11. THE MONEY SUPPLY PROCESS
We examine the Federal Reserve’s balance sheet in this chapter and explain how
fluctuations in the Fed’s assets and liabilities affect the money supply. Money supply greatly
influences the interest rates, exchange rates, inflation, and a country’s production of goods and
services. Furthermore, fluctuations in the money supply impact the financial markets, such as
bond and stock prices and the economic well-being of society. Unfortunately, the Fed can only
influence the money supply because the public and banks also influence the money supply. For
this chapter, we use the definitions of money, M1 and M2, to explain how the banking system
expands the money supply by the multiple deposit expansion.
The Fed’s Balance Sheet
Monetary base equals the currency in circulation plus reserves held by commercial banks.
Currency in circulation is the Federal Reserve Notes the public is holding, i.e. U.S. money,
which does not include vault cash at the banks because we already counted the vault cash as
bank reserves. Moreover, the Fed can directly influence the monetary base, and in turn, the
monetary base influences the money supply. Before understanding how the money supply
process works, we introduce the Fed’s balance sheet. Consequently, the currency in circulation
and bank reserves are liabilities to the Federal Reserve.
Using a simple example, the Fed sets the required reserve ratio to 10%, which is the
percentage of total reserves that banks must hold as reserves at the Fed or as vault cash. If you
open a bank account by depositing $100, then the bank must hold 10% of your deposit, which
equals $10. Thus, the $10 is the required reserves. A bank could hold more than $10, which are
excess reserves. Consequently, the bank holds reserves to meet depositors’ withdrawals. You
could return to your bank and withdraw your $100 deposit. Subsequently, the bank returns your
money from its reserves. Bank either holds $10 in its vault or deposits the $10 with the Fed. Did
you notice bank reserves are assets to the bank, but liabilities to the Fed? On the other hand, the
public holding money is an asset, but money is a liability to the Fed.
The Fed has two important assets: government securities and discount loans. When the Fed
increases its assets, the monetary base rises When the Fed decreases its assets, the monetary
base declines. The Fed can change the monetary base through open-market operations. An open-
market operation is the Fed buying and selling financial securities. Usually the Fed buys and
sells U.S. government securities. When the Fed buys U.S. government securities, we call it an
open-market purchase because the Fed’s assets increase, expanding the monetary base. The Fed
can sell U.S. government securities, called an open-market sale. The Fed’s assets decrease,
contracting the monetary base. For example, the Fed buys a $10,000 T-bill from your bank. We
list the transaction on the next page in the T-account: