Chapter 14: The Money Supply Process
The value of money is a factor of supply and demand. Demand will be discussed later (chapter 20).
The author attributes the supply of money to the interaction of four groups: depositors, borrowers, commercial banks, and the central bank.
Depositors and borrowers influence the supply of money by their behavior: when depositors place money into a bank, it increases the bank's supply of money to be lent; and when borrowers take out loans, this decreases the bank's supply of money. The bank, in turn, influences the supply of money by determining how much money to hold in its reserves as opposed to how much it will lend - but ultimately the amount it has is determined by depositors and the amount it can lend is determined by borrowers, so its influence is indirect.
The central bank has a more direct influence over the money supply by its own ability to provide more or less money to the market (as well as its influence over banks, such as determining a minimum required reserve). But like any other organization, the central bank must manage assets on a balance sheet.
Essentially, all money is an asset of the central bank: when such a bank is formed, it has cash as an asset and an equivalent value in its equities. The bank provides money to commercial banks in exchange for notes of deposit - the cash is removed from the CB's assets and an equal amount is added to accounts receivable (representing its repayment by the commercial banks).
Another transaction that can be used to increase the bank's cash reserves is the issuance of bonds. Where the bank needs money, it can issue bonds (accounts payable) and receive cash (asset of equal value), which it can then dispense to the banking system by the transactions noted above.
The "reserve" of the federal reserve is the cash that it maintains on its balance sheet. This money is not in circulation in the economy, and is therefore not part of the money supply. So to adjust the money supply, the federal reserve can increase the money in circulation by lending more of it out to banks or decrease the money supply by lending less, and to sell or redeem its own bonds when commercial banks are unable or unwilling to take on or redeem debt.
Unlike other banks, the central bank can arbitrarily create or destroy money by flexing its equity. The bank has the ability to create new money without corresponding debt by printing cash to distribute and adding that amount to its equity, or to retire money from circulation without replacing it by destroying the money and decreasing its equity. For other banks, the equity is only affected by their profits and losses, whereas the central bank's equity is the result of its own arbitrary decisions.
Prior to 1965, money was based on commodity (redeemable for silver or gold), so there had to be some physical asset to justify its equity, in the form of precious metals that were transferred between its vaults and the vaults of the US treasury. In the present day, all dollars are fiat money, based on no commodity, so the US treasury can issue notes that create future money at will, governed only by the knowledge that consumers will reject the currency if they create it with wild abandon and cannot redeem it with future tax revenues. The central bank mitigates that by determining how much of the government-created money makes it into the money supply.
Essentially, this is a two-check system against rampant inflation: both the treasury and the federal reserve must use their power with reckless abandon.
Open Market Operations
The buying and selling of securities to adjust the money supply are known as the central bank's "market operations," and this usually constitutes the majority of the bank's activities. Again, buying a security means releasing cash from its reserves and holding an investment whereas selling a security means increasing its cash reserves and reducing its investment holdings. Here, the author illustrates the various journal transactions that occur.
It's also noted that non-central banks do the same thing: they can buy and sell investments, or move commercial paper, to make adjustments between their cash holdings, investments, and payables. The main difference is that most commercial banks do so with a goal of managing their own profits, whereas the central bank is not concerned with its own profit, merely with stabilizing the money supply.
A Simple Model of Multiple Deposit Creation
For a commercial bank, the amount of money it has on deposit is determined by its customers - the amount of money that individuals and businesses choose to keep in their checking and savings accounts (and CDs). A bank's balance sheet fluctuates according to the amount of money people save against the amount that it lends to people who want to borrow.
This presumes that there are roughly an equal number of dollars being saved and dollars being borrowed - or actually slightly more being saved so that the bank can maintain a reserve. And because money chances hands in an economy, this is its aggregate tendency: every dollar that one person borrows is spent, and that means the dollar passes to the hand of the seller, who deposits his receipts in his bank account (at least temporarily, before spending it on something else and giving it to his seller).
The same is true of capital markets: every dollar that is borrowed is removed from one account and deposited in another. The only question is how long that dollar remains outstanding (in circulation, or in someone's pocket) before it is again deposited. This duration cannot be controlled, but can be compensated for by providing reserve dollars to the market until such time as that borrowed dollar makes its way to the banking system.
Fluctuations in saving and spending are evened out across all products and all markets, but a bank that serves a subset of the market may find that it has greater fluctuations. For example, a bank whose sole clients are farmers will find that most of its depositors want to withdraw their funds and take out loans in the spring (when they must undertake the expense of planting) and that most of them will have money to deposit or repay loans in the fall (when crops are harvested and sold).
As the holder of reserves for virtually every bank in the nation, the central bank can even out the seasonal fluctuations among banks by maintaining the central reserves of all, can flex the money supply seasonally when there are systemic variations, which tend to be predictable, and can extend the money supply when there is a significant crisis in the economy by providing cash to all banks from the central reserve so that they can weather certain crises.