Money Supply Process
• We have learnt the concepts and measurement of money.
• While there are several monetary aggregates, we will focus on
the narrowest definition of money, i.e. M1, consisting of
Currency + Deposits.
• Money is held (Money demand) to facilitate transactions and as
a part of asset portfolio.
• Thus, the holding of money depends crucially on the volume of
transactions (normally measured by GDP) and the cost of
holding money relative to other assets (normally represented by
an interest rate).
• Other variables might affect monetary holding as well.
M/P = L(Y, r, X)
• Ly = income elasticity of
money demand
• Lr = interest rate elasticity of
money demand
[X is other variables that can
affect monetary holding]
• To complete the money market model, we need to understand
the money supply process.
• Simplifications
- Money = Currency + Deposits
- Bank holds no EXCESS reserve
(will modify this later)
- Economic agents hold money only in the form of deposits
(will modify this later)
- There is only one bank in the economy.
(can be viewed as consolidation of all banks).
• We first use the simple T-account to illustrate the money supply
process and how monetary instruments can affect the stock of money
supply.
• Monetary Instruments:
- Open market operations
- Discount Rate
- Required Reserve Ratio (assumed to be 10%)
• Definition:
Monetary Base = Reserve + Currency
Money Supply = Deposit + Currency
(For the moment: we assume currency = 0)
• Question: How is money supply related to monetary base.
Initial Balance Sheet
Open Market Purchases
• Suppose that the government
purchases the government securities
from the banking system worth a
total of RM200 million.
Money Supply = 2,000
• Reserves in banking system increase.
• Money supply remains at 2,000
• At this point, the banking system fi nds itself having an excess reserve
• of RM200 million.
• Since the banking system does not keep the excess reserve, it is lent
out to say Mr or Corporation A, who deposits the loans obtained in
the banking system. This will increase total deposits to RM2,200, the
initial deposits of RM2 billion and the new deposits of RM200 million.
• With the extension of loans, the loans in the banking system increases
to RM1.5 billion.
• Since money is deposited back in the bank, reserves in the banking
system remains at RM400 million.
• Bank Balance sheet would be……
• A simple fact from Figure 3.3 is that, through the lending of
RM200, money supply increases to RM2,200.
• Simply stated, money supply is created through lending. It
should be noted that the creation of money does not stop here
since the banking system still have the excess reserve at hand.
• Money Supply = 2,200
• At this point, no further lending can be made.
• Money Supply = 4,000
• Note: with the initial increase of reserve by 200, money supply
increases by 2,000.
• Question restated: how is money supply related to reserve (monetary
base)?
• M=m×B
M is Money Supply
m is money multiplier
B is monetary base
• Given our assumption of no currency, we can restate the above
as:
D=m×R
• The simple money multiplier can be show to be equal 1/rr,
where rr is the required reserve ratio. Thus, we have:
D = (1/rr) × R
• Let relax the assumptions of no excess reserve and no currency.
• Denote ER/D the excess reserve to deposit ratio and C/D is
currency to deposit ratio.
• Total Reserve = Excess Reserve + Required Reserve
• From M = m × B, we have:
m = M/B
• This can be expanded to:
m = (D + C)/(ER + RR + C)
• Divide the numerator and denominator by D, we have
m = (1 + cd)/(er + rr + cd)
M = (1 + cd)/(er + rr + cd)  B
• What does this money supply process tell us?
• The Central Bank does not have complete control over the stock of
money supply.
• Three economic agents determine the level of money supply in the
economy. They are: Central Bank (through rr and B), Bank (through
er) and the public (through cd).
• Still, it is safe to state that the Central Bank can control the level of
money supply through its monetary instruments to a certain degree.