BNFN 403
MONETARY THEORY AND POLICY
WEEK 2
MISHKIN (2004),
CH.15
Multiple Deposit Creation and The
Money Supply Process,
The Money Supply Process
• The Money Supply is an economic
variable that has an impact on interest
rates,exchange rates, inflation and an
economy’s output.
• The Central Bank attempts to manage the
money supply
• How does a central bank do it?
• We must know what influences the money
supply.
Money Supply Process
Monetary
Base
Determined by
CB
x
Money
Multipilier
Determined by
CB
The Banking System
The nonbank public
=
Money
Supply
Money Supply Process
•
1.
2.
3.
4.
•
Four Players in the Money Supply
Process
The Central Bank
Banks
Depositors
Borrowers from banks
The CB is the most important
Central Bank’s Balance Sheet
Assests
Liabilities
Securities
Discount Loans
Gold and SDR certificate
accounts
Coin
Cash item in process of
collection
Other CB assets
Bank notes (currency in
circulation)
Reserves
Treasury Deposits
Foreign and Other Deposits
Deffered availability cash
items
Other CB liabilities and
capital accounts
Monetary Base
• In order to follow its responsibilities as keeping
economic stability, CB should be able to affect
money supply.
• Or CB should be capable to bring the targeted
level of liquidity in the economy.
• As a measurment of liquidity,CB should choose
a monetary indicator that can follow at daily base
• In the most economies,a such indicator is
Monetary Base
Monetary Base
• Why not to follow Money Supply instead of
MB?
ØMB can be followed within balance sheet of
CB
ØMB has strong relation with money supply
ØMB consist of all monetary tools.
Monetary Base
• The monetary base equals currency in
circulation plus total reserves in banking
system.
• MB = C + R
• MB is also called high-powered money as
being a very important part of money
supply. An increase in MB will lead to a
multiple increase in money supply.
Monetary Base
• Uses of the base
MB= (CB banknotes+Treasury currency-coin)+reserves
• Sources of the base
MB=Net Foreign Assets+Net Domestic Assets- Net Other
Liabilities
Or
MB= Securities+discount loans+gold&SDRs+float+ other
assets+Treasury currency-Treasury deposits-foreign and
other deposits-other cb liabilitiesand capital
• CBs can affect the monetary base by
– Increase or decrease of NFA
– Increase or decrease of NDA
Factors that affect the Monetary
base
Control of the Monetary Base
• CBs exercises control over the monetary
base via its three assets
– Through its purchases or sales of goverment
securities in the open market which is called
Open Market Operations
– Through its purchases or sales of foreign
exchange in the FX market.
– Through its extension of discount loans to
banks
Control of the Monetary Base
• Increase in the Monetary Base
–
–
–
–
Open market purchase from a bank
Open market purchase from the Nonbank Public
Foreign exchange purchase
Making discount loan to a bank
• Decrease in the Monetary Base
– Open market sale
– Foreign exchange sale
– Bank to pay off a loan
• Comparing OMOs and Discount loans
– Both causes change in the monetary base
– CB has greater control over OMOs
– CB sets discount rate,however banks borrow or not.
• Other Factors that affect the Monetary Base
– Float
– Treasury deposits
– Fluctuations are ususally predictable and so can be
offset through OMOs
– Although Float and Treasury deposits with CB
undergo substantial short-run fluctuations, tehy do not
prevent CB from accurately controlling it.
• Budget deficit and the Monetary Base
– Budget deficit is financed by Treasury securities
– Sales of securities by the Treasury = change in
Treasury securities held by banks and nonbank
public+ CB purchase of Treasury securities
– If it is financed by CB purchase of Treasury securities
which is called “ monetizing the debt” causes
monetary base to increase.
Multiple Deposit Creation
• Monetary Base is the base for money
supply. Changes in the monetary base
causes change in the money supply
• When CB supplies the banking system $1
of additional reserves,deposits increase by
a multiple of this amount- a process called
multiple deposit creation
• Deposit creation: Assumptions of the
Model
– There is only checkable deposits in the
banking system
– Required reserve ratio is %10 and applied to
all banks
– No cash/currency leakage from the banking
system
– No excess reserves that are hold by banks
•
•
•
•
•
•
•
•
•
•
•
•
•
First National Bank
Assets
Securities – $100
Reserves + $100
First National Bank
Assets
Securities – $100
Reserves + $100
Loans
+ $100
First National Bank
Assets
Securities – $100
Loans
+ $100
Liabilities
Liabilities
Deposits
+ $100
Liabilities
Deposits
+ $100
•Bank A
•Assets
•Reserves
•Bank A
•Assets
•Reserves
•Loans
•Bank B
•Assets
•Reserves
•Bank B
•Assets
•Reserves
•Loans
+ $100
+ $10
+ $90
+ $90
+$9
+ $81
Liabilities
Deposits
+ $100
Liabilities
Deposits
+ $100
Liabilities
Deposits
+ $90
Liabilities
Deposits
+ $90
• A single bank can create deposits equal
only to the amount of its reserves.
• The banking system as a whole can
generate a multiple expansion of deposits.
• The model also works in reverse, when
CB withdraw reserve from the system.
Deposit Creation
• Deriving the Formula
?D= change in total checkable deposits in the banking
system
rd= required reserve ratio
?RR= change in reserves for the banking system
Reserves= Required reserve(RR) + excess reserve(ER)
ER=0
R=RR
RR= rd x D
D= 1/rd x RR
?D = 1/rd x ?RR
• The critique of the Simple Model
– The Simple Model seems to indicate that CB
is able to complete control over the level of
deposits by setting RRR.
– In the real life CB is not,because
• Banks hold excess reserve
• Depositors may hold cash
• No demand for loans