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MONETARY POLICY AND THE MONEY MULTIPLIER

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When a monetary authority conducts monetary policy, its objective is either to stimulate
economic activity (expansionary monetary policy) or dampen it (contractionary monetary
policy). To implement monetary policy, the monetary authorityfor example, a central bank
like the U.S. Federal Reservehas three primary tools at its disposal: open market operations
(OMO) [the buying or selling of government securities], the discount rate [the rate at which
commercial banks borrow from the central bank], or the required reserve ratio1 [the fraction of

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deposits that commercial banks must send to the central bank for safekeeping]. In the United
States, for example, the Federal Reserve (the Fed) uses all three tools, but open market
operations have become the dominant method by which monetary policy is conducted.
Monetary authorities enjoy varying degrees of independence from central governments when
formulating policy, and the Fed is considered to be on the independent end of the spectrum. For
purposes of exposition, this note will focus on how the Fed conducts monetary policy.
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The Fed conducts expansionary monetary policy by purchasing government securities
like Treasury bills (T-bills) through open market operations, lowering the discount rate, lowering
the required reserve ratio, or through some combination of the three. Conversely, if the Fed
wished to conduct contractionary monetary policy, it would sell T-bills, raise the discount rate,
raise the required reserve ratio, or some combination of the three. The ultimate policy objectives
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of monetary policies are to influence the levels of gross domestic product (GDP),
unemployment, and inflation. (Note: in keeping with contemporary economic convention, GDP
rather than GNP is used in this note.)

Although the ultimate policy objectives of monetary policy are to influence the Big 3,
intermediate targets bridge the policy action with the ultimate objectives. These intermediate
targets include market-determined interest rates, such as the interest rate at which banks borrow
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from each other, called the federal funds rate, or monetary aggregates like M1 or M2, which are
different measures of the money supply. While the Feds ultimate policy objectives have
remained unchanged, its main intermediate target has changed over time. For example, shortly
after Paul Volcker became the chair of the Federal Reserve in 1979, the Fed switched from
targeting interest rates to targeting monetary aggregates. The Fed has since switched back to
targeting interest rates.
1
Monetary authorities in some countries, e.g., New Zealand, do not impose a required reserve ratio.
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This note was prepared by Professors Melissa Appleyard and Petra Christmann. Copyright 2001 by the
University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send
an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

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How Monetary Policy Works

A primary lesson of monetary policy is that a policy action by the Fed (i.e., conducting
OMOs, or altering the discount rate, or the required reserve ratio) leads to a sequence of events
that amplifies the effects of the initial policy change. The following simplified example

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illustrates this amplification process.

If the Fed wants to stimulate economic activity it purchases government securities by

writing a check on itself. This action injects high-powered money (H) into the system when the
check is cashed and cleared through the Fed. (Alternatively, some economics books use the term
monetary base, instead of high-powered money.) Only the Fed has the power to create or
destroy H. High-powered money is the sum of currency (CU) and reserves (RE) that

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commercial banks hold with the Fed or in the form of vault cash.

The person from whom the Fed bought the T-bill2 takes the Feds check to his/her bank
and cashes it and deposits most of the amount in a checking account (a demand deposit or DD),
while taking a portion of it in cash (currency or CU). The persons bank then clears the check
through the Fed, which credits the banks reserves with the Fed in the amount of the check. The
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bank now has excess reserves (i.e., more reserves than required to cover the demand deposits of
its customers), which allows this bank to extend additional loans in the amount of these excess
reserves.

Assuming both that the bank wants to lend out these excess reserves and that there is a
customer for the loan, the bank extends a loan to the customer, who decides to hold part of the
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loan in cash (CU) and deposits the rest of the loan in a checking account (DD). The bank where
this deposit is made will need to hold a proportion of the new deposit as required reserves at the
Fed, as dictated by the required reserve ratio, and then can lend out the rest. The customer who
takes out this loan again divides it up between a DD and CU. That customers bank then loans
out what it does not hold as required or excess reserves. This process repeats until there are no
more excess reserves to be loaned out (or no more customers who want to take out loans).
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By the end of this cycle, the money supply grows much more than the Feds initial
injection. One should note that this arises due to the United Statess fractional reserve banking
system (i.e., banks are only required to hold a small share of their total deposits in reserve) and
the fact that banks are willing to loan and economic agents are willing to borrow. This
amplification process is captured by a parameter called the money multiplier (mm). Figure 1
depicts how the high-powered money grows into the money supply (M) or money stock (for
example, M1 = CU + DD) via the money multiplier:
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H*mm=M

2
The Fedactually the New York Fed on behalf of the Federal Reserve Systemreally buys and sells
government securities from designated banks rather than from individuals, but this simplified example captures the
spirit of what actually happens.

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Through an understanding of the variables that influence the money multiplier,
economists are able to conjecture how changes in monetary policy will affect the money supply.
A simple representation of the mm is 1/v, where v represents the total percentage of leakages
from the system. The Appendix contains a more complete derivation of the money multiplier.

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Figure 1

The Amplification of High-Powered Money into the Money Supply

High-Powered Money (H)

(also called the monetary base) =

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CU + RE
CU RE

mm
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CU DD
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Money Supply (M)

(For example, M1 = CU + DD)

In the simple example above, two sets of variables are particularly important in
determining the size of the money multiplier. The first is the propensity of the public to hold
currency relative to demand deposits (CU/DD or cu). The greater this ratio, the smaller the pool
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of loanable funds, because the money held by the public in the form of currency cannot be
loaned out by banks, leading to a smaller money multiplier. Currency held by the public can be
thought of as a leakage from the amplification process.

Secondly, the required reserve ratio and the desire of banks to hold excess reserves also
determine the size of the money multiplier. The total reserves held by banks are simply the sum
of required reserves and excess reserves. The reserve ratio (note: this is a broader concept than
the required reserve ratio) is defined by the ratio of total reserves to demand deposits (RE/DD or
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re). The more reserves held, the smaller the money multiplier. Again, reserves are a leakage
from the money creation process because they decrease the amount of loanable funds.

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Money Multiplier Exercise

To get a feel for how monetary policy works, please see the companion spreadsheet:
MoneyMultiplierExercise.xls. Fill in the blanks in the spreadsheet. Pay particular attention to
how the leakages into currency and reserves influence the amplification process.

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The money supply process works through a re-lending process. The magic of the
money supply process lies in the fact that injections of high-powered money by the Federal
Reserve increase the money supply in a multiplicative manner. The money supply process
depends on the fractional reserve system, the willingness of commercial banks to lend, and the
willingness of people to borrow and deposit at least a portion of what they borrow into a bank.
When banks hold reserves (i.e., lend out less than their deposits) and people hold currency

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instead of depositing all of their money into banks, these actions are leakages from the process
and, therefore, reduce the money multiplier. In the examples in the spreadsheet, these leakages
are greater than typical in a country like the United States, but the numbers were chosen for ease
in computation.

In summary, the money multiplier exercise should give one a feel for how the
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amplification process of monetary policy unfolds and how policy variables (for example, the
required reserve ratio) and peoples preferences (for example, their desire to hold currency)
influence the process. One should keep in mind that the amplification process works in the
negative direction as well. For example, if the monetary authority were to decrease high-
powered money, the cumulative decrease in the money supply would exceed the initial decrease
(in absolute value terms).
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Important Final Notes

It is imperative that the reader does not confuse the re-spending process characterized by
the income multiplier with the re-lending process reflected by the money multiplier.
Both processes amplify the initial policy change, but they work through different
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mechanisms.
Over the last 100 years, two principal camps of economic policymakers have arisen.
Monetarists favor monetary policy over fiscal policy and believe that, to avoid high
inflation, monetary aggregates should be grown at a steady pace. Keynesians advocate
fiscal rather than monetary policy when GDP is far below potential GDP. Money does
matter in a Keynesian world, but when changes to monetary policy occur, Keynesians do
not believe there is as close a relationship between money supply and GDP as monetarists
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believe. Instead, they point to the importance of the interest rate as the transmission
mechanism in influencing interest-sensitive consumption and investment. In other words,
Keynesians rely on the real economy to trace policy changes, while monetarists believe
there is a more direct correspondence between changes to monetary policy and changes
in the macroeconomy.

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This note focuses only on the money supply and its creation. One would have to include
an analysis of money demand in order to calculate an equilibrium interest rate.
The presence of lagsboth in the formulation of policy and in the subsequent influences
on the economymakes policymaking difficult. In the United States, fiscal policy is
said to suffer from a decision lag (or an inside lag), meaning that actually arriving at a

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policy change can be quite time-consuming. While the decision lag in conducting
monetary policy is a trivial issue for the FOMC, monetary policy in contrast suffers from
an execution lag (or an outside lag), meaning that patience is required to view the final
effects of changes to monetary policy. In 1999, the Federal Reserve Bank of San
Francisco estimated that the influence of monetary policy on the growth in the overall
production of goods and services required three months to two years to be felt, and the

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influence on inflation can take one to three years.3
Often the press reports that the Fed cut or raised the federal funds rate after one of its
policy meetings, but the Fed does not actually control the federal funds rate directly as it
does with the discount rate. Following one of its meetings, the Feds monetary policy
committee (FOMC),4 will announce a target for the federal funds rate, which is a market-
determined rate. (Note that the Fed may accompany the announced move in the federal
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funds rate with a complementary move in the discount rate, which is under the Feds
direct control.) The Fed conducts open market operations to push the federal funds rate
to the target. The federal funds rate has upstaged the discount rate in terms of being the
key interest rate that the Fed announces after its policy meetings, because the value of
transactions carrying the federal funds rate is much greater than the value of transactions
governed by the discount rate. Many banks actually try to avoid borrowing from the Fed,
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even though the discount rate is generally lower than the federal funds rate, because this
will likely lead to closer monitoring by the Feds supervisory arm.
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3
Federal Reserve Bank of San Francisco, U.S. Monetary Policy: An Introduction (January 1999): 15.
4
The members of the FOMC comprise the seven governors of the Federal Reserve Board (including the
chairperson), the president of the Federal Reserve Bank of New York, and four presidents from the remaining 11
Federal Reserve regional banks. These four presidents serve on the FOMC in rotation. The seven Board members
and the New York Fed president are permanent members of the FOMC.

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Appendix

MONETARY POLICY AND THE MONEY MULTIPLIER

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This appendix is for those students whose understanding of the results in the text above is
enhanced by a mathematical derivation of the money multiplier.

By rewriting the equations for high-powered money (H) and the money supply (M), one
can calculate the money multiplier. Recall:

(A) H = CU + RE

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(B) M = CU + DD

Above we stated that cu = CU/DD and re = RE/DD. Therefore, (A) and (B) can be re-
written as follows:
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(A) H = (cu + re)*DD

(B) M = (cu + 1)*DD

To calculate the money multiplier, we know that:

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(C) M = mm*H or mm = M/H

and substituting in for H and M from (A) and (B), respectively, we arrive at the money
multiplier:

mm = (1 + cu)/(re + cu)
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It can be shown that if either cu or re increases, then the money multiplier decreases.
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THE MONEY SUPPLY PROCESS *
Money Creation

The 5 steps below demonstrate the money creation process when a central bank (The Fed in this example) buys a government bond. In the real world, the Fed buys bonds from designated banks and
money (in this case reserves) simply through an electronic addition to the bond seller's assets on account at the Fed. Also, rather than merely a $100 purchase, the Fed buys bonds in the millions of d
expansionary monetary policy. To add simplicity to the example, we assume that the Fed buys the bond from you (rather than one of the designated banks) and writes you a check written on itself for
making an electronic entry).

(1) The Fed

buys a gov't
bond from you Commercial Bank Total Money
for $100. Currency DD Loans Reserves Supply
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Assumptions: Person 1 100.00 20 80 80 100.00 (2) see below for explanat
1. People hold 20% of money in currency (CU) Bank 1 53.33 26.67 (3)
and 80% in demand deposits (DD) Person 2 10.67 42.67 153.33 (4)
2. Banks hold 1/3 of DD in Reserves Bank 2 28.44 14.22 (5)
and loan out 2/3 of DD. Person 3 5.69 22.76 181.78
Bank 3 15.17 7.59
Basic Relationships: Person 4 3.03 12.14 196.95
H = CU + reserves Bank 4 8.09 4.05
cu = CU/DD Person 5 1.62 6.47 205.04
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re = reserves/DD Bank 5 4.32 2.16
mm=(1+cu)/(cu+re) Person 6 0.86 3.45 209.35
M = CU + DD Bank 6 2.30 1.15
M = mm*H Person 7 0.46 1.84 211.66
Bank 7 1.23 0.61
Here: Person 8 0.25 0.98 212.88
H = SUM (CU+reserves) = 100.00 Bank 8 0.65 0.33
cu = 0.2/0.8 = 0.25 Person 9 0.13 0.52 213.54
re = 0.33 Bank 9 0.35 0.17
mm = 2.14 Person 10 0.07 0.28 213.89
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M = SUM (CU+DD) = 214.28 Bank 10 0.19 0.09
= mm*H = 214.28 Person 11 0.04 0.15 214.07
Bank 11 0.10 0.05
Person 12 0.02 0.08 214.17
Bank 12 0.05 0.03
Person 13 0.01 0.04 214.23
Bank 13 0.03 0.01
Person 14 0.01 0.02 214.25
Bank 14 0.02 0.01
Person 15 0.00 0.01 214.27
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Bank 15 0.01 0.00
Person 16 0.00 0.01 214.28
Bank 16 0.00 0.00
Person 17 0.00 0.00 214.28
Bank 17 0.00 0.00
Sum 42.86 171.42 114.28 57.14
Note: This sum starts at row H8.
Explanation of Steps:
(1) You keep $20 in cash in case you need to go out to dinner and deposit the rest in your bank account.
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(2) Your banker returns from lunch and realizes you have made a deposit of $80. Your bank holds a portion of your deposit as reserves with the Fed because it has to (required reserves--say the requ
25% of deposits) and holds some extra reserves for safe keeping (excess reserves--say 8.33% of deposits). It is assumed that all banks hold 1/3 of their deposits as total reserves (25%+8.33%). You
the rest.
(3) The person who receives the loan also holds 20% in currency and deposits the rest in a checking account. That person's bank also holds 1/3 of its demand deposits as reserves and loans out the
(4) And so on, and so on, and so on Note that Bank 2 and the banks that follow Bank 2 immediately divide any new deposits between loans and reserves. Only Bank 1 had a slight delay (the $80 s
because the banker was at lunch.

Summary:
The Fed only needed to inject $100 in order to have the money supply grow to: $214.28
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Note, the above example demonstrates money creation by the Fed. When the Fed conducts contractionary monetary policy, the same mechanisms apply, but in reverse. In that case, the money sup
than the initial amount of bond sales by the Fed. t

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Assignment:
Under the new assumptions below, please fill in the table, and calculate H, cu, re, mm, and M
How did these values change relative to the example above?

(1) The Fed

buys a gov't
bond from you Total Money
New Assumptions: for $100 Currency DD Loans Reserves Supply
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1. Fed buys bond for $100 in currency (CU). Person 1 100.00
2. People hold 25% of money in currency (CU) Bank 1
and 75% in demand deposits (DD) Person 2
3. Banks hold 1/3 of DD in Reserves Bank 2
and loan out 2/3 of DD. Person 3
Bank 3
Here: Person 4
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H= _____________ Bank 4
cu = _____________ Person 5
re = _____________ Bank 5
mm = _____________ Person 6
M= _____________ Bank 6
= mm*H = _____________ Person 7
Bank 7
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Person 8
Bank 8
Person 9
Bank 9
Person 10
Bank 10
Person 11
Bank 11
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Person 12
Bank 12
Person 13
Bank 13
Person 14
Bank 14
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Person 15
Bank 15
Person 16
Bank 16
Person 17
Bank 17
Sum
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