Defining the Money Supply
• M1 is sometimes
referred to as the
narrow definition of
the money supply or as
transactions money.
• M1 consists of
currency held outside
banks, checkable
deposits, and
traveler’s checks.
Defining the Money Supply: M2
• M2 is sometimes referred to as the broad
definition of the money supply.
• M2 is made up of M1 plus smalldenomination time deposits, savings
deposits, money market accounts, overnight
repurchase agreements, and overnight
eurodollar deposits held by US residents.
The Money Creation Process
• The sum of bank deposits at the Fed and the
bank’s cash vault is total bank reserves.
• The Fed mandates member commercial banks to
hold a certain fraction of their checkable deposits
in reserve form. This fraction is called the
required reserve ratio.
• The difference between a bank’s total reserves and
its required reserves is its excess reserves.
The Banking System and The
Money Creation Process
• The process starts with the Fed (Central Bank).
• The Fed prints the funds, and Jack deposits the
funds in his bank.
• The Reserves of the bank increases, while the
reserves of no other bank decreased.
• The banking system made loans and in the process
created checkable deposits for the people who
received the loans.
• Remember, checkable deposits are part of the
money supply. So, in effect, by extending loans,
and in the process creating checkable deposits, the
banking industry has increased the money supply.
The Banking System Creates
Checkable Deposits (Money)
The Banking System And The
Money Expansion Process
• When the $9000 that bankers created in new
checkable accounts is added to the $1000 the Fed
initially printed, we see that $10,000 has been
added to the money supply.
Maximum change in checkable deposits = (1/r) x R
• Where r = the required reserve ratio and R is the
change in reserves resulting from the original
injection of funds.
• In the formula, (1/r) is known as the simple
deposit ratio.
Why Maximum? Answer: No Cash
Leakages And Zero Excess Reserves
• All monies were deposited in bank checking
accounts.
• Every bank lent all its excess reserves,
leaving every bank with zero excess
reserves.
• Because we assumed no cash leakages and
zero excess reserves, the change in
checkable deposits is the maximum possible
change.
Who Created What?
• The money expansion
process has two major
players: the Fed, and
the Banking System.
• The maximum change
in bankable deposits is
equal to: (1/r) x ER,
where ER is the excess
reserves.
The Money Contraction Process
• This process is the Money Creation process
in reverse
Q&A
• If a bank’s deposits equal $579 million and the
required-reserve ratio is 9.5%, what dollar amount
must the bank hold in reserve form?
• If the Fed creates $600 million in new reserves,
what is the maximum change in checkable
deposits that can occur if the required-reserve ratio
is 10%?
• Bank A has $1.2 million in reserves and $10
million in deposits. The required-reserve ratio is
10%. If Bank A loses $200,000 in reserves, by
what dollar amount is it reserve deficient?
A model of the money supply
• exogenous variables
• the monetary base, H = C + R
controlled by the central bank
• the reserve-deposit ratio, r = R/D
depends on regulations & bank policies
• the currency-deposit ratio, c = C/D
depends on households’ preferences
The money multiplier
• M = C+DD
• M={[c + 1] / [c + r]}H = m x H
• If r < 1, then m > 1
• If monetary base changes by H,
then M = m  H
• m is called the money multiplier.
• An increase in c increases the denominator
of m proportionally more than the
Three instruments of monetary
policy
Open market operations
Reserve requirements
The discount rate
Which instrument is used most
often?
• Open market operations:
Most frequently used.
• Changes in reserve requirements:
Least frequently used.
• Changes in the discount rate:
Largely symbolic;
Balance sheet approach
• M3=net bank credit to govt.+ bank credit to
commercial sector + Net foreign assets+
govt currency+ other assets-Non monetary
liabilities
Money Demand
• The amount of money demanded for
transaction and speculative purposes
depends: personal income and interest rate
• At any level of personal income, quantity
demanded of money is a negative function
of interest rate; (M/P)d = L(i, Y)
Money Demand Line
M/P = L(Y, i)
Y = income
i = interest rate
Interest Rate (%)
10
5
(M/P)d
80
100
Quantity of Money
Money Market Equilibrium
Interest Rate (%)
(M/P)s
5
(M/P)d
80
Quantity of Money
Expansionary Monetary Policy
Interest Rate (%)
(M1/P)s
(M2/P)s
5
4
(M/P)d
80 85
Quantity of Money