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Figure 22.3 (Macro 9) The Structure of the Fed

Figure 22.3 (Macro 9) The Structure of the Fed

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2. The Fed and the Banks: Creators of Money

• 2c. Banks are an integral part of the moneycreation process due to the fractional value of the

reserve requirement.

• 2c.1 Deposit expansion occurs as a bank-by-bank

process and is treated in detail in Tables 24.3, 24.4,

and 24.5.

2c.2 The simple reserve multiplier in a system

with only deposits as money is given by:

Deposits= (1/reserve ratio) x reserves.

Copyright © 2001 by H


3. How the Fed Controls the Money Supply:

Currency Plus Deposits

3a. The money supply and bank reserves are

related through the usual set of definitions:

M =CU +D , where is the money stock,CU is

currency, and is deposits

BR =rD ,where BR is bank reserves and r the

reserve ratio

Copyright © 2001 by H


3. How the Fed Controls the Money Supply

CU =k D , where k is the currency to deposit


MB =CU +BR , where MB is the monetary base

Substitution yields M = (k + 1)D and MB =(k +r

)D so that the money multiplier is:

M /Mb = (k + 1)/(r +k )

Copyright © 2001 by H


3. How the Fed Controls the Money Supply

• The currency to deposit ratio (k ) reflects the decisions

of the public in terms of transaction habits, the state of

the economic environment, and the like and is

ordinarily not subject to large changes. The reserve

ratio r is a Fed decision variable that remains fairly

fixed. The implication for control is clear: The Fed

can alter M by changes in the base,MB .However,r

and especially k will change as conditions change, as

in the early years of the Great Depression and again

with the onset of World War II.


Copyright © 2001 by H


3. How the Fed Controls the Money Supply

Some values of k for this period are:

April 1928: k = .091 (prior to financial


March 1933: k = .225 (bank holiday


May 1941: k = .251 (World War II)

Copyright © 2001 by H


4. Money Growth and Inflation

• 4a. The relationship between money and

nominal GDP that reflects the transactions

of the economy is the quantity equation of

money, MV = PY or, in terms of velocity, V

= PY / M . So for V, a constant, the growth

in M is reflected in the growth in nominal

GDP, PY . In growth form, g P + g Y = g M


Copyright â 2001 by H


4. Money Growth and Inflation

4b. Figure 22. 4 plots inflation and money growth

for the G-7 economies. Persistent inflation is a

post-World War II phenomenon, especially since


4c. Hyperinflation occurs when the government

prints money to finance spending, as in Germany

in 1923 or Argentina in the early 1990s. See

Figure 22.5

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Figure 22.4

(Macro 9)

The Relation Between Money Growth and


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Figure 22.5 (Macro 9)

German Hyperinflation of 1923

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Figure 22.3 (Macro 9) The Structure of the Fed

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