© 2008 Pearson Education Canada Chapter 16 Determinants of the Money Supply © 2008 Pearson Education Canada

© 2008 Pearson Education Canada The Money Supply Model Define money as currency plus chequable deposits: M1 The Bank of Canada can control the monetary base better than it can control reserves Link the money supply (M) to the monetary base (MB) and let m be the money multiplier © 2008 Pearson Education Canada

Deriving the Money Multiplier Assume the desired level of currency (C) and excess reserves (ER) grows proportionately with chequable deposits (D) Then: c = (C / D) = currency ratio r = DR / C = desired reserve ratio e = (ER / D) = excess reserve ratio © 2008 Pearson Education Canada

Deriving the Money Multiplier (Cont’d) The monetary base (MB) equals reserves (R) plus currency (C) MB = R + C = ( (r x D) + ER ) + C Shows the monetary base needed to support existing amounts of r, D, ER and C An increase in MB going into C is not multiplied, but an increase in MB going into D is multiplied via the deposit multipler © 2008 Pearson Education Canada

The Money Multiplier in Terms of the Currency Ratio After several computations M = (1+c)/(c+r) x MB where m = (1+c)/(c+r) M = m x MB and MB = 1/m x MB While there is a multiple expansion of deposits, there is no such expansion for currency © 2008 Pearson Education Canada

Factors that Determine the Money Multiplier Changes in the currency ratio c The money multiplier and the money supply are negatively related to c Changes in the desired reserve ratio r The money multiplier and the money supply are negatively related to r Market Interest Rates Expected Deposit Outflows © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Additional Factors Open market operations are controlled by the Bank of Canada The Bank of Canada cannot determine the amount of borrowing by banks from the Bank of Canada © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Split the monetary base into two components MB = MBn + BR therefore M = m (MBn + BR) MBn = nonborrowed monetary base MB = monetary base BR = borrowed reserves from the Bank of Canada © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Since M = m (MBn + BR) The money supply (M) is - positively related to the non-borrowed monetary base MBn - positively related to the level of borrowed reserves (BR) from the Bank of Canada © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Money Supply Response © 2008 Pearson Education Canada

Deposits of Failed Commercial Banks in U.S. in the Depression © 2008 Pearson Education Canada

Desired Reserves and Currency Ratios © 2008 Pearson Education Canada

© 2008 Pearson Education Canada M1 and the Monetary Base © 2008 Pearson Education Canada