Money Supply Process

We have learnt the concepts and measurement of money. While there are several monetary aggregates, we will focus on the narrowest definition of money, i.e. M1, consisting of Currency + Deposits. Money is held (Money demand) to facilitate transactions and as a part of asset portfolio. Thus, the holding of money depends crucially on the volume of transactions (normally measured by GDP) and the cost of holding money relative to other assets (normally represented by an interest rate). Other variables might affect monetary holding as well.

M/P = L(Y, r, X) L y = income elasticity of money demand L r = interest rate elasticity of money demand [X is other variables that can affect monetary holding]

To complete the money market model, we need to understand the money supply process. Simplifications - Money = Currency + Deposits - Bank holds no EXCESS reserve (will modify this later) - Economic agents hold money only in the form of deposits (will modify this later) - There is only one bank in the economy. (can be viewed as consolidation of all banks).

We first use the simple T-account to illustrate the money supply process and how monetary instruments can affect the stock of money supply. Monetary Instruments: - Open market operations - Discount Rate - Required Reserve Ratio (assumed to be 10%) Definition: Monetary Base = Reserve + Currency Money Supply = Deposit + Currency (For the moment: we assume currency = 0) Question: How is money supply related to monetary base.

Initial Balance Sheet Money Supply = 2,000 Open Market Purchases Suppose that the government purchases the government securities from the banking system worth a total of RM200 million. Reserves in banking system increase. Money supply remains at 2,000

At this point, the banking system fi nds itself having an excess reserve of RM200 million. Since the banking system does not keep the excess reserve, it is lent out to say Mr or Corporation A, who deposits the loans obtained in the banking system. This will increase total deposits to RM2,200, the initial deposits of RM2 billion and the new deposits of RM200 million. With the extension of loans, the loans in the banking system increases to RM1.5 billion. Since money is deposited back in the bank, reserves in the banking system remains at RM400 million. Bank Balance sheet would be……

A simple fact from Figure 3.3 is that, through the lending of RM200, money supply increases to RM2,200. Simply stated, money supply is created through lending. It should be noted that the creation of money does not stop here since the banking system still have the excess reserve at hand. Money Supply = 2,200

At this point, no further lending can be made. Money Supply = 4,000 Note: with the initial increase of reserve by 200, money supply increases by 2,000. Question restated: how is money supply related to reserve (monetary base)?

M = m × B M is Money Supply m is money multiplier B is monetary base Given our assumption of no currency, we can restate the above as: D = m × R The simple money multiplier can be show to be equal 1/rr, where rr is the required reserve ratio. Thus, we have: D = (1/rr) × R

Let relax the assumptions of no excess reserve and no currency. Denote ER/D the excess reserve to deposit ratio and C/D is currency to deposit ratio. Total Reserve = Excess Reserve + Required Reserve From M = m × B, we have: m = M/B This can be expanded to: m = (D + C)/(ER + RR + C) Divide the numerator and denominator by D, we have m = (1 + cd)/(er + rr + cd)

M = (1 + cd)/(er + rr + cd)  B What does this money supply process tell us? The Central Bank does not have complete control over the stock of money supply. Three economic agents determine the level of money supply in the economy. They are: Central Bank (through rr and B), Bank (through er) and the public (through cd). Still, it is safe to state that the Central Bank can control the level of money supply through its monetary instruments to a certain degree.