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8.3
Controlling the Money Supply
By changing the money supply a central bank can influence economic activity through monetary policy. The central bank controls the money supply by controlling the money base cash plus commercial banks' deposits with the central bank (claims on the central bank) and thereby controlling the quantity of reserves in the banking system. Commercial banks can use as reserves any part of the money base in their hands. By increasing the money base, the Fed increases commercial banks' reserves, enabling them to increase their loans (and thus the money supply) while continuing to meet their reserve requirement. Note that an increase in reserves does not guarantee that the money supply will increase: for the money supply to increase commercial banks must react by increasing loans. The central bank's control over the money supply is thus subject to some uncertainty.
The main way in which the central bank controls the money base is by buying and selling government bonds, a process referred to as open-market operations. It deals only in government bonds, not in any other types of bonds; it has a big stock of government bonds it has bought in the past when it buys bonds it augments this stock, and when it sells bonds it diminishes this stock.
Suppose the central bank buys a $1,000 government bond from you, paying you with a check drawn on itself. When you deposit this check in your bank account, your bank credits your account and ends up in possession of this $1,000 check, a claim on the central bank. This check could be taken to the central bank and exchanged for cash, so it is treated as cash for the purposes of satisfying the legal reserve requirement. It ends up increasing your bank's deposits with the central bank and thus your bank's reserves.
Therefore, any bond purchase by the central bank increases reserves in the banking system, directly increasing the money supply and indirectly inducing banks to increase the money supply further by making it possible for them legally to make more loans. The ultimate increase in the money supply is therefore more than the original purchase of bonds.
8.4
The Money Multiplier
It is instructive to trace through the process whereby an open-market bond purchase by the Fed increases the money supply. Suppose the Fed buys a government bond from you for $4,000, paying you with a check for $4,000. When you deposit this check in your checking account, the money supply increases by $4,000 because your account balance has increased by $4,000 and nobody else's has decreased. When your bank (bank AAA) increases the balance in your checking account by $4,000, it now possesses a $4,000 claim on the central bank. Its balance with the central bank increases by $4,000, so its reserves increase by $4,000.
Now view this situation through the eyes of bank AAA. Its deposits are $4,000 higher, and it has $4,000 extra reserves. Suppose the reserve requirement is 5 percent. Bank AAA must

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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