Defining the Money Supply M1 is sometimes referred to as the narrow definition of the money supply or as transactions money. M1 consists of currency held outside banks, checkable deposits, and traveler’s checks.

Defining the Money Supply: M2 M2 is sometimes referred to as the broad definition of the money supply. M2 is made up of M1 plus small-denomination time deposits, savings deposits, money market accounts, overnight repurchase agreements, and overnight eurodollar deposits held by US residents.

The Money Creation Process The sum of bank deposits at the Fed and the bank’s cash vault is total bank reserves. The Fed mandates member commercial banks to hold a certain fraction of their checkable deposits in reserve form. This fraction is called the required reserve ratio. The difference between a bank’s total reserves and its required reserves is its excess reserves.

The Banking System and The Money Creation Process The process starts with the Fed (Central Bank). The Fed prints the funds, and Jack deposits the funds in his bank. The Reserves of the bank increases, while the reserves of no other bank decreased. The banking system made loans and in the process created checkable deposits for the people who received the loans. Remember, checkable deposits are part of the money supply. So, in effect, by extending loans, and in the process creating checkable deposits, the banking industry has increased the money supply.

The Banking System Creates Checkable Deposits (Money)

The Banking System And The Money Expansion Process When the $9000 that bankers created in new checkable accounts is added to the $1000 the Fed initially printed, we see that $10,000 has been added to the money supply. Maximum change in checkable deposits = (1/r) x R Where r = the required reserve ratio and R is the change in reserves resulting from the original injection of funds. In the formula, (1/r) is known as the simple deposit ratio.

Why Maximum? Answer: No Cash Leakages And Zero Excess Reserves All monies were deposited in bank checking accounts. Every bank lent all its excess reserves, leaving every bank with zero excess reserves. Because we assumed no cash leakages and zero excess reserves, the change in checkable deposits is the maximum possible change.

Who Created What? The money expansion process has two major players: the Fed, and the Banking System. The maximum change in bankable deposits is equal to: (1/r) x ER, where ER is the excess reserves.

The Money Contraction Process This process is the Money Creation process in reverse

Q & A If a bank’s deposits equal $579 million and the required-reserve ratio is 9.5%, what dollar amount must the bank hold in reserve form? If the Fed creates $600 million in new reserves, what is the maximum change in checkable deposits that can occur if the required-reserve ratio is 10%? Bank A has $1.2 million in reserves and $10 million in deposits. The required-reserve ratio is 10%. If Bank A loses $200,000 in reserves, by what dollar amount is it reserve deficient?

A model of the money supply exogenous variables the monetary base, H = C + R controlled by the central bank the reserve-deposit ratio, r = R/D depends on regulations & bank policies the currency-deposit ratio, c = C/D depends on households’ preferences

The money multiplier M = C+DD M={[c + 1] / [c + r]}H = m x H If r < 1, then m > 1 If monetary base changes by H, then M = m  H m is called the money multiplier. An increase in c increases the denominator of m proportionally more than the numerator. So m falls, causing M to fall too.

Three instruments of monetary policy Open market operations Reserve requirements The discount rate

Which instrument is used most often? Open market operations: Most frequently used. Changes in reserve requirements: Least frequently used. Changes in the discount rate: Largely symbolic;

Balance sheet approach M3=net bank credit to govt.+ bank credit to commercial sector + Net foreign assets+ govt currency+ other assets-Non monetary liabilities

Money Demand The amount of money demanded for transaction and speculative purposes depends: personal income and interest rate At any level of personal income, quantity demanded of money is a negative function of interest rate; (M/P)d = L(i, Y)

Money Demand Line M/P = L(Y, i) Y = income i = interest rate 10 5 (M/P)d 100 80 Quantity of Money

Money Market Equilibrium Interest Rate (%) (M/P)s 5 (M/P)d 80 Quantity of Money

Expansionary Monetary Policy Interest Rate (%) (M1/P)s (M2/P)s 5 4 (M/P)d 80 85 Quantity of Money