Lecture 28:
Money supply
Mishkin Ch14 – part B
page 351- 369
1
Introduction
What affect money supply?
 Money supply
= monetary multiplier *money base
 Monetary multiplier
 Money base

2
What affect monetary base?




Open market operations are controlled by the
Fed.
The Fed cannot determine the amount of
borrowing by banks from the Fed (discount
loans).
Split the monetary base into two components
 Discount loans: borrowed reserves, BR
 Remainder: non-borrowed monetary base,
MBn, (MBn= MB - BR )
M = m*(MBn + BR)
3
Factors that determine the money
supply

Previously we knew that required reserve ratio
(r), currency ratio (c), and excess reserves ratio
(e) negatively affect monetary multiplier (m) and
thus negatively affect money supply.

The money supply is positively related to
nonborrowed monetary base (MBn).

The money supply is positively related to
borrowed reserve from the Fed (MR).
4
Changes in the nonborrowed
monetary base (MBn )

M = m*(MBn + BR)

The Fed’s open market purchase  increase in
nonborrowed monetary base (MBn)  increase
in monetary base (MB)  support more
currency and deposits  increase money
supply (M).
The money supply (M) is positively related to the
nonborrowed monetary base (MBn).
How about open market sale?


5
Changes in the borrowed reserves
(MR) from the Fed

M = m*(MBn + BR)

If discount loans increase  borrowed reserves
(BR) increase  monetary base (MB) increase
 support more currency and deposits and thus
a higher money supply.

The money supply is positively related to the
level of borrowed reserves, BR, from the Fed.
6
Overview of the money supply
process
7
Application I: explain money supply
movements
8
• change in
MB (mainly
MBn) is
important for
long-term
movements.
• change in m
(currency
ratio c) is
important for
short-term
movements.
Explain money supply
movements – cont’d

Over long periods, the primary
determinant of movements in the money
supply is the nonborrowed monetary base,
which is controlled by the Fed’s open
market operations.
10
Application II: bank panics and
reduction in money supply
11
12
Application: bank panics and
money supply – cont’d


Bank panics  relative risks of deposits
increase, relative expected return of deposits
decrease  demand for deposits decrease 
people shift to holding cash  currency ratio c
increase  money multiplier m decrease 
money supply decrease.
In times of uncertainty  expected deposit
outflow increases  banks would increase
excess reserves ratio e  money multiplier m
decrease  money supply decrease.
13
14
Application: bank panics and
money supply – cont’d

Although the Fed tried its best to increase
monetary base, it can not fully offset the
negative effect of money multiplier on
money supply.
15
Recap

The relationship between money supply
and:
reserve ratio  interest rate, expected
deposit outflow
 currency ratio (short-term effects)
 Nonborrowed monetary base  open market
operation (long-term effects)
 excess
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