Copyright  2011 Pearson Canada Inc Chapter 16 The Money Supply Process

Copyright  2011 Pearson Canada Inc Players in the Money Supply Process Central bank (Bank of Canada) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions)

Copyright  2011 Pearson Canada Inc Bank of Canada’s Balance Sheet I Monetary Liabilities –Notes in circulation—in the hands of the public –Reserves - bank deposits at Bank of Canada and vault cash Assets –Government securities - holdings by the Bank of Canada that affect money supply and earn interest –Advances to banks - provide reserves to banks and earn the discount rate Bank of Canada AssetsLiabilities Government securitiesNotes in circulation Advances to banksReserves

Copyright  2011 Pearson Canada Inc Bank of Canada’s Balance Sheet II Define: –Currency = Notes + Coins –Reserves = Vault cash + Settlement balances Banks hold desired reserves to manage their short term liquidity requirements and respond to clearing drains and currency drains Reserves above that desired are known as excess reserves

Copyright  2011 Pearson Canada Inc Monetary Base MB = C + R – MB: monetary base (high-powered money) –C: currency in circulation (notes and coins held by the public outside banks) –R: total reserves in the banking system (vault cash + settlement balances) The Bank of Canada controls the monetary base through open market operations and advances to banks

Copyright  2011 Pearson Canada Inc Open Market Purchase from a Bank Net result is that reserves have increased by $100 No change in currency Monetary base has risen by $100 Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Reserves+$100 Reserves+$100 Bank of Canada purchases $100 of bonds from a bank and pays them with a $100 cheque

Copyright  2011 Pearson Canada Inc Open Market Sale Reduces the monetary base by the amount of the sale Reserves remain unchanged Nonbank PublicBank of Canada AssetsLiabilitiesAssetsLiabilities Securities+$100Securities-$100Currency in circulation -$100 Currency-$100 Bank of Canada sells $100 of bonds to a bank or the non- bank public

Copyright  2011 Pearson Canada Inc Bank of Canada Advances Monetary liabilities of the Bank of Canada have increased by $100 Monetary base also increases by this amount Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100Advances+$100Advances+$100Reserves+$100 When the Bank makes a $100 loan to the First Bank, the bank, the bank is credited with $100 of reserves (settlement balances) from the proceeds of the loan

Copyright  2011 Pearson Canada Inc Paying Off a Loan from the Bank of Canada Net effect on monetary base is a reduction Monetary base changes one-for-one with a change in the borrowings from the Bank of Canada Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves-$100Advances-$100Advances-$100Reserves-$100 A loan is from the Bank of Canada is paid off by a bank

Copyright  2011 Pearson Canada Inc Deposit Creation: Single Bank First Bank AssetsLiabilitiesAssetsLiabilities Securities-$100Securities-$100Chequable deposits +$100 Reserves+$100Reserves+$100 Loans+$100 First Bank AssetsLiabilities Securities-$100 Loans+$100 Excess reserves increase Bank loans out the excess reserves Creates a chequing account Borrower make purchases The money supply has increased

Copyright  2011 Pearson Canada Inc Deposit Creation: The Banking System Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves+$10Chequable deposits +$100 Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Chequable deposits +$90Reserves+$9Chequable deposits +$90 Loans+$81 $100 of deposits created by First Bank’s loan is deposited at Bank A. This bank and all other banks hold no excess reserves

Copyright  2011 Pearson Canada Inc Creation of Deposits

Copyright  2011 Pearson Canada Inc The Formula for Multiple Deposit Creation

Copyright  2011 Pearson Canada Inc Simple Deposit Multiplier

Copyright  2011 Pearson Canada Inc Critique of the Simple Model Holding cash stops the process Banks may not use all of their excess reserves to buy securities or make loans

Copyright  2011 Pearson Canada Inc Changes in the Non-borrowed monetary base (MB n ) - the money supply is positively related to the non-borrowed monetary base (MB n ) Changes in advances from the Bank of Canada - the money supply is positively related to the level of borrowed reserves (BR) from the Bank of Canada Factors that Determine the Money Supply

Copyright  2011 Pearson Canada Inc Factors that Determine the Money Supply II Changes in the Desired Reserve Ratio, r –The money supply is negatively related to the desired reserve ratio Changes in Currency Holdings –The money supply is negatively related to the currency holdings

Copyright  2011 Pearson Canada Inc The Money Multiplier 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 M = m x MB

Copyright  2011 Pearson Canada Inc Deriving the Money Multiplier I Assume the desired level of currency (C) and excess reserves (ER) grows proportionately with chequable deposits (D) Then: c = (C/D) = currency ratio e = (ER/D) = excess reserve ratio

Copyright  2011 Pearson Canada Inc Deriving the Money Multiplier II The total amount of reserves (R) equals the sum of desired reserves (DR) and excess reserves (ER) R = DR + ER The total amount of desired reserves equals the desired reserve ratio times the amount of chequable deposits DR = r x D Substituting for DR R = (r x D) + ER The banks set r to be less than 1

Copyright  2011 Pearson Canada Inc Deriving the Money Multiplier III The monetary base (MB) equals currency (C) plus reserves (R) MB = R + C = (r x D) + ER + C Shows the monetary base needed to support existing amounts of D, C, ER An increase in MB going into C is not multiplied, but an increase in MB going into D is multiplied

Copyright  2011 Pearson Canada Inc The Money Multiplier in Terms of the Currency Ratio MB = (c x D) + (r x D) = (c + r) x D D = 1/(c+r) x MB M = C + D M = (c x D) + D = (1 + c)D M = (1+c)/(1+r) x MB m = (1+c)/(1+r) While there is a multiple expansion of deposits, there is no such expansion for currency

Copyright  2011 Pearson Canada Inc The Money Multiplier in Terms of the Currency Ratio Suppose r = 0.03, C = $200 billion, D = $800 billion. Then M = C+D = $1 trillion. The currency ratio c is then c = 200/800 = 0.25 The money multiplier m is then: m = ( )/( ) = So a $1 increase in MB increases M by $4.46. If r or c increases, m falls. This is thought to be one of the causes of the Great Depression.