Transcript Chapter 16 The Money Supply Process Copyright  2011 Pearson Canada Inc. 16- 1

Chapter 16
The Money Supply Process
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Players in the Money Supply Process
• Central bank (Bank of Canada)
• Banks (depository institutions; financial
intermediaries)
• Depositors (individuals and institutions)
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Bank of Canada’s Balance Sheet I
Bank of Canada
Assets
Liabilities
Government securities
Notes in circulation
Advances to banks
Reserves
• 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 bank rate
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Bank of Canada’s Balance Sheet II
• Monetary liabilities of the Bank = Notes in circulation
+ Settlement balances+ vault cash
• Monetary base = Bank of Canada’s monetary
liabilities + Royal Canadian Mint’s monetary liabilities
(coins in circulation)
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Bank of Canada’s Balance Sheet III
• 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
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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
Bank of Canada purchases $100 of bonds from a
bank and pays them with a $100 cheque
Banking System
Assets
Bank of Canada
Liabilities
Securities
-$100
Reserves
+$100
Assets
Securities
Liabilities
+$100 Reserves
+$100
• Net result is that reserves have increased
by $100
• No change in currency
• Monetary base has risen by $100
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Open Market Purchase from Nonbank Public I
Non bank public sells $100 of bonds to the Bank of
Canada and deposits the Bank’s cheque in the local
bank
Banking System
Assets
Reserves
Bank of Canada
Liabilities
+$100 Chequable
deposits
+$100
Assets
Securities
Liabilities
+$100 Reserves
+$100
• 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 Nonbank Public II
The person selling the bonds cashes the Bank’s cheque
Nonbank Public
Assets
Bank of Canada
Liabilities
Securities
-$100
Currency
+$100
Assets
Securities
Liabilities
+$100 Currency in
circulation
+$100
• 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 (MB) always increases the base
by the amount of the purchase
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Open Market Sale
Bank of Canada sells $100 of bonds to a bank or the nonbank public
Nonbank Public
Assets
Bank of Canada
Liabilities
Securities
+$100
Currency
-$100
Assets
Securities
Liabilities
-$100 Currency in
circulation
-$100
• 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
-$100
Currency
+$100
Assets
Reserves
Bank of Canada
Assets
Liabilities
Currency in
circulation
+$100
Reserves
-$100
Liabilities
-$100 Cheqeable
deposits
-$100
•Net effect of monetary
liabilities is zero.
• Reserves are changed by
random fluctuations.
•Monetary base is more
stable
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Bank of Canada Advances
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
Banking System
Assets
Reserves
Bank of Canada
Liabilities
+$100 Advances
+$100
Assets
Advances
Liabilities
+$100 Reserves
+$100
• Monetary liabilities of the Bank of Canada have
increased by $100
• Monetary base also increases by this amount
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Paying Off a Loan from the Bank of Canada
A loan is from the Bank of Canada is paid off by a bank
Banking System
Assets
Reserves
Bank of Canada
Liabilities
-$100 Advances
-$100
Assets
Advances
Liabilities
-$100 Reserves
-$100
• 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
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Other Factors Affecting the Monetary Base
1. Float
2. Government deposits at the Bank of Canada
Overview of the Bank’s Ability to Control the Monetary Base
•
MBn=MB - BR
•
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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Deposit Creation: Single Bank
First Bank
Assets
First Bank
Liabilities
Assets
Liabilities
Securities
-$100
Securities
-$100 Chequable
deposits
Reserves
+$100
Reserves
+$100
Loans
+$100
Excess reserves increase
First Bank
Assets
Liabilities
Securities
-$100
Loans
+$100
+$100
Bank loans out the excess
reserves
Creates a chequing account
Borrower make purchases
The money supply has increased
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Deposit Creation: The Banking System
$100 of deposits created by First Bank’s loan is deposited
at Bank A. This bank and all other banks hold no excess
reserves
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Chequable
deposits
Assets
+$100 Reserves
Loans
Reserves
+$100
Bank B
Liabilities
+$90 Chequable
deposits
Assets
+$90 Reserves
Loans
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+$10 Chequable
deposits
+$90
Bank B
Assets
Liabilities
Liabilities
+$9 Chequable
deposits
+$90
+$81
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Creation of Deposits
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The Formula for Multiple Deposit Creation
Asssuming banks do not hold excess reserves
Desired Reserves (DR)  Total Reserves (R)
DR  Desired Reserve Ratio (r) times the total amount
of chequable deposits (D)
Substituti ng r x D  R
Dividing both sides by r
1
D R
r
Taking the change in both sides yields :
1
D   R
r
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Simple Deposit Multiplier
1
Simple Deposit Multiplier 
r
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Multiple Deposit Creation:
The Banking System
Desired reserve ratio = 10%. If reserves increase by
$100, chequable deposits rise to $1000 in order for total
desired reserves to also increase by $100
Banking System
Assets
Liabilities
Securities - $100
Deposits + $1000
Reserves + $100
Loans + $1000
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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
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Factors that Determine the Money Supply
• Changes in the Non-borrowed monetary base
(MBn)
- the money supply is positively related to the
non-borrowed monetary base (MBn)
• 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
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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
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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
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Deriving the Money Multiplier I
• Assume the desired level of currency (C)
and desired reserves (DR) grows
proportionately with chequable deposits
(D)
Then:
c = (C/D) = currency ratio
r = (DR/D) = desired reserve ratio
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Deriving the Money Multiplier II
• The total amount of reserves (R) equals the sum of
desired reserves (DR). Assume excess reserves are zero
at the equilibrium.
R = DR
• 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)
The banks set r to be less than 1
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Deriving the Money Multiplier III
• The monetary base (MB) equals currency (C) plus
reserves (R)
MB = R + C = (r x D) + C
• Shows the monetary base needed to support existing
amounts of D and C
• An increase in MB going into C is not multiplied, but
an increase in MB going into D is multiplied
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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)/(c+r) x MB
m= (1+c)/(c+r)
While there is a multiple expansion of
deposits, there is no such expansion for
currency
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Money Supply Response to Changes in the
Factors
Split the monetary base into two components
M = m x (MBn + BR)
• The money supply is positively related to both the
non-borrowed monetary base MBn and
to the level of borrowed reserves, BR, from
the Bank of Canada
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Desired Reserve Ratio and Currency Ratio
1929-1933
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M1 and the Monetary Base, 1929-1933
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