Part I Money and the Government

1.1 Debt Measurement

Macroeconomic debt can be measured in absolute and relative terms, with the latter providing more informative content. shows various levels of macroeconomic debt in the United States between 1952 and 2023.

highlights that, while all measures of debt have experienced growth since the middle of the 20th century, household debt has represented the largest component of debt most of that period. However, the Great Financial Crisis (GFC) that led to the Great Recession of 2008, represented a major shift in debt dynamics. After 2008, the federal debt began growing much more rapidly, outstripping all other debt growth, so that by the mid 2010s, federal debt overtook household debt as the largest component of debt. Since the COVID-19 period of 2020, the distance between the U. S. federal debt and all other debt has only been made larger.

1.2 The United States Federal Government Debt

On any given year, the federal government makes decisions on spending programs that add up to a federal budget. The government also collects various taxes throughout the year, which represent the government’s revenues for the year.

When the government spends less than it collects in taxes, it runs a budget surplus. This means the government has some measure of revenues leftover after it has made its expenditures. This leads to the question of what to do with the surplus. This is not a question that gets asked often, as the United States has rarely enjoyed budget surpluses. The question was asked at the end of the 1990s when the end of the Clinton presidency left the government with a surplus. What to do with that surplus became a point of debate in the 2000 United States presidential election, where suggestions to use it to pay down the national debt or to add them to the Social Security funds were bandied about.

A balanced budget implies that the government roughly spends the same amount of U. S. dollars as it collects in taxes. Balanced budgets have also been relatively rare in the United States, at least since the 1970s.

Any year the federal government spends above and beyond its own revenue, which stems mainly from tax collection, it runs a budget deficit. Since the deficit has to be financed by taking on new debt, any budget deficit automatically adds to the national debt. The national debt is affected by many factors, including government taxing and spending decisions, government’s participation in capital markets, business cycle fluctuations, natural disasters, militarization, and wars.

shows the United States federal debt as a share of gross domestic product (GDP). In the postwar period through about 1980, the absolute level of U. S. government debt grew at a slower rate than GDP, leading to a secular downward trend of U. S. relative debt relative to GDP.

After 1980, federal debt began to grow faster than GDP. The debt-to-GDP ratio steadily increased until the middle of the 1990s, when the United States economy experienced a sustained economic expansion (or boom) due to the information technology (IT) revolution and the mass adoption of the internet. From the middle of the 1990s, the federal debt-to-GDP ratio began to decline until about 2000 (commonly associated with the end of the dot com bubble of the 1990s) and then the ratio stabilized around 40%. In the aftermath of the GFC and the Great Recession of 2008, this ratio increased massively from 40% to over 80% by the end of 2019. Then the ratio experienced another massive hike in 2020 when, in response to the COVID-19 global pandemic, the federal debt was allowed to exceed 100% of GDP—a ratio that was only reached once before during World War II.

1.3 The United States Treasury Department

While policy decisions on federal spending and taxation are made by the legislative and executive branches of the United States government, policy actions are implemented by the United States Treasury Department. The Treasury is the arm of the federal government responsible for implementing fiscal policy: this involves federal government spending, taxation (through its largest bureau, the Internal Revenue Service, or IRS) and debt management.

From the Treasury’s own website, the basic functions of the Department of the Treasury include:

1.

Managing federal finances.

2.

Collecting taxes, duties, and monies paid to and due to the U. S. and paying all bills of the U. S.

3.

Currency and coinage.

4.

Managing government accounts and the public debt.

5.

Supervising national banks and thrift institutions.

6.

Advising on domestic and international financial, monetary, economic, trade, and tax policy.

7.

Enforcing federal finance and tax laws.

8.

Investigating and prosecuting tax evaders, counterfeiters, and forgers.

1.4 Residential (Household) Debt

The largest share of debt incurred by United States households goes to housing services in the form of mortgage debt. Mortgage debt as a share of GDP has increased steadily since 1945.

shows the 1990s and early 2000s saw a dramatic increase in mortgage debt. Many factors accounted for this run-up in mortgage debt, including a policy during the President George W. Bush administration to drive up home ownership for families. Bubble behavior, which was typically reserved for financial markets, was now for the first time showing up in real estate. Many purchased houses on the expectation that their price would continue to increase. When prices begin to rise faster than the fundamental value of the house, this “decoupling” between value and price led to prices simply increasing because they were expected to increase.

This dynamic—that current prices tend to increase simply on the expectation that they will continue to do so—may lead to a self-fulfilling prophecy that may hold for a while… until the bubble pops!

It is possible this “irrational exuberance” (as Alan Greenspan, a former Federal Reserve chairperson, called it)—which led many households to speculate that housing demand and home prices would continue to increase ad infinitum— would have been less destructive had it had been financed by homeowners’ income, savings, and wealth.

However, very low financing costs and high competition in commercial banking made it possible for homeowners to finance overvalued home purchases through mortgages. High competition in residential lending meant commercial banks derived low margins from issuing these loans. In order to compete, financial institutions relaxed lending standards. The term NINJA loans (no income—no job—no assets… no problem) became popular.

It could be argued that banks aided and abetted this runaway speculation. But this overabundance of mortgages exposed both homeowners and banking institutions to higher risk. When the bubble burst in 2007, housing prices declined sharply. Many homeowners were left with mortgage debt that was higher than the value of the home. This led to high delinquency, large losses for lenders, and bank bankruptcies and failures. The term Depression 2.0 became a rallying word for the massive monetary and fiscal response that would follow in 2008 and beyond. We will discuss more of this later in the book.

1.5 Other Debt

Non-financial firms also incur debt. Firms often finance investment in property, plant, and equipment by taking out loans.

shows that, fueled by the IT boom of the 1990s and more general productivity gains, corporate debt began increasing in the 1990s. This expansion continued until the GFC and the Great Recession of 2008. Low interest rates after 2007 contributed to low financing costs, which fueled a renewal in corporate borrowing through the 2010s. The global pandemic of 2020 saw a substantial spike in corporate debt, likely driven by low interest rates and the low cost of debt financing at the time. However, the spike was relatively short lived and corporate debt realigned rather quickly, returning to pre-COVID-19 levels by 2021. In addition to the federal government, other government entities in the United States, namely state and local governments, also take out loans to finance government works, education, infrastructure spending, etc.

shows that the debt incurred by state and local governments has represented the lowest levels of macroeconomic debt. It has ranged between 10% and 15% of GDP for most of the postwar period, except for the period following the Great Recession of 2008, when it spiked to about 20% of GDP before returning to its historical values.

shows that as a share of GDP, both household and corporate debt has steadily increased in the United States. However, in the aftermath of the GFC, household debt moderated somewhat. State and local debt has remained fairly level as a share of GDP. The federal debt has skyrocketed since GFC and through the global pandemic period, exceeding 100% of GDP. This leaves an open question as to whether this high level of debt is sustainable in the long run.

1.6 Glossary

Balanced Budget

A situation where government spending equals government revenue in a given fiscal year. Like budget surpluses, balanced budgets have been relatively rare in the U. S. since the 1970s.

Budget Deficit

The situation that occurs when the federal government’s spending exceeds its revenue (primarily from tax collection) in a given fiscal year. Any budget deficit must be financed by taking on new debt, which adds to the national debt. Budget deficits can be influenced by various factors, including economic conditions, policy decisions, and unexpected events like natural disasters.

Budget Surplus

The opposite of a budget deficit—when the government collects more in taxes and other revenue than it spends in a given year. Budget surpluses have been relatively rare in recent U. S. history, with a notable period occurring during the late 1990s at the end of the Clinton presidency.

Corporate Debt

Debt incurred by non-financial companies, typically used to finance investments in property, plant, equipment, and other business operations. This form of debt often fluctuates with economic cycles and interest rates, as seen in the IT boom of the 1990s and the post-2008 low interest rate environment.

Debt-to-GDP Ratio

A key metric for measuring relative debt levels, calculated by dividing total debt by the Gross Domestic Product (GDP). This ratio provides more informative content than absolute debt values, as it shows debt in relation to the economy’s size and capacity to generate income.

Deficit Spending

When the government spends above and beyond the revenues it collects from taxation, it runs a deficit. Deficit spending automatically contributes to growing the national debt.

Federal Debt (National Debt)

The total amount owed by the U. S. federal government, which accumulates over time as a result of budget deficits. The federal debt has grown dramatically since the 2008 financial crisis and exceeded 100% of GDP following the COVID-19 pandemic.

Fiscal Policy

Government actions regarding taxation and spending, implemented by the U. S. Treasury Department. Fiscal policy decisions affect the federal budget, debt levels, and overall economic activity.

Fundamental Value

The actual worth of an asset based on its underlying characteristics and income-generating potential, as opposed to speculative market prices. The disconnect between fundamental values and market prices can indicate bubble conditions.

Global Financial Crisis (GFC)

The severe financial crisis of 2008 that led to the Great Recession, marked by the collapse of the housing market, widespread bank failures, and a significant increase in federal debt. This event represented a major shift in debt dynamics across all sectors.

Gross Domestic Product (GDP)

The market value of all final goods and direct services sold in a country over a calendar year. It can be reflected in currency units or as an index.

Household Debt

Debt incurred by individuals and families, with mortgage debt typically representing the largest component. Household debt was historically the largest component of total U. S. debt until being surpassed by federal debt in the mid-2010s.

Internal Revenue Service (IRS)

The largest bureau of the Treasury Department, responsible for collecting taxes and enforcing tax laws. The IRS plays a crucial role in government revenue collection, which affects budget deficits and debt levels.

Irrational Exuberance

A term popularized by former Federal Reserve Chairperson Alan Greenspan, referring to unsustainable investor enthusiasm that drives asset prices well above their fundamental values.

Lending Standards

The criteria used by financial institutions to evaluate potential borrowers and decide whether to extend loans. The relaxation of these standards contributed to the housing bubble and subsequent financial crisis.

Monetary Response

Actions taken by the Federal Reserve and other monetary authorities to address economic crises, often including interest rate adjustments and other measures that affect borrowing costs and debt levels.

Mortgage Debt

The primary component of household debt, representing loans used to purchase homes. Mortgage debt played a central role in the 2008 financial crisis due to relaxed lending standards and speculative behavior in the housing market.

NINJA Loans

An acronym for “No Income, No Job, No Assets” loans that became notorious during the housing bubble of the early 2000s. These loans exemplified the dangerously relaxed lending standards that contributed to the 2008 financial crisis.

Real Estate Bubble

A period when housing prices rise far above their fundamental values, driven by speculative behavior and expectations of continued price increases. The bursting of the real estate bubble in 2007 triggered the Global Financial Crisis.

State and Local Government Debt

Debt incurred by state and local governments to finance public works, education, and infrastructure. This has historically been the smallest component of total U. S. debt, typically ranging between 10 and 15% of GDP.

Sustainable Debt

A level of debt that can be maintained over the long term without causing economic instability or requiring dramatic policy changes. The sustainability of current U. S. federal debt levels (over 100% of GDP) remains an open question.

Treasury Department

The executive agency responsible for managing federal finances, including debt management, tax collection, and fiscal policy implementation. The Treasury issues government debt securities to finance budget deficits.

2.1 The Federal Reserve System

Most countries have a central bank. A central bank is unlike the bank you and I may have a bank account with a neighborhood branch close by. Banks like Bank of America, Wells Fargo, Truist, Banco de Santander, Deutsche Bank, Bank of Yokohama, etc. are financial institutions who have at least two stakeholders: customers (like you or I) and shareholders (owners and managers of the bank). The objective of these financial institutions is to maximize profits and shareholder value and to compete for (and serve) customers.

A central bank has different objectives and stakeholders from commercial banks. First, the central bank’s stakeholders are the public and residents/citizens of the country. For example, if I am a citizen of the U. S., technically I am automatically served by the central bank of the U. S., whereas if I want to be served by Wells Fargo in the U. S., then I need to enter into a contractual agreement with the bank for service (i. e., open an account with the bank). Second, a central bank is a nonprofit seeking institution. The objectives of central banks may vary from country to country, but they work to maximize the welfare of the country and, by extension, the welfare of its citizens.

As a result of various central bank panics plaguing the U. S. economy at the end of the 19th and beginning of the 20th centuries, the U. S. Congress, with the approval of President Woodrow Wilson, passed into law the Federal Reserve Act of 1913 (see below). This act of Congress established the Federal Reserve as the central bank of the U. S.

Section 2A of the Federal Reserve Act outlines the objectives of the Fed as follows:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Note that the objectives are maximum employment, price stability, and moderate long-term interest rates. Importantly, monetary and credit aggregates are listed as implicit “levers” though which it was understood the objectives could be reached.

So, the understanding was that the Fed could maintain (i. e., manage) long-run growth of the money supply to accomplish price stability and maximum employment. However, as we discuss below, it is not clear that the Federal Reserve has complete control of the money supply. Similarly, it is not clear that the Federal Reserve has complete control over the market rate that banks charge each other for very short-term loans (which is called the effective Federal Funds rate).

The Federal Reserve Act establishes the Fed as a special kind of bank—one that is not allowed to maximize its own profits. Instead, it is charged with the dual mandate of price stability and maximum employment. Even as a nonprofit institution, this act of Congress allows the Fed to hold a balance sheet made up of assets and liabilities. This enables the Fed to hold monetary instruments, typically U. S. government securities such as bills and bonds, as well as currency and other assets. Therefore, while it is not clear how much control the Fed has over the money supply or interbank rates, we can be more definitive about the Federal Reserve’s ability to control its own balance sheet.

This means that any given trading day, the Fed can buy and sell U. S. government securities in the open market and manage the size of its balance sheet. When the Fed sells securities in the open market, the portfolio of securities it holds goes down (shrinking the size of its balance sheet). When the Fed buys securities in the open market, the portfolio of securities it holds increases (enlarging the size of its balance sheet). So, the Fed enjoys very good control over the treasuries it holds in its balance sheet. And this gives it a lot of control over bank reserves, which we define below. After all, we do not call it the Federal Money System, we call it the Federal Reserve System. The Fed controls bank reserves. But you and I care about money, not bank reserves. In the next sections, we discuss how the Fed can influence (but not control) the money supply and monetary aggregates through its control of bank reserves.

2.2 Monetary Aggregates and the Money Supply

There are myriad monetary assets that people hold in a national economy. For example, an individual might hold paper currency (cash) in her pocket. She might also deposit some of her cash or part of her income directly in a bank and hold it in the form of bank deposits. She might also hold cryptocurrencies (outside the banking system) and corporate bonds (debt issued by firms). A firm might also hold bank deposits, shares of stock, and Treasury bonds. Governments might hold gold reserves and other nations’ currencies, as well as their own currencies.

Why hold these various monetary assets? For two main reasons:

1.

they render some value in exchange (i. e., they can be used to trade for other monetary assets, various goods, or various services).

2.

they render some intrinsic value (i. e., they render some monetary service, such as investment returns, access to capital markets, inflation protection, or storage of value, to name a few).

Different monetary assets may have different properties from one another. This means these monetary assets can be similar to each other in some respects and quite different from each other in other respects. The difficulty lies in keeping an accurate measure of the total amount, or the total value, of these various monetary assets in an economy. This falls under the typical purview of a central bank.

Simply summing all these various monetary assets into a single measure sounds simple enough. But it is deceptively simple. The reason is that each monetary asset that we might think of falls along a spectrum between value in exchange and intrinsic value—the two categories mentioned above.

The easier it is to use a monetary asset for exchange, the more liquid it is. Cash (e. g., the U. S. dollar in the U. S.) is the most liquid of assets because it can be directly exchanged for goods and services. A checking account of U. S. dollars in the U. S. is generally perfectly substitutable for cash (absent capital rationing by the government or banks), so that it is also very liquid. Foreign cash (e. g., the Euro) is a little bit less liquid in the U. S. because it generally is not accepted as a means of payment. It requires the extra step of exchanging it for the dollar before we can access goods/services. A U. S. Treasury bond cannot typically be used to buy groceries at the corner store. It is less liquid than cash because it takes a few more steps to convert the bond into cash before it can be used to access goods/services. Liquidity is a relative term that denotes how quickly and easily a monetary asset can be converted into cash.

For example, a checking account is relatively liquid because, generally, it is easily convertible into cash. On the other hand, a certificate of deposit (CD) is less liquid because the buyer of a CD generally needs to wait a pre-specified period before the CD can be converted back into cash. So the CD provides less liquidity to the buyer but it provides other monetary services, such as an interest payment. Generally, we can think of the interest rate a particular asset offers as the monetary service it provides to the holder in exchange for parting with liquidity.

Therefore, monetary assets lie along a spectrum between liquidity and monetary services—as highlights.

Now, the difficulty arises for central banks when they add up all these monetary assets into a measure of the money supply. The money supply is an aggregate of various monetary assets that range in degrees of liquidity.

Therefore, the money supply (M) is necessarily an arbitrary measure that depends on what gets included or not as part of the aggregate. Central banks differ on their preferred measure of the money supply, or which monetary assets are reflected in the money supply. Most central banks, however, agree that whatever is reflected in their M measure must be an asset to the public and a liability to banks and/or the central bank.

The Federal Reserve uses two measures of the money supply for the U. S.: M1 and M2. M1 is the primary measure of the money supply. From the Federal Reserve inception in 1913 to 2020, M1 was the measure of the medium of exchange. Since March 2020, this has become less clear. Historically, M1 consisted of currency in circulation, checkable deposits available to customers on demand (also known as demand deposits or checking accounts), and nonbank traveler’s checks. M2 added savings deposits to M1. Saving deposits constituted roughly 60% of M2, making them the largest component of M2.

2.3 Divisia Monetary Aggregates and Simple-Sum Monetary Aggregates

Savings deposits are different from checking account deposits. Checking deposits typically pay no interest and, therefore, must be made available when the depositor demands them back. This means they are highly liquid. On the other hand, savings deposits provide a trade. Savings holders are paid an interest rate in exchange for a promise not to demand the funds back on short notice, or all at once. This means it takes a little more time to convert savings deposits into cash (known as liquidating). The interest rate savings provide are the reward to depositors for parting with liquidity.

Since checking and savings deposits have different liquidity profiles, they really are different types of deposits. It made sense for the Fed to separate them into the different aggregates (as it used to since 1913), where M1 was a narrower and more liquid measure of the money supply—since it excluded savings—and M2 was the broader and less liquid measure—since it included the vast balances of U. S. savings.

All of this changed in May 2020, when—bucking over 100 years of tradition—the Federal Reserve made an unprecedented change to these monetary aggregates. The Fed took savings out of M2 and began to include them in M1 instead. At first glance, this might seem like a harmless change. But it has portentous implications, and it may lead to big problems in the way money is measured.

First, in one fell swoop, M1 is now a much broader measure of the money supply than it ever was. As we discuss later, there may be advantages from keeping track of a narrow measure of the money supply. Second, M1 now conglomerates highly liquid checking accounts and less liquid savings accounts. Adding together assets with different liquidity profiles is highly misguided and leads to large measurement errors. Professor William A. Barnett showed this in an influential paper in 1980.

Professor Barnett argued the way Federal Reserve adds up deposits into their (M1 or M2) monetary aggregates is highly misguided. The reason is that all deposits are simply summed up into the aggregate without regard for their liquidity. For example, imagine that in last month’s economy we had $2 of currency ($\mathrm{C}=\mathrm{\$}2$) and $3 of checking deposits ($\mathrm{D}=\mathrm{\$}3$) and no savings ($\mathrm{S}=\mathrm{\$}0$). The Federal Reserve would simply add up all of these into their M2 measure.

Now, say that this month (today) currency was reduced by $1, all checking deposits moved to savings and an extra $1 of savings was added. The Federal Reserve would again sum up all these deposits today to conclude the money supply remains unchanged:

According to this simple-sum calculation, last month the money supply was $5 and this month it remains at $5. But these are not necessarily comparable. Last month’s M2 measure was much more liquid, and this month’s measure seems to add up to the same quantity, but it is generating interest (since S is interest-yielding). Essentially, simply summing up all deposits implicitly assigns them equal importance.

If we have three deposits C, D, and S to add up, then giving them the same importance can be done by assigning each an equal value of [1/3]. This is called a weight. Equal weights shows:

and

Adding up this way suggests that this simple-sum aggregate is essentially the same as aggregating with equal weights. Equal importance assumes D and S are perfect substitutes. But they are not!

Professor Barnett first raised this problematic way of simply summing up assets into a monetary aggregate, which became known as the Barnett Critique. He invented what became known as the Divisia Monetary Aggregate. A Divisia aggregate is a weighted sum (instead of a simple-sum) monetary index that assigns different weights according to the liquidity and monetary services each component provides.

In our example above, imagine that liquidity gets assigned more importance, so that liquid deposits receive a weight of (2/5) and the less liquid deposits receive a weight of (1/5). The Divisia measures would be calculated as follows:

and

This would suggest the money supply has decreased from last month to this month, which better reflects the loss in liquidity that took place between the two months as a consequence of deposit substitution.

Beginning in the 1980s, research studies of the effects of monetary policy mostly abandoned analysis of monetary aggregates in favor of interest rates, because economists stopped finding monetary aggregate data useful for modeling. However, the vast majority of economists focused on simple-sum measures the Federal Reserve produces, which is problematic, as we discussed. On the other hand, growing research literature is finding that correctly measured monetary aggregates like the Divisia measure of the money supply are very useful for modeling.

2.4 The Determinants of the Money Supply

The Federal Reserve is responsible for controlling the money supply and regulating the banking system. However, while the Fed can influence the money supply, it cannot completely control it, since there are other actors in the money supply determination. For example, the banking system creates the deposit accounts that are a major component of the money supply. In addition, the nonbank public (all households and firms) decides the form in which they wish to hold money (e. g., currency vs. deposits).

Beginning with some definitions: Currency in circulation (C) is paper money and coins held by the nonbank public. Vault cash is currency held by banks. Currency in M1 is currency held by the nonbank public, which is what is left after subtracting vault cash from currency in circulation.

Bank reserves (R) are deposit accounts that commercial banks keep in their accounts with the Fed plus vault cash. Reserve deposits are assets for banks and liabilities for the Fed. Why? Because banks can request that the Fed repay the deposits on demand with Federal Reserve Notes.

The process starts with the monetary base. Monetary base (or high-powered money) is the sum of bank reserves and currency in circulation.

The monetary base is an important determinant of the money supply, because it acts as a base effect. There is also a multiplier effect, so that the monetary base can generate more money M1 or M2 in the economy (the money multiplier). The money multiplier links the monetary base to the money supply. There is a close connection between the monetary base and the Fed’s balance sheet. See .

When the money multiplier is stable, the Fed can hold a strong influence over the money supply by controlling the monetary base. The Fed’s management of the monetary base is, by and large, accomplished through the market for reserves.

The Fed supplies reserves to the banking sector. We discuss how this is done below. On the other side of the coin, commercial banks demand reserves. There are two main reasons why commercial banks demand reserves. One, reserves provide core funding to the bank. So, the more reserves the bank holds, the better it can withstand an unexpected deposit outflow or a bank run. Two, reserves furnish the bank with financial capital, which in turn can be used to generate loans. The more reserves a bank has, the more ability it has to generate loans, which is the most important source of profit for the bank.

So, reserves play double duty for commercial banks, and they create a trade-off. Reserves act as insurance against unexpected deposit outflows, and they can be turned into profitable loans. The more reserves the commercial bank hoards, the more capitalized it is at the cost of fewer opportunities for loan issuance. On the other hand, the more the bank converts its reserves holdings into loans, the more profits it can generate, at the cost of its ability to weather a major deposit outflow—when customers run to the bank to withdraw their deposits.

So, more reserves provide more insurance and lower profits. Fewer reserves translate to less insurance and higher profits. So how does the bank find the optimal trade-off? In other words, what are the optimal levels of reserves holdings? Banks spend a lot of time and resources on this question.

Profits are beneficial for the specific bank that collects them through loan issuance. On the other hand, the insurance provided by holding more reserves makes for a better capitalized bank. Since banks are highly interconnected, more reserves are beneficial not only to the specific bank, but to the whole banking system.

Since one of the tasks of the Federal Reserve is to safeguard the banking system, it has always fallen under its purview to find ways to induce banks to remain well capitalized. In the past, the Fed would set a required reserve ratio. This required reserve ratio (rr) is the percentage of checkable deposits that the Fed specifies that banks must hold as reserves.

So, the Fed would require banks to hold a portion of their total reserves (R). These were called required reserves ($\mathrm{RR}$). So, banks would hold required reserves to comply with the Fed’s rule. Sometimes, they would hold extra. Any reserves they would hold above the Fed’s requirement were called excess reserves ($\mathrm{ER}$). Banks would demand reserves according to the following two equations:

These equations suggest that if the Fed wanted banks to slow down loan creation, it could simply raise the reserve ratio, thereby requiring banks to keep more reserves “in the vault” and issue fewer loans. Conversely, if the Fed wanted banks to issue more loans, it would lower required reserves by reducing the reserve ratio. Therefore, the required reserve ratio was one of the tools the Federal Reserve would use to conduct monetary policy.

This all changed in March 2020, when the Federal Reserve effectively ended its reserve requirement. On the Fed’s website—you can read the details in below—the Fed also explains the elimination of required reserves prompted the consolidation of other statistical releases of various money measures; which suggests this to be a momentous change in policy.

One way to think about this is that if there is no longer a requirement for banks to hold reserves, then required reserves are zero and all reserves are now excess reserves (in excess of zero) and the equations above now look like:

Depository institutions are no longer required to keep reserves. So, what keeps them well capitalized? In 2008, the Federal Reserve began offering a new interest rate for whatever level of reserves banks voluntarily keep in the vault. This is called interest on reserves (IOR). This rate is managed exclusively by the Fed. Since the Fed retains exclusive control over the setting of this rate, IOR effectively establishes a floor against other rates that banks could sell their reserves at. This gives the Fed some loose degree of influence over banks’ demand for reserves.

While the Fed began to pay interest on reserves in 2008, IOR did not have traction because it was effectively set at zero for a long time after and, presumably, the reserve ratio still mattered from 2008 to 2020. But after 2020, the Federal Reserve switched instruments of monetary policy. Before 2020, it had used the proverbial “stick.” Banks would be penalized if they held reserves below the requirement. After 2020, it switched to IOR as the proverbial “carrot,” rewarding banks for keeping reserves, as suggests.

Therefore, in 2020, the Federal Reserve effectively traded one of their tools of monetary policy for another by abandoning the reserve ratio and adopting IOR.

IOR is a relatively new tool of monetary policy the Federal Reserve can use to have an impact on the determination of the money supply. IOR’s impact will manifest mainly through the money multiplier in our model, shown in (the middle box of) . We discuss this in more detail below. But first, the left box in suggests that determination of the money supply can also be accomplished by management of the monetary base.

2.5 The Monetary Base

The Federal Reserve changes the monetary base by altering the levels of assets it holds in its balance sheet—one way to do this is through management of the Fed’s System Open Market Account (SOMA) portfolio. The Fed’s buys and sells securities in the open market, usually U. S. Treasury securities, but also mortgage-backed securities (MBSs) since 2008.

When the Fed purchases these securities, its SOMA portfolio balances increase, and when the Fed sells securities, its SOMA portfolio balances decreases.

These transactions are carried out electronically with primary dealers by the Fed’s trading desk. As of May 2024, there were 24 primary dealers (commercial banks, investment banks, and securities dealers).

These primary dealers are approved to hold reserve accounts with the Federal Reserve. This means they are part of the banking system in the U. S. For instance, if the Federal Reserve were to inject $100 of reserves into one of these banks, say Bank of America (BoA), then $100 would be credited to the reserve account of BoA. Technically, since BoA is part of the banking system, reserves in the banking system would increase by $100.

Case A: Fed’s open market purchase

The Fed buys $1 million worth of Treasury bills from Wells Fargo. Remember treasuries are an asset to the holder and a liability to the issuer (the U. S. Treasury). This means the Fed would be adding $1 million worth of Treasury bills on the asset side of its own balance sheet and Wells Fargo would be losing (deducting) $1 million worth of assets from its balance sheet.

So far so good. But how is the transaction fulfilled? No representative from the Fed would put $1 million in cash in a bag and walk it over across the street to the Manhattan Branch of Wells Fargo in New York City. Which is to say, how does the Fed purchase those treasuries from Wells Fargo?

The Fed buys the treasuries with reserves. So it credits Wells Fargo with $1 million worth of reserves, which means the Fed is adding $1 million worth of reserves as a liability on its own balance sheet. All of this is reflected on , which shows a T-account for the whole banking system and the T-account for the Fed:

This open market transaction means Wells Fargo bank is out one asset ($1 million of treasuries) and gains another asset ($1 million of reserves). Wells Fargo’s balance sheet remains balanced. On the other side of the transaction, the Fed’s balance sheet increases its assets by $1 million (worth of treasuries), but it also increases its liabilities by $1 million (of reserves), so the Fed’s balance sheet also remains balanced.

Since reserves are part of the monetary base, whenever the Fed purchases x-dollar amount of securities in the open market, it adds x-dollar of reserves in the monetary base.

The monetary base increases dollar-for-dollar by the same amount of a Fed’s open market purchase

Case B: Fed’s open market sale

An open market sale by the Fed reverses all the results from an open market purchase. When the Fed sells $1 million worth of Treasury bills to Wells Fargo, the Fed would be draining $1 million worth of Treasury bills from the asset side of its own balance sheet, while Wells Fargo at the same time would be adding $1 million worth of assets to its balance sheet. The transaction takes assets in the amount $1 million of reserves from Wells Fargo’s balance sheet, which means the Fed’s liabilities to Wells Fargo (and therefore the banking system) decrease by $1 million worth of reserves.

All of this is reflected in , which shows a T-account for the whole banking system and the T-account for the Fed:

This open market transaction means Wells Fargo bank is out one asset ($1 million of reserves) and gains another asset ($1 million of treasuries). Wells Fargo’s balance sheet remains balanced.

On the other side of the transaction, the Fed’s balance sheet decreases its assets by $1 million (worth of treasuries) but it also decreases its liabilities by $1 million (of reserves), so the Fed’s balance sheet also remains balanced.

Since reserves are part of the monetary base, whenever the Fed sells x-dollar amount of securities in the open market, it drains x-dollar of reserves from the monetary base.

The monetary base decreases dollar-for-dollar by the same amount of a Fed’s open market sale

So, one way for the Fed to control the monetary base is to conduct open market operations (purchases and sales of securities). This is the most common tool and possibly the most powerful tool, but there are others.

Case C: Fed’s discount loans

A discount loan is a reserves loan made by the Fed directly to a commercial bank. This is a different way to supply reserves to the banking system. Instead of supplying reserves through outright purchases/sales, the Fed supplies reserves by lending them to a willing bank and charging them a specific interest rate, called the discount rate. The discount rate is not a market rate but a managed rate (i. e., set exclusively by the Fed).

Discount loans generate reserves that are being borrowed by banks. Therefore, discount loans alter bank reserves. For example, an increase in discount loans affects both sides of the Fed’s balance sheet: $1 million of discount loans increases bank reserves and the monetary base by $1 million. This is reflected in .

If banks repay $1 million in discount loans to the Fed, the preceding transactions are reversed. This can be seen in .

Comparing open market operations and discount loans reveals a few interesting facts. Both change the monetary base, but the Fed has greater control over open market operations. The Fed holds exclusive control over its own balance sheet, so it enjoys good control over its own open market operations. On the other hand, the Fed sets the discount rate—the interest rate the Fed charges on discount loans.

The discount rate differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets. Even if the Fed can control the discount rate, it cannot force banks to take discount loans—the Fed cannot effectively force banks to borrow from it. This means the tool of open market operations is more effective, and more powerful, than the discount loan tool.

The monetary base (MB) includes what is called nonborrowed reserves (NBR), which are reserves that come from open market operations (so they are not borrowed). It also includes borrowed reserves (BR), which come from discount loans.

$\begin{array}{c}\mathrm{MB}=\mathrm{NBR}+\mathrm{BR}.\end{array}$

Again, the Fed has better control over the nonborrowed part of the monetary base.

The monetary base increased sharply in the fall of 2008 and stayed at high levels through 2019, before beginning a slow decline that ended in March 2020 with the onset of COVID-19, when it rose again. Most of these increases occurred because of an increase in the bank reserves component, not the currency in circulation component of the monetary base.

The Fed’s holdings of Treasury securities actually fell while the base was exploding. As the Fed began to purchase private debt connected with Bear Stearns and AIG during the 2007 Financial Crisis, the asset side of its balance sheet expanded, and so did the monetary base. Early in 2020, the Fed resumed purchases of U. S. treasuries at a fast pace in response to the COVID-19 shock.

Conclusion: Whenever the Fed purchases assets of any kind (whether treasuries or private debt), the monetary base increases

The first step in the money supply determination is the monetary base. We have established the Fed can control the monetary base through open market operations and through discount loans. Both open market operations and discount loans can exert a quantitative impact on the monetary base. Can the public’s liquidity preference impact the monetary base?

The answer is not likely. The public’s preference for currency relative to checkable deposits does not affect the monetary base. For example, assume households and firms decide to withdraw $1 million from their checking accounts. Should this not affect the monetary base? Well, it may affect the composition but not the quantity of the monetary base. This results from the fact that one component of the monetary base (reserves) would fall along with deposits, while the other (currency in circulation) would rise by the same amount—a full offset in the monetary base. This is shown in .

2.6 The Money Multiplier

The monetary base includes two tools of monetary policy the Fed can use: open market operations and discount loans. The Fed can conduct monetary policy by managing the monetary base. But the monetary base alone does not determine the money supply. The money multiplier is the other determinant of our money supply model—the middle box in .

The money multiplier will combine with the monetary base to help us arrive at an aggregate money supply. We will show later that the Fed can influence the money multiplier with another tool of monetary policy we have already discussed: interest on reserves (IOR). But importantly, the Fed alone cannot control the money multiplier. This is because the money multiplier is determined by the actions of three actors in the economy: the Fed, the nonbank public, and banks.

Before we can understand the money multiplier, we must first discuss another concept: the multiple deposit expansion. Expansion in deposits generates a deposit multiplier—which relates directly to the money multiplier—and helps us understand the final step in the money supply determination.

The idea is simple. In a fractional reserve system, as that of the U. S. and all other industrialized economies, a commercial bank keeps only a fraction of reserves in its “vault” or its account with the central bank and typically loans the rest. A loan then becomes a new deposit, a fraction of which is kept by the next bank, which then issues more loans, which become more deposits… rinse and repeat.

Let’s return to our previous example. Imagine now that the Fed buys $100K worth of U. S. treasuries from Wells Fargo. Recall the Fed buys them by crediting Wells Fargo’s balance sheet with $100K in reserves, so the monetary base has increased by $100K. Now imagine that Wells Fargo chooses to use these reserves to issue a $100K loan to Belle, a Wells Fargo customer. So, Wells Fargo credits Belle’s checking account with the $100K loan. This transaction keeps Wells Fargo’s balance sheet balanced. Wells Fargo’s assets increase by $100,000 worth of loans (which should be paid back with interest in the future), and its liabilities increase by $100,000 worth of checkable deposits (now Belle’s money to dispose of as she wants). See .

Now, imagine Belle does not borrow the $100K to simply keep them in her checking account at Wells Fargo. Let’s say she spends the loan proceeds by writing a check for $100,000 to buy ovens from Ashley’s Bakery Equipment. Ashley sells the equipment to Belle and deposits the $100,000 payment in her own bank, say PNC. This means Wells Fargo loses $100,000 worth of checkable deposits and PNC gains those $100,000 of checkable deposits. After PNC has cleared the check and collected the funds from Wells Fargo, both banks T-accounts look like .

Notice that this transaction—Belle purchasing bakery equipment from Ashley—does not impact the monetary base. The original $100K injection of reserves remains in the banking system, it simply has transferred from Wells Fargo to PNC, both part of the Federal Reserve System. In addition, notice the money supply has not changed either. This is because $100K worth of deposits were deducted from Wells Fargo and added to PNC. Essentially, $100K worth of reserves in the banking system substantiates $100K worth of deposits in the money supply.

Now, imagine PNC makes a calculated bet that Ashley will not close her account and will only demand a portion of her checking account from time to time for the foreseeable future. So, PNC decides to take a fraction of the $100 reserves and loan them out. This will garner PNC some interest rate returns in the future. Suppose that PNC makes a $90,000 loan to Sam’s Printing who writes a check in that amount for equipment from Computer Universe, who has an account at SunTrust Bank.

Something important is happening here! What was a new loan to Sam became a new deposit to Computer Universe’s account at SunTrust Bank. The total amount of reserves in the system remains unchanged at $100K in the banking system. But because the process of loaning a fraction of reserves creates more loans, reserves are being redistributed within the banking system, multiplying the amount of deposit generated. This can be seen more specifically in the T-accounts of PNC and SunTrust in .

The total amount of reserves from the original Fed injection is still $100K. Originally, the whole $100K of reserves was sitting in Wells Fargo’s reserve account. Now $10K sits in PNC and $90K sits at SunTrust. Now imagine, SunTrust decides to take the same calculated risk as PNC did before.

After conducting its analysis and due diligence, SunTrust decides it wants to keep $9K in reserves and loan its excess reserves of $81,000 to Val’s Barber Shop to use for remodeling. If the proceeds of the loan to Val’s Barber Shop were deposited in another bank, checkable deposits in the banking system would rise by another $81,000. See .

Therefore, while reserves in the banking system would remain the same at $100K ($10K in PNC, $9K in SunTrust, and $81K in some other bank), checkable deposits would have increased by $100K (in PNC) plus $90K (in SunTrust) plus $81K (in some third bank). Therefore, through the loan process, an injection of $100K worth of reserves has given rise to $271K of deposits in our example. This is called the multiple deposit creation. This multiple deposit creation is part of the money supply process, in which an increase in bank reserves results in rounds of bank loans and generation of checkable deposits. See .

As a result, an increase in the money supply is a multiple of the initial increase in reserves. Note that the multiple deposit creation process depends on the ability and willingness of banks (like SunTrust and PNC and others) to use a fraction of their reserves to issue loans. And it also depends on the nonbank public’s (people like Sam and Val and others) willingness to borrow. But we mentioned earlier that three agents helped determine the multiplier (and by extension the multiple deposit creation process): Banks, the nonbank public, and the Fed.

How does the Fed impact the multiple deposit creation process? With the new tool of monetary policy that we have already partially discussed: Interest on Reserves (IOR).

2.7 The Last Tool of Monetary Policy: IOR Impact on the Money Multiplier

Many banks may demand reserves for two purposes: to loan some of their excess reserves and to voluntarily keep a portion of reserves and collect the IOR from the Fed to remain well capitalized.

The amount of reserves demanded by banks must be inversely related to market rates, since these rates constitute the opportunity cost of holding reserves. Every dollar kept “in the vault” does not collect a market rate. As the interest rate gets lower, the opportunity cost of holding reserves lowers as well, which is reflected as a downward movement along the banks’ demand curve for reserves, as shown in .

Presumably, as banks accumulate more and more reserves, interest rates could be driven unnaturally low.

If market rates for federal funds reach levels below IOR, banks would be happier keeping reserves on hand and collecting IOR than lending those reserves to collect a lower rate. Therefore, IOR acts as a floor against interest rates on loans. When market rates reach the IOR, the bank should hold reserves (perfectly elastically) while collecting the IOR. See .

Prior to 2020, banks kept a reserve ratio that was (“required”) set by the Fed. After 2020, any given bank began to keep a reserve ratio that was (“voluntary”) set by itself. This means that the bank may dispose of its excess reserves by loaning a portion (and collecting a market rate) and voluntarily holding a portion (and collecting IOR). So, after 2020, the new equation for a bank’s demand (${\mathrm{R}}^{\mathrm{D}}$) for reserves is given by

Since the optimal level of voluntary reserves ($\mathrm{VR}$) is subjective and varies from bank to bank, voluntary reserves are very difficult to model. We now make the following strong simplifying assumptions about voluntary reserves:

1.

The bank keeps an idiosyncratic “rule of thumb” in its own desired $\mathrm{VR}$. So, we assume banks keep a voluntary reserve ratio ($\mathrm{vrr}$), which is held fixed (at a constant %) for a given IOR.

2.

Competition drives all banks to choose the same voluntary reserve ratio ($\mathrm{vrr}$).

3.

Banks increase their $\mathrm{vrr}$ if IOR increases and decrease their $\mathrm{vrr}$ if IOR decreases.

As an example, imagine that at an IOR of 1%, the bank keeps a $\mathrm{vrr}$ of 10%. This means that the bank volunteers to hold 10% of its reserves to collect a 1% return ($\mathrm{IOR}=1\mathrm{\%}$) from the Fed, and loans 90% of its reserves to collect other rates from the market. See .

These 90% of reserves being loaned out will generate more deposits, which will generate more loans and more deposits again… in the process of multiple deposit creation we saw in the previous section.

Let’s say the Fed feels that this deposit creation is too large and would like to tamp down all this loan activity. The Fed could use its IOR tool of monetary policy to do so. In order to persuade banks to loan less, the Fed could raise the IOR and reward banks with a higher interest rate for keeping more reserves on hand. In our example, assume the Fed raises the IOR (from 1%) to $\mathrm{IOR}=3\mathrm{\%}$.

Banks would then (independently) demand more reserves for any level of the interest rate. This would shift the demand curve to the right. The total amount of reserves in the system would now be larger because banks would voluntarily hold more, incentivized by the higher IOR. But more reserves in the system means reduced loans, because banks are now loaning a smaller fraction of their reserves at a higher IOR than before (when the reward for holding reserves was lower). See .

So, even if a higher IOR increased reserves in the system, it would ultimately be a contractionary policy action, because fewer loans lead to fewer deposits, which lead to a reduction of the money supply.

To see this, let’s take our example out to its logical conclusion. Remember the original injection of reserves in the previous sections? The Fed had purchased $100K of treasuries from Wells Fargo, which then ended up at PNC. At an IOR of 1% PNC would loan out 90% of reserves and voluntarily keep 10%.

But the story does not stop there. If PNC lends out ($1-\mathrm{vrr}\ast \mathrm{R}=0.9\ast \mathrm{\$}100\mathrm{K}$), the $90K loan becomes a new deposit in SunTrust. If SunTrust voluntarily keeps 10% ($9K) and lends the rest, the $81K loan becomes a new deposit at a third bank, and so on. If every bank voluntarily keeps 10%, the total amount of reserves in the banking system remains equal to the original injection of $100K of reserves.

But the multiple deposit creation process suggests a magnification of deposits, and an increase in the money supply ensues as a result of the loan creation process.

The simple deposit multiplier ($\mathrm{dm}$) is the ratio of the amount of deposits created by banks ($\mathrm{\Delta }\mathrm{D}$) to the amount of new reserves ($\mathrm{\Delta }\mathrm{R}$). In our example, the initial deposit was $100K, the second was $90K, the third $81K, etc.… So, the total amount of new deposits created is given by

which simplifies to $\mathrm{\Delta }\mathrm{D}=\mathrm{\$}100\mathrm{K}\ast [1+0.9+0.9^2+0.9^3+\cdots ]$.

An infinite series $[1+0.9+0.9^2+0.9^3+0.9^4+\cdots ]$ reduces to 1/(1−0.9). If we apply this result for an infinite series to the amount of new deposits created, it results in:

This means the simple deposit multiplier is the inverse of the voluntary reserve ratio $\mathrm{dm}=1\mathrm{/}\mathrm{vrr}$.

So, in our example, if $\mathrm{vrr}=10\mathrm{\%}$ when IOR is 1%, then the total amount of deposits generated if every bank keeps ($\mathrm{vrr}=10\mathrm{\%}$) and loans all the rest, would be $900K! Added to the original deposit, would mean that an injection of $100K of reserves would increase the money supply by a factor of 10 to $1 million. See .

Now if the Fed wanted to conduct a contractionary monetary policy and contract the money supply, one way to do it would be to raise the IOR. If the Fed raised the IOR from 1% to 3% and this led banks to raise their own vrr from 10% to 20%, then the deposit multiplier (recall $\mathrm{dm}=1\mathrm{/}\mathrm{vrr}$) would decrease from [1/0.1]=10 to now [1/0.2]=5. See .

This means that when the Fed raised IOR to 3%, which led banks to increase the vrr so that $\mathrm{vrr}=20\mathrm{\%}$, the same injection of reserves of $\mathrm{\Delta }\mathrm{R}=\mathrm{\$}100\mathrm{,}000$ would generate a lower amount of deposits $\mathrm{\Delta }\mathrm{D}=\mathrm{\$}500\mathrm{,}000$ since the multiplier is now smaller at a higher $\mathrm{vrr}$. $\mathrm{\Delta }\mathrm{D}=\mathrm{\$}100\mathrm{,}000\ast [1\mathrm{/}0.2]=\mathrm{\$}500\mathrm{K}$. And this makes sense, if each bank is voluntarily keeping more reserves each time a new deposit is brought in; even if the number of loan-deposit rounds remains the same, fewer dollars are being lent and deposited each time. Now, in order to build a complete account of the money supply process, we augment the concept of the simple deposit multiplier in three ways:

1.

In addition to the link between reserves and deposits, we need a link between the monetary base and the money supply.

2.

We need to include the effects of changes in the nonbank public’s liquidity preference (the desire to hold currency relative to checkable deposits). The more currency the nonbank public holds relative to checkable deposits, the smaller the multiplier deposit creation process.

3.

We need to include the effects of changes in banks’ voluntary reserve ratio. The more reserves banks hold relative to their checkable deposits, the smaller the multiplier deposit creation process.

We make two key assumptions for deriving the money multiplier. First, banks hold a fixed amount of reserves. Second, the nonbank public keeps a fixed holding of currency.

In the same way that the deposit multiplier links deposits and reserves (in rates) as we have seen:

where $\mathrm{dm}=\frac{1}{\mathrm{vrr}}$. We need a money multiplier that links the money supply and the monetary base (in levels).

Recall $\mathrm{M}1$ includes currency (C) and deposits (D)—and, since 2020, D contains both checking and savings deposits. We assume deposits (D) are less liquid than currency (C), so that $\mathrm{M}1=\mathrm{C}+\mathrm{D}$.

Now recall the monetary base ($\mathrm{MB}$) includes currency (C) and reserves (R). Before 2020, the relationship used to be $\mathrm{R}=\mathrm{ER}+\mathrm{RR}$, but since 2020, $\mathrm{RR}=0$, so all reserves are now voluntarily held by banks.

Substituting the money supply equation ($\mathrm{M}1=\mathrm{C}+\mathrm{D}$) and the monetary base equation ($\mathrm{MB}=\mathrm{C}+\mathrm{R}$) into the money multiplier equations ($\mathrm{mm}=\mathrm{M}1\mathrm{/}\mathrm{MB}$) gives us:

Multiplying and dividing this expression by $1\mathrm{/}\mathrm{D}$ gives us:

This multiplier gives us some insight into the money supply determination. The money supply equation

This equation suggests that every one dollar increase in the monetary base will ultimately generate more than one dollar in the money supply, if the multiplier in the brackets is greater than 1.

For example, assume $\mathrm{C}=\mathrm{\$}500\text{bn}$; $\mathrm{D}=\mathrm{\$}1\mathrm{,}000\text{bn}$; and $\mathrm{R}=\mathrm{\$}250\text{bn}$. Then, the multiplier would be $\mathrm{mm}=2$, which means for every $1 added to the MB, there’s ultimately a $2 increase in $\mathrm{M}1$.

Now imagine that banks begin to hoard reserves (increasing their $\mathrm{vrr}$) and this leads to fewer loans and an increase in reserves (all else being equal). If R increased to $1,000 bn, the multiplier would decline. The new multiplier would be $\mathrm{mm}=1$.

On the other hand, if $\mathrm{C}=\mathrm{\$}500\text{bn}$ decreased to $\mathrm{C}=\mathrm{\$}200\text{bn}$; $\mathrm{D}=\mathrm{\$}1\mathrm{,}000\text{bn}$; and $\mathrm{R}=\mathrm{\$}250\text{bn}$, then the multiplier would increase from $\mathrm{mm}=2$ to $\mathrm{mm}=2.7$, which means for every $1 added to the monetary base, there’s ultimately a $2.7 increase in $\mathrm{M}1$ due to the reduced liquidity preference of the public. This increased multiplier effect makes sense because reducing currency in circulation by depositing it in banks should lead to a larger deposit-loan feedback.

Summarizing, the Federal Reserve can affect the money supply by controlling the monetary base. The Fed can ostensibly do this through open market operations. When the Fed buys treasuries in the open market it does so with reserves. An increase in reserves raises the monetary base and, therefore, raises the money supply, according to equation (). This is a purely quantitative effect.

In addition, the Fed can also influence the money supply through the multiplier in equation (). Through its management of IOR, the Fed can make reserves more or less attractive for banks to hold.

But as we saw at the beginning of the chapter, the Fed is not the only agent who influences the money supply. For example, if banks (perhaps enticed by higher levels of IOR) voluntarily choose to hold more reserves so that $\mathrm{vrr}$ increases, then this would decrease the money creation process. When banks hoard more reserves, they issue fewer loans, which leads to fewer rounds of deposits-loans. So if $\mathrm{vrr}$ increases, the multiplier in equation () goes down, which effectively contracts the money supply.

Related to this, if banks reserve-to-deposit ratio increases, then the value of the money multiplier would fall, reducing the loan-deposit expansion and leading to a reduction in the money supply.

Finally, one more agent can have an impact. Namely, the nonbank public. If individuals idiosyncratically prefer higher levels of liquidity and draw down from their bank deposits or close their bank accounts, this removes reserves from the banking system. In other words, if the currency-to-deposit ratio were to increase, the multiplier in () goes down, effectively contracting the money supply through the ensuing reduction of the deposit-loan expansion.

2.8 Glossary

Balance Sheet

A financial statement showing assets and liabilities, crucial for understanding how Fed operations affect the monetary base and banking system.

Bank Reserves

Deposits that commercial banks keep in their accounts with the Fed plus vault cash, serving as assets for banks and liabilities for the Fed.

Currency in Circulation

The total amount of paper money and coins held by the nonbank public.

Discount Loans

Direct loans from the Fed to commercial banks, with interest charged at the discount rate, serving as a tool for supplying reserves to the banking system.

Divisia Aggregate

A weighted measure of the money supply that accounts for the different degrees of “moneyness” or liquidity of various monetary assets. Developed by William A. Barnett in 1980, it provides a more accurate picture of monetary conditions than simple-sum aggregates in that it assigns different weights according to the liquidity and monetary services each component provides.

Federal Funds Rate

The interest rate that banks charge each other for overnight loans of reserves.

Federal Reserve (Fed)

The central bank of the United States, established in 1913, charged with conducting monetary policy with objectives of maximum employment, price stability, and moderate long-term interest rates.

Interest on Reserves

The interest rate the Federal Reserve pays banks on their reserve balances. Introduced in 2008 and became a primary monetary policy tool in 2020 when reserve requirements were eliminated. Acts as a floor for other interest rates and influences banks’ decisions about holding versus lending reserves.

Liquidity

The ease with which an asset can be converted into cash without significant loss of value. Cash is the most liquid asset.

Monetary Base

The sum of bank reserves and currency in circulation. Often called “high-powered money,” it serves as the foundation for money supply expansion in the banking system. The Federal Reserve can directly influence the monetary base through open market operations.

Money Multiplier

The ratio showing how much the money supply increases for each unit increase in the monetary base through the banking system’s lending activities.

Money Supply

The total amount of monetary assets available in an economy at a specific time. The Fed measures it by simply summing up assets together into an M1 monetary aggregate and an M2 monetary aggregate (which is a broader measure).

Multiple Deposit Creation

The process by which an initial deposit leads to multiple rounds of lending and new deposit creation, expanding the money supply.

Nonborrowed Reserves

Reserves that come from open market operations rather than discount loans, representing the portion of reserves over which the Fed has more direct control.

Open Market Operations

The buying and selling of government securities by the Federal Reserve to control the monetary base. When the Fed buys securities, it increases bank reserves dollar-for-dollar; when it sells securities, it decreases reserves by the same amount.

Primary Dealers

Selected banks and securities firms authorized to trade directly with the Fed and participate in Treasury auctions.

Simple-Sum Monetary Aggregate

The traditional method of measuring money supply by simply adding up all monetary components, assuming perfect substitutability between different types of money. This can often lead to large measurement error.

System Open Market Account (SOMA)

The Fed’s portfolio of securities used for conducting monetary policy through open market operations.

Voluntary Reserve Ratio (vrr)

The percentage of deposits that banks choose to hold as reserves after the elimination of required reserves in 2020.