ECON248: Money and Banking
Ch 8
Money Supply (MS) Process
• Money supply (MS) process refers to the
mechanism that determines the money
supply.
• It refers to the implementation of monetary
policy.
• It is important to understand the MS
Process to understand exactly how open
market operations (OMOs) change the
money supply, and thereby affect the
economy (interest rates, inflation, output,
employment, money, etc.)
CHAPTER 8
(Ch. 13 in the Text)
Multiple Deposit Creation
and
the Money Supply Process
Dr. Mohammed Alwosabi
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2
3
Four Players in the Money Supply Process:
1. Central Bank (CB): Most important player
since it ultimately controls the supply of
money in the economy.
2. Commercial banks: Depository
institutions that accept deposits and
make loans.
3. Depositors: Bank customers (individuals,
companies and institutions holding bank
deposits - checking and savings
accounts.
4. Borrowers from banks: Individuals and
companies who borrow money from
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banks.
• The majority of money (M1) is in the form
of deposits.
• Therefore, we want to understand how the
banking system creates deposits, and in
the process, creates money.
• The central bank is a key player in the
money supply
l process but
b not the
h only
l
player.
The Central Bank's Balance Sheet (BS) and
the Monetary Base (MB):
• In this simplified version of the Central
bank’s BS, we will focus on only 4 items to
see how they affect the economy’s money
supply.
C
Central
l Bank’s
B k’ Si
Simplified
lifi d BS
Assets
Government securities
Discount loans
Dr. Mohammed Alwosabi
Liability
Currency in circulation
Reserves
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Assets
1. Government securities:
• The CB holds government securities
(Treasury bills, bonds, notes) for two
reasons:
(i) buying and selling of government
securities is one of the CB’s major tool
(known as OMO) in controlling the
economy’s money supply, and
(ii) holding government securities provides a
return.
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ECON248: Money and Banking
Ch 8
2. Discount loans:
• The CB makes loans to banks through its
discount window operation.
• The CB does not encourage banks to
borrow through its discount window on a
regular basis since the CB is acting as a
l d off last
lender
l
resort for
f the
h banks.
b k
Dr. Mohammed Alwosabi
Liabilities
1. Currency in circulation (C):
• Cash in the hands of the public, outside
the banking system.
• They are basically IOUs from the
government issued by the CB, like a
government bonds, but pays zero
interest.
• Currency is a liability of the CB, because
a BD20 bill could be redeemed for 2 tens,
or 4 fives, etc; or if it is worn out, banks
can redeem it for a new BD20 bill
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2. Reserves (R):
• All banks have to keep a certain
percentage of the deposits as the reserve
requirements established by the CB.
• The banks do so in two ways:
(a) Banks are required to open an account
with the CB and they can maintain their
reserves by making a deposit into that
account.
(b) They can keep cash in the banks’ vaults.
• Reserves are a liability of the CB, an asset
for commercial banks.
• We can further break that reserve into two
components:
(i) Required reserve (RR):
• This is the amount of money a bank
needs to keep by law.
• This is determined by the reserve
requirement ratio (expressed as a
percentage of a bank’s total deposit) set
by the CB.
(ii) Excess reserve (ER):
• This is the additional amount of money a
bank chooses to hold for liquidity reason.10
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Monetary base or high-powered money:
• The two liabilities of the CB are called the
Monetary Base (MB).
• MB = currency in hands of public +
reserves of banking system
MB = C + R
• MB is also called High-powered Money, or
M0.
• It is called high-powered because an
increase in the MB leads to a multiple
increase in the MS (M1 or M2).
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• CB directly controls the monetary base by
increasing or decreasing government
securities and thereby increasing or
decreasing bank reserves and/or
currency.
• If CB purchases a Treasury bill for BD100,
it increases assets by BD100 and liabilities
by BD100.
• By increasing bank reserves by $100, the
MS is increased.
• Monetary policy works by affecting the
CB's balance sheet.
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ECON248: Money and Banking
Ch 8
Control of the Monetary Base (MB)
• OMOs always affect MB, one to one.
(OMO = UMB) and (UMB = UR + UC)
• However, whether the OMO increases or
decreases R or C depends on the public's
g
to hold cash,, which depends
p
willingness
on MD.
• This mean that although OMOs always
affect MB it is not always affecting
reserves.
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15
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(2) CB Open Market Purchase from the
nonbank public, and the person makes a
bank deposit.
• A person gives the $100 government bond
to the CB in exchange for a $100 check
issued by the CB, and the person deposits
the check from CB into a bank,
• The net effect on the economy is exactly
the same
• When a CB check is deposited in a bank,
the net result of the OMP from nonbank
public is identical to the effect of its OMP
from a bank with OMP = $100, Res.Ç and
MB Ç.
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Liabilities
Central Bank
Assets
Securities
+$100
• Also, when the CB increases the monetary
base (MB) by supplying the banking
system with BD1 of additional reserves,
deposits (D) and M1 increase by a multiple
greater than 1, a process called multiple
deposit creation.
• When the CB wants to increase the MS, it
engages in
i an open market
k purchase
h
off
government securities from the public and
adds them to its portfolio.
• For contractionary (restrictive) policy, it
engages in an open market sale of
government securities from its portfolio to
the public.
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(1) CB Open Market Purchase from a Bank.
• CB implements expansionary monetary
policy and purchases $100 government
bond from Bank A.
• Bank A gives CB a $100 Bond and CB
writes a check to Bank A for $100.
• When the check clears at the CB the
Bank's reserves at CB increased by $100.
• Bank A has exchanged $100 government
security for $100 Reserves.
• CB has a new $100 bond, an increase in
Assets, and bank reserves (liab. for CB)
also increase by $100.
• Thus, with OMP = $100, Res.Ç and MB Ç16
Illustration of Open Market Operations,
3 Scenarios:
• Government securities represent an asset
and the reserve represents a liability for
the CB balance sheet.
• On the other hand, Government securities
p
assets for a
and reserve both represent
depository institution.
• There is a direct relationship between
money supply in the economy and the
reserves in the banking system, i.e. when
the reserves go up, the money supply also
goes up.
Bank A
Assets
Securities
-$100
Reserves
+$100
Dr. Mohammed Alwosabi
Liabilities
Reserves +$100
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ECON248: Money and Banking
Ch 8
Nonbank Public
Assets
Liabilities
Securities
-$100
Checkable Deposits +$100
Bank A
Res.
Assets
+100
Liabilities
Checkable Deposits +$100
Dr. Mohammed Alwosabi
(3) CB Open Market Purchase from the
nonbank public, and they cash the check
for $100 in currency.
• In that case, the investor has exchanged
a $100 security for $100 in cash.
• The CB has increased its assets by $100
((new securities)) and increased its
liabilities by $100 (increased currency in
circulation).
Central Bank
Assets
Securities +$100
•
•
Res.
Liabilities
+$100
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The bank has given out $100 in vault
cash to the person who cashed the CB
check (R = -$100), but get an increase in
reserves (R=+$100) from the CB check,
for their account at the CB.
Bank reserves remain unaffected, net
effect is 0 for bank reserves (R). In this
case: with
i h OMP = $100,
$100 Res.
R
unchanged,
h
d
Currency Ç and MB Ç
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Nonbank Public
Assets
Liabilities
Securities -$100
Currency
+$100
Central Bank
Assts
Securities +$100
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Conclusion:
• The Open Market Sale is just the opposite
of what have been discussed above
• The effect on the MB is always the same,
equal to OMO
• (OMO = UMB).
• The effect of OMO on MB is certain, the
effect of OMO on Reserves (R) and
currency (C) is not.
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Liabilities
Currency
+$100
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Shifts from Deposits into Currency
• The shift from deposits into currency
affects reserves in the banking system but
has no affect on MB.
• If a $100 withdrawn from a deposit , then
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ECON248: Money and Banking
Ch 8
Nonbank Public
Assets
Checkable Deposits -$100
Currency
+$100
Liabilities
Bank A
Assets
Res.
Liabilities
Checkable Deposits -$100
-100
Central Bank
Liabilities
Currency
+$100
Res.
-$100 25
Assets
Making and recalling discount loans
• Discount loans are loans made by the CB
to commercial banks through its discount
window operation.
• Discount loans represent assets for the
CB but represent liabilities for a
d
depository
i
institution.
i
i i
• Suppose the CB made a $100 loan to Bank
A through its discount window.
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• When the CB makes the $100 discount
loan (DL) to Bank A, that represents an
increase of $100 in its asset (since a
discount loan represents an asset to the
CB). And the CB simply “deposit” the
money in Bank A’s account with the CB.
• In the above example, we see that when
the
h CB makes
k a di
discount loan
l
to a bank,
b k
Res.Ç and MB Ç
• Similarly, we can easily verify that when
the CB recalls a discount loan from a bank,
the reserve will go down by the amount of
the loan.
Bank A
Assets
Liabilities
Reserves +$100 Discount Loans +$100
C
Central
Bank
Assets
Discount Loans
Dr. Mohammed Alwosabi
Liabilities
+$100 Reserves +$100
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MULTIPLE DEPOSIT CREATION: A SIMPLE
MODEL
• In the above scenarios, we have seen that
the CB can change the reserve of a bank
simply by buying/selling government
securities and making/recalling loans.
• With
Wi h these
h
scenarios
i in
i mind,
i d we will
ill
proceed to examine the impact of such
changes in a bank’s reserve on the
economy’s money supply.
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• To understand the impact of the changes
in a bank’s reserve (due to the CB’s
actions) on the economy’s money supply,
we will illustrate with the following
example.
• Before we proceed, it is important to note
that this example is based on a very
simple model with the following three
assumptions:
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ECON248: Money and Banking
Ch 8
1. Banks hold no excess reserve because
excess reserve earns no return (and they
are not required by law).
2. Individuals prefer to hold checking
deposits than hold cash (i.e. individuals
conduct all transactions with checks and
not cash).
cash)
3. RRR = 10%
Dr. Mohammed Alwosabi
• Assume that CB conducts OMP of a $100
bond from bank A (or from an investor
who deposits the $100 into Bank A).
•
Bank A
Assets
Liabilities
Securities
- $100
Res.
+$100
Central Bank
Assets
Liabilities
Securities
+$100
Res.
+$100
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• Since the increase in Bank A’s reserve is a
result of a sale of government securities to
the CB and not an acceptance of deposit,
it does not need to keep any of it as
required reserve. Hence, the $100 increase
in reserve represents a $100 increase in
excess reserve
reserve. Since reserve earns no
return for the bank, it is assumed that the
bank will “get rid” of the excess reserves
by using them to make loans.
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• To simplify our scenario, we will assume
that Bank A makes a loan of $100 to a
borrower.
Bank A
Assets
Liabilities
Loans +$100 Checkable Deposit +$100
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—Since Bank B is not earning return for
holding excess reserve, it will keep only
the required reserves and make loan of the
remaining ER
—Because checkable deposits are part of
money supply the bank’s act of lending
has created money.
—The borrower of the loan deposits it in it
bank, say bank B
Bank B
AAssets
Li bili i
Liabilities
Reserves + 10 Checkable Deposit +$100
Loan
+90
Bank B
Assets
Liabilities
Reserves +$100 Checkable Deposit +$100
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ECON248: Money and Banking
Ch 8
—The borrower deposited the $90 loan in
Bank C
Dr. Mohammed Alwosabi
—Bank C would keep only 10% of the $90
and loaned out the ER
Bank C
Bank c
Assets
Liabilities
Reserves
+$90 Checkable Deposit +$90
Assets
Liabilities
Reserves + 9 Checkable Deposit +$90
Loan
+81
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—The $81 will be deposited in another bank.
—From the initial $100 increase of reserves
in banking system the total increase in the
checkable deposits so far is $271 ($100 +
$90 + $81)
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—The multiple increase in deposits
generated from an increase in the banking
system’s reserves is called simple money
(or deposit) multiplier (SDM).
1
1
=
= 10
RRR
0 . 10
• The total change in deposit are equal to
SDM times the initial change in reserves
= UD = (SDM) (UR) =10x100 = $1000
• Total change in loans are equal to SDM
times the initial change in loans
SDM
=
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—This process will continue from one bank
to another bank until there is no more ER.
—We can observe that the amount of loan a
bank can make decreases as the process
continues.
—It will get to a point where banks are
making
ki very small
ll amount loans.
l
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—So far, we have seen how the banking
system is able to create deposits based on
an initial increase in reserves (by selling
securities to the CB or taking a loan from
the CB).
—The same situation can easily be applied
to the case when the CB reduces the
reserves by selling securities to the banks
or recalling loans from the banks.
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ECON248: Money and Banking
Ch 8
Dr. Mohammed Alwosabi
• Note that if a bank decides to use its excess
reserves to make loans or to purchase
securities, the effect on deposit expansion
is the same.
• Assume that Bank A bought a $100 Treasury
bill instead of making a $100 loan. The
process would be the same because the
bank would write a check for $100, which
would get deposited at another bank, Bank
B, and increases Bank B's reserves by $100.
• Thus, whether excess reserves are used for
making loans or buying securities, the
deposit expansion is the same.
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Problems with the simple model
• There are several problems with this simple
model of determining the impacts of the
CB’s actions on the economy’s money
supply. This model assumes that
(i) banks do not like to keep excess reserves
and like to loan out any money that they are
nott required
i d to
t keep,
k
and
d
(ii) individuals have preference for checkable
deposits over currency. SDM really shows
the potential maximum effect that an OMO
can have on deposits (D) and the money
supply (M).
• However, this is not the case in the real
world.
• There are many reasons why a bank would
like to keep excess reserves and why an
individual would like to have currency rather
than checkable deposit.
• So it is important to observe that CB directly
controls the MB, but can't directly control
M1. M1 is influenced by public's behavior
(cash demand) and bank's behavior (holding
excess reserves).
• Also, observe that reserve requirements are
not used very often for monetary policy,
they are typically set and left in place for
years at a time.
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