Monetary Base vs Money Supply AP ECONOMICS MR

Monetary Base vs. Money Supply AP ECONOMICS MR. BORDELON

Monetary Base vs. Money Supply Confusion about the monetary base and the money supply happens a lot, especially when we talk about open market operations. Hopefully, this little Power. Point will walk you through the finer points. The general idea behind the monetary base is the combination of commercial banks’ reserves and currency in circulation. Open market operations are conducted by the central bank, in the U. S. case, the Federal Reserve. When we talk about open market operations as affecting the money supply, what we really mean is the expansion or contraction of the monetary base.

Monetary Base vs. Money Supply Assets Liabilities Required Reserve $10, 000 Deposits Loans $45, 000 Excess Reserve $45, 000 $100, 000 In this particular example, this bank has $100, 000 in deposits, with required reserve of $10, 000 (10% required reserve ratio), leaving $90, 000. That $90, 000 is split between $45, 000 in loans, and $45, 000 in excess reserve. Remember, the monetary base is the bank’s reserves and currency in circulation. Here, we assume there is no currency in circulation (common AP assumption in prompts). In terms of the monetary base, we would say that there is $55, 000 in the monetary base ($10, 000 from required reserve and $45, 000 in the excess reserve).

Monetary Base vs. Money Supply Going back to open market operations, when the Federal Reserve conducts an open market purchase, the bonds are considered assets of the commercial bank. Additionally, the bank is not required to pull out a portion for the required reserve. As such, the bank can loan out the amount of the bonds in their entirety. In terms of the monetary base, this would mean that an open market purchase would expand the monetary base, making more money available for loans. An open market sale would contract the monetary base, making less money available for loans.

Monetary Base vs. Money Supply Assets Liabilities Required Reserve $10, 000 Deposits Loans $45, 000 Excess Reserve $45, 000 Government Bonds $30, 000 $100, 000 In this particular example, this bank has $100, 000 in deposits, with required reserve of $10, 000 (10% required reserve ratio), leaving $90, 000. That $90, 000 is split between $45, 000 in loans, and $45, 000 in excess reserve. The central bank conducts an open market purchase of $30, 000 in government bonds (Treasury bills, notes and bonds). This $30, 000 is an asset of the bank and can be loaned out in its entirety, without taking anything out for the required reserve. In terms of the monetary base, the central bank has increased the monetary base by $30, 000. This means the monetary base is a total of $85, 000 ($10, 000 required reserve, $45, 000 excess reserve, $30, 000 government bonds).

Monetary Base vs. Money Supply Now, here’s the gig. Open market operations expand or contract the monetary base. That DOES NOT mean that the money supply itself is automatically changed. In order for the money supply to expand, the money has to be loaned out. Once the money is loaned, the money multiplier creates a much larger increase in the money supply, affecting both currency in circulation and demand deposits. Because of the money multiplier, this means that the money supply will always be larger than the monetary base. In order for the money supply to contract, less money must be available to loan out. The less money available, the less money loaned out. Additionally, with interest rates higher in contractionary monetary policy, less loans will be made overall. Currency in circulation and demand deposits will decrease.