Chapter 16. Determinants of the Money Supply Money multiplier Factors that determine multiplier & MS Applications: Great Depression

given problems with simple money multiplier, construct better multiplier cash holdings excess reserves holdings based on M1 = C + D

I. money multiplier how $1 change in MB will affect MS: M = m x MB

1 + c m = rD + e + c rD = required reserve ratio c = ratio of currency to deposits e = ratio of excess reserves to deposits

example rD = .10 C = $400 billion D = $800 billion ER = $.8 billion or $800 million 1 + .5 m = = 2.5 .10 + .001 + .5 $1 increase in MB, $2.5 increase in M

II. Factors affecting m & MS changes in rD changes in c changes in e changes in MB

changes in rD higher reserve requirement fewer excess reserves to lend smaller amount of deposit creation smaller multiplier higher rD

example rD was .10 suppose it rises to .20 1 + .5 m = .20 + .001 + .5

changes in c higher c currency does not expand like deposits smaller amount of deposit creation smaller multiplier higher c

example original example: c = .5 suppose c = .8 1 + .8 m = = 2.00 .10 + .001 + .8

changes in ER/D higher e banks hold more ER, lend less smaller amount of deposit creation smaller multiplier higher e

example original example: e = .001 suppose e = .005 1 + .5 m = = 2.48 .10 + .005 + .5

what affects e? as interest rates rise opportunity cost of holding ER rise (money could be lent out) ER fall higher i

expected deposit outflows must hold more ER

Factors affecting MB MB = MBn + DL MBn is nonborrowed MB -- open market purchase will increase MBn -- open market sale will decrease MBn increase MBn will increase M

DL is discount loans -- increase as banks borrow from the Fed -- increase as spread between market interest rate and discount rate increases

Great Depression 1930-33 big contraction in M1 big increases in c, e depositors withdrew cash banks increase ER due to increase in deposit outflow

as c and e rise, money multiplier declines M1 declines by 25% from 1930-33