Banking, money supply and the
instruments of monetary policy
Lecture 22 – academic year 2014/15
Introduction to Economics
Fabio Landini
Money supply and the instruments of
monetary policy
So far we have assumed that the money supply is
completely controlled by the Central Bank and that
it was the only instrument of monetary policy.
To what extent does the Central Bank control the
supply of money?
What is the role of private banks in determining the
supply of money?
What are the other policy instruments used by the
Central Bank?
Money supply and the instruments of
monetary policy
• The role of private banks in the creation of
money
• Re-examine the equilibrium in financial
markets
• Instrument of monetary policy
Banks and the creation of money
So far we assumed that the money supply was
entirely control by the Central Bank.
In reality in economic systems there exist different
financial intermediaries(e.g., private banks) that:
• Receive funds from firms and individuals (bank
deposit)
• Give loans and purchase financial assets
The activities of private banks affect the money
supply.
Banks and the creation of money
Let’s examine the relationships among households,
firms and private banks
a)Let’s assume that households and firms are
endowed with a certain amount of cash (K)
K is split in two parts
Part kept at home
in form of cash
Part that is saved
in a bank account
Cash flow
Bank deposit
Banks and the creation of money
b)Banks receive the sum that is saved in deposits
This sum can be used in any moment by their
owners (withdrawal, payments, etc.) -> Banks
should keep an amount of cash equal to the total
amount of deposits
In reality, however, only a fraction of deposit is
available for withdrawal -> banks keep less cash
than the value of their deposits.
Banks and the creation of money
This amount of cash is called: Bank reserves (e.g.
10% of deposits).
The Central Bank set the minimum value of the
reserves(mandatory reserves)
The bank can keep a higher amount if she wish
(voluntary reserves)
Bank reserve=
Mandatory reserves + Voluntary reserves
Banks and the creation of money
c) Once fixed the reserves, what happens to the
remaining part of deposits?
Two alternatives: i) loans (e.g. mortgage); ii)
purchase of financial assets
Deposits
Reserve
Loans+Assets
Loans and purchase of financial assets have
very similar effects -> for simplicity we consider
only the purchase of financial assets.
Banks and the creation of money
d) Purchase of financial assets
Banks purchase assets from firms and households.
Those who sell assets receive cash in exchange.
How is this cash spent?
Cash
Circulating
Deposits
e) … and the previous mechanism starts again…
Banks and the creation of money
In conclusion we have:
Cash k
Circulating
Deposits
Reserves
Assets
Cash
Circulating
Deposits
and so on…
Banks and the creation of money
At each “step” a smaller quantity of cash is
reintroduced in the system.
The cash that is reintroduced can be used to make
transactions: each introduction of cash “create”
new money -> the interaction among banks, firms
and household “create” new money.
Equilibrium of financial markets
Given this mechanism, let’s now go back to the
determination of equilibrium in financial markets
Components used to determine the equilibrium:
a) Demand of money
MD=$YL(i)
(Chapter 4)
Equilibrium of financial markets
b) Firm and household behaviour
Demand of money
MD
Demand of circulating units
Demand of deposits
CUD = cMD
DD = (1-c)MD
with 0 < c < 1
c) Bank behaviour
Demand of reserve -> fraction of deposits
RD= rDD
with 0< r <1
Equilibrium of financial markets
Let’s introduce a new variable: Money issued by the
Central Bank (cash) -> Monetary Base (H).
The monetary base is not the total supply of money
(there is also money “created” by private banks).
The monetary base is equal to the overall cash
owned in the economy.
Which form does this cash take?
Households and firms -> Circulating units
Banks -> Reserves
Equilibrium of financial markets
H = Circulating units + Reserves
= CUD + RD
By substituting the preceding equations
H = CUD + RD = cMD + rDD
= cMD + r(1-c)MD
= [c + r(1-c)] MD
= [c + r(1-c)] $YL(i)
Equilibrium of financial markets
From previous equation we know that
H = [c + r(1-c)] $YL(i)
Equilibrium condition in financial markets is
MS = $YL(i)
By substituting the second equation in the first we get
H = [c + r(1-c)] MS
from which we get
MS = H /[c + r(1-c)]
Equilibrium of financial markets
Let’s examine the money supply:
•H -> controlled by the Central Bank
•1 /[c + r(1-c)] -> depends on (i) c -> behaviour of
households and ii) r -> behaviour of banks
The Central Bank controls only part of the Money
Supply.
Equilibrium of financial markets
Moreover, it can be shown that 1/[c + r(1-c)]>1
It follows that: Money supply > monetary base
1/[c + r(1-c)]
Money multiplier
Equilibrium of financial markets
What happens if the Central Bank want MS?
The CB impact on the Money Supply by increasing
the monetary base ( H).
The effect of H is amplified by the actions of banks.
The overall effect is only partially under CB’s control
(if banks and households change their behaviour the
money multiplier changes too)
The effect of the intervention can be only
approximately forecasted by the CB.
Instruments of monetary policy
(no exam)
We conclude the analysis of monetary policy
examining the set of instruments that is used by the
Central Bank.
The main instruments are three:
• Monetary base
• Coefficient of mandatory reserves
• Interest rate
Instruments of monetary policy
(no exam)
1) Monetary base
The Central Bank can affect the short-period
equilibrium by changing the monetary base H.
It is the mechanism that we have been considering
so far: H -> MS -> i -> Y
These effect (as we saw before) depend on the
value of the money multiplier and thus on the
behaviour of households, firms and banks.
Instruments of monetary policy
(no exam)
2) Coefficient of mandatory reserve.
Money multiplier 1/[c + r(1-c)] contains the reserve
coefficient r.
This coefficient depends on the value of
mandatory reserve set by the Central Bank:
r -> 1/[c + r(1-c)]
If the Central Bank
r -> multiplier -> MS -> i -> Y
Instruments of monetary policy
(no exam)
The effect depends also on the behaviour of
banks
It is possible that mandatory reserve but banks
voluntary reserve -> r does not change
Instruments of monetary policy
(no exam)
3) Reference interest rate
Another way of affecting the short period
equilibrium is the one of changing the reference
interest rate iR.
iR - rate of banks’ re-financing (very short term).
What happens when iR vary?
Instruments of monetary policy
(no exam)
Premise:
So far we have assumed that there exist only one asset
and one interest rate.
In reality there exist different financial assets (bonds,
shares, short-term assets, long-term assets, etc.)
There exist substitutability among the different assets:
those who purchase one asset compare the return of
alternative assets and decides consequently -> the
interest rate of the different assets are linked one
another.
Instruments of monetary policy
(no exam)
The link among the different assets imply that if iR
changes also the other interest rate change in the
same direction
For instance if the Central Bank
iR -> I
The relation between i and iR is not stable so that
the overall effects of the intervention cannot be
determined with certainty.
Instruments of monetary policy
(no exam)
In conclusion:
• The Central Bank has three instruments:
monetary base, reserve coefficient and interest
rate
• Each of these three instruments allow one to
impact on the short period equilibrium
• The effects obtained are influenced by the
behaviour of individuals and by financial
intermediaries.
Instruments of monetary policy
(no exam)
Given that behaviour can change over time the
effects are foreseen with some errors.
For this reason the choice of the instruments
depend also on the greater or smaller stability of the
effects that are obtained.