The document discusses central banks and monetary policy tools. It explains that central banks can control the money supply by changing the monetary base through open market operations, foreign exchange interventions, and discount loans. It also notes they can impact the money supply by adjusting the required reserve ratio set for banks. The document provides examples of how central banks can expand the monetary base and money supply by purchasing assets from banks, like bonds, in exchange for reserves. This process allows them to effectively create more money in the banking system.

1. MaC BGIE4: Central Banks
& Monetary Policy Tools
April 4, 2012
Prof. Nestor Azcona

2. S&P 500 Stock Market Index

3. Interest Rate on 5-year Treasury Note

4. Monetary Aggregates
Central Bank
Assets Liabilities
Bonds Bank Reserves Monetary
Other Currency in Circ. Base
Other
Banking System Non-Bank Public
Assets Liabilities Assets Liabilities
Bank Reserves Deposits M2 Currency in Circ. Loans
Bank Money
Reserves • Vault Cash Other
Supply
Bank Deposits Other
• Deposits at CB Other Net Worth
Loans

5. The M1 & M2 Money Multipliers
M1 Money Supply 720
M1 Money Multiplier 3
Monetary Base 220 20
M1 Money Supply 1080
M2 Money Multiplier 4.5
Monetary Base 220 20

6. The Money Multipliers
M2 Money Supply = M2 Money Multiplier Monetary Base
• How much money banks create (by making loans) depends on:
– Central Bank’s Required Reserve Ratio (rr)
– Households’ Currency to Checking Deposits ratio (Cc/D)
– Households’ Near Money to Checking Deposits ratio (N/D)
– Banks’ Excess Reserves to Checking Deposits ratio (U/D)
(Excess Reserves = Customary Reserves)

7. How Does the Fed Control the Money Supply?
M2 Money Supply = M2 Money Multiplier Monetary Base
• Required Reserve Ratio (Fed)
• Preferred Asset Ratios (Others)
• Open Market Operations (Fed)
• Foreign Exchange Interventions (Fed)
• Discount Loans (Fed)

8. How Does the Fed Create Money “Out of Thin Air”?
Banking System Central Bank
Assets Liabilities Assets Liabilities
Reserves $10 Deposits $20 Bonds $10 Bank Reserves $10
Loans $10 Currency in Circ $0
M2 Money Supply Currency in Circ. + Deposits $20
Monetary Base Currency in Circ. + Reserves $10

9. How Does the Fed Create Money “Out of Thin Air”?
Banking System Central Bank
Assets Liabilities Assets Liabilities
Reserves $10+$5 Deposits $20+$5 Bonds $10+$5 Bank Reserves $10+$5
Loans $10 Currency in Circ $0
• Fed buys $5 Treasury bond from “primary dealer”
• Fed pays with new bank reserves
M2 Money Supply Currency in Circ. + Deposits $20+$5
Monetary Base Currency in Circ. + Reserves $10+$5

10. Takeaway Points
• Central Bank can change money supply by changing
monetary base or by changing required reserve ratio
• Only the central bank can change the monetary base
• Money supply can also change if preferred asset ratios
change