Transcript Lecture Slides on Chapter 16 of Mishkin and Serletis (5th Cdn. ed.)

Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Fifth Canadian Edition
Chapter 16
THE MONEY
SUPPLY PROCESS
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Learning Objectives
1. Characterize the framework for the implementation
of monetary policy in Canada
2. Explain the market for reserves and the
channel/corridor system for setting the overnight
interest rate in Canada
3. Identify the Bank of Canada’s approach to monetary
policy and the tools of policy
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Three Players in the Money Supply Process
1. The central bank
–
the government agency that oversees the banking system
and is responsible for the conduct of monetary policy
2. Banks (depository institutions)
–
the financial intermediaries that accept deposits from
individuals and institutions and make loans
3. Depositors
–
individuals and institutions that hold deposits in banks
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The Bank of Canada’s Balance Sheet
Bank of Canada
Assets
Liabilities
Securities
Currency in circulation
Loans to financial institutions
Reserves
• Liabilities
– currency in circulation: in the hands of the public
– reserves: deposits (settlement balances) at the Bank of Canada and vault
cash
• Assets
– government securities: holdings by the Bank of Canada that affect money
supply and earn interest
– loans to financial institutions: provide loans (advances) to banks and
charge the bank rate
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Reserves
• Banks (LVTS participants), have an account at the Bank
of Canada in which they hold deposits (also called
settlement balances )
• Reserves consist of settlement balances at the Bank of
Canada plus vault cash
• Banks hold reserves in order to manage liquidity
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Reserves (cont’d)
• Desired reserves
– reserves that are held to meet the central bank’s
requirement that for every dollar of deposits at a bank, a
certain fraction must be kept as reserves
• Desired reserve ratio
– the fraction of deposits that the bank desires be kept as
reserves
• Excess reserves
– reserves in excess of desired reserves
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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
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Open Market Purchase from a Bank
Banking System
Assets
Bank of Canada
Liabilities
Securities
$100m
Reserves
+$100m
Assets
Securities
Liabilities
+$100m Reserves
+$100m
• Bank of Canada purchases $100m of bonds from a bank and pays
them with a $100m cheque
• Net result is that reserves have increased by $100m
• No change in currency
• Monetary base has risen by $100m
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Open Market Purchase from the Nonbank Public
Banking System
Assets
Reserves
Bank of Canada
Liabilities
+$100m
Chequable
deposits
+$100m
Assets
Securities
Liabilities
+$100m
Reserves
+$100m
• Non bank public sells $100m of bonds to the Bank of Canada and
deposits the Bank’s cheque in the local bank
• Person selling bonds to the Bank of Canada deposits the Bank’s
cheque in the bank
• Identical results as the purchase from a bank
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Open Market Purchase from the Nonbank Public
(cont’d)
Nonbank Public
Assets
Bank of Canada
Liabilities
Securities
-$100m
Currency
+$100m
Assets
Securities
Liabilities
+$100m Currency in
circulation
+$100m
• The person selling the bonds cashes the Bank’s cheque
• Reserves are unchanged
• Currency in circulation increases by the amount of the open
market purchase
• Monetary base increases by the amount of the open market
purchase
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Open Market Purchase: Summary
• The effect of an open market purchase on reserves
depends on whether the seller of the bonds keeps the
proceeds from the sale in currency or in deposits
• The effect of an open market purchase on the
monetary base always increases the monetary base by
the amount of the purchase
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Open Market Sale
Nonbank Public
Assets
Liabilities
Securities
+$100
Currency
-$100
Bank of Canada
Assets
Securities
Liabilities
-$100 Currency in
circulation
-$100
• Bank of Canada sells $100 of bonds to a bank or the non-bank
public
• Reduces the monetary base by the amount of the sale
• Reserves remain unchanged
• The effect of open market operations on the monetary base is
much more certain than the effect on reserves
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Shifts from Deposits into Currency
Nonbank Public
Assets
Banking System
Liabilities
Chequable
deposits
+$100m
Currency
-$100m
Assets
Reserves
Bank of Canada
Assets
Liabilities
Currency in
circulation
+$100m
Reserves
-$100m
Liabilities
+$100m Chequeable
deposits
-$100m
• Net effect on monetary
liabilities is zero
• Reserves are changed by
random fluctuations
• Monetary base is a more
stable variable
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Loans to Financial Institutions
Banking System
Assets
Reserves
Bank of Canada
Liabilities
+$100m Advances
+$100m
Assets
Advances
Liabilities
+$100m Reserves
+$100m
• When the Bank makes a $100m loan to a bank, the bank is credited
with $100m of reserves (settlement balances) from the proceeds of
the loan
• Monetary liabilities of the Bank of Canada have increased by $100m
• Monetary base also increases by this amount
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Other Factors that Affect the Monetary Base
•
•
•
•
Float
Government deposits at the Bank of Canada
Interventions in the foreign exchange market
Although technical and external factors complicate
control of the monetary base, they do not prevent the
Bank of Canada from accurately controlling it
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Overview of the Bank of Canada's Ability to
Control the Monetary Base
• 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
• Split the monetary base into two components
MBn= MB - BR
• The money supply is positively related to both the nonborrowed monetary base MBn and to the level of borrowed
reserves, BR, from the Bank of Canada
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Multiple Deposit Creation: A Simple Model
Deposit Creation: Single Bank
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-$100m
Securities
-$100m Chequable
deposits
Reserves
+$100m
Reserves
+$100m
Loans
+$100m
First National Bank
+$100m
• Excess reserves increase
Securities
-$100m
• Bank loans out the excess
reserves
Loans
+$100m
• Creates a chequing account
Assets
Liabilities
• Borrower makes purchases
• Money supply increases
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Deposit Creation: The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Chequable
m deposits
Assets
+$100m Reserves
Loans
Liabilities
+$10m Chequable
deposits
+$90m
Bank B
Assets
Reserves
+$100m
Bank B
Liabilities
+$90m Chequable
deposits
Assets
+$90m Reserves
Loans
Liabilities
+$9m Chequable
deposits
+$90
+$81m
• $100m of deposits created by First Bank’s loan is deposited at Bank A.
• This bank and all other banks hold no excess reserves
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Creation of Deposits (assuming 10% reserve
requirement and a $100 million increase in reserves)
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The Formula for Multiple Deposit Creation
Desired Reserves (DR)  Total Reserves (R)
DR  Desired Reserve Ratio (r) times the total amount
of chequable deposits (D)
Substituti ng rd for DR
rd x D  R
Dividing both sides by r
1
D xR
rd
Taking the change in both sides yields :
1
D  x R
rd
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Simple Deposit Multiplier
1
D  x R
rd
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Multiple Deposit Creation: The Banking System
• Desired reserve ratio = 10%
• If reserves increase by $100m, chequable deposits rise to
$1000m in order for total desired reserves to also increase by
$100m
Assets
Securities
Reserves
Loans
Banking System
Liabilities
- $100m
Deposits
+ $100m
+ $1000m
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+ $1000m
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Critique of the Simple Model
• Holding cash stops the process
– Currency has no multiple deposit expansion
• Banks may not use all of their excess reserves to buy
securities or make loans
• Depositors’ decisions (how much currency to hold)
and bank’s decisions (amount of excess reserves to
hold) also cause the money supply to change
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Factors that Determine the Money Supply
• Changes in the nonborrowed monetary base MBn
– the money supply is positively related to the non-borrowed
monetary base MBn
• Changes in borrowed reserves from the Bank of
Canada
– the money supply is positively related to the level of
borrowed reserves, BR, from the Bank of Canada
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Factors that Determine the Money Supply
(cont’d)
• Changes in the desired reserves ratio
– the money supply is negatively related to the required
reserve ratio
• Changes in currency holdings
– the money supply is negatively related to currency holdings
• Changes in excess reserves
– the money supply is negatively related to the amount of
excess reserves
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Money Supply Response
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The Money Multiplier
• Define money as currency plus chequable deposits: M1+
• Link the money supply (M) to the monetary base (MB)
and let m be the money multiplier
M  m  MB
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Deriving the Money Multiplier
• Assume that the desired holdings of currency (C) and
excess reserves (ER) grow proportionally with
chequable deposits (D)
• Then,
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio
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Deriving the Money Multiplier (cont’d)
• 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 = rd x D
• Substituting for DR
R = (rd x D) + ER
• The banks set rd to be less than 1
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Deriving the Money Multiplier (cont’d)
• The monetary base MB equals currency (C) plus
reserves (R):
MB = C + R = C + (rd x D) + ER
• Equation reveals the amount of the monetary base
needed to support the existing amounts of chequable
deposits, currency and excess reserves
• An increase in MB going into C is not multiplied, but an
increase in MB going into D is multiplied
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Deriving the Money Multiplier (cont’d)
c = {C / D}  C = c  D and
e = {ER / D}  ER = e  D
Substituting in the previous equation
MB  (r  D)  (e  D)  (c  D)  (r  e  c)  D
Divide both sides by the term in parentheses
1
 MB
r  e c
M  D  C and C  c  D
D
M  D  (c  D)  (1 c)  D
Substituting again
1 c
 MB
r  e c
The money multiplier is then
M
m
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1 c
r ec
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Application: The Great Depression Bank Panics, 1930–1933,
and the Money Supply
• Bank failures (and no deposit insurance) determined:
– increase in deposit outflows and holding of currency
(depositors)
– an increase in the amount of excess reserves (banks)
• For a relatively constant MB, the money supply
decreased due to the fall of the money multiplier
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Deposits of Failed Commercial Banks, 1929–1933
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Excess Reserves Ratio and Currency Ratio, 1929–
1933
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M1 and the Monetary Base, 1929–1933
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APPLICATION The 2007-2009 Financial Crisis and the
Money Supply
• During the recent financial crisis the monetary base
more than tripled as a result of the Fed's purchase of
assets and new lending facilities to stem the financial
crisis
• The currency ratio fell during this period
• Money supply model suggests that would raise the
money multiplier and the money supply because it
would increase the overall level of deposit expansion
• However, the effects of the decline in c were entirely
offset by the extraordinary rise in the excess reserves
ratio e
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M1 and the Monetary Base, 2007-2009
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Excess Reserves Ratio and Currency Ratio, 2007-2009
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