)