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Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply
Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply
• Money multiplier
• Factors that determine multiplier & MS
• Applications: Great Depression
• Money multiplier
• Factors that determine multiplier & MS
• Applications: Great Depression
• given problems with simple money multiplier,
• construct better multiplier• cash holdings• excess reserves holdings
• based on M1 = C + D
• given problems with simple money multiplier,
• construct better multiplier• cash holdings• excess reserves holdings
• based on M1 = C + D
I. money multiplierI. money multiplierI. money multiplierI. money multiplier
• how $1 change in MB will affect MS:
M = m x MB• how $1 change in MB will affect MS:
M = m x MB
rD = required reserve ratio
c = ratio of currency to deposits
e = ratio of excess reserves to deposits
m =
rD + e + c
1 + c
exampleexampleexampleexamplerD = .10 C = $400 billion D = $800 billion
ER = $.8 billion or $800 million
= 2.5
$1 increase in MB, $2.5 increase in M
m =.10 + .001 + .5
1 + .5
II. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MS
• changes in rD
• changes in c
• changes in e
• changes in MB
• changes in rD
• changes in c
• changes in e
• changes in MB
changes in rchanges in rDDchanges in rchanges in rDD
• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation
• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation
higherrD
smallermultiplier
exampleexampleexampleexample
• rD was .10
• suppose it rises to .20
• rD was .10
• suppose it rises to .20
m = 2.14
m =.20 + .001 + .5
1 + .5
changes in cchanges in cchanges in cchanges in c
• higher c• currency does not expand like deposits• smaller amount of deposit creation
• higher c• currency does not expand like deposits• smaller amount of deposit creation
higherc
smallermultiplier
exampleexampleexampleexample
• original example: c = .5
• suppose c = .8• original example: c = .5
• suppose c = .8
m =.10 + .001 + .8
= 2.001 + .8
changes in ER/Dchanges in ER/Dchanges in ER/Dchanges in ER/D
• higher e• banks hold more ER, lend less• smaller amount of deposit creation
• higher e• banks hold more ER, lend less• smaller amount of deposit creation
highere
smallermultiplier
exampleexampleexampleexample
• original example: e = .001
• suppose e = .005• original example: e = .001
• suppose e = .005
m =.10 + .005 + .5
= 2.481 + .5
what affects e?what affects e?what affects e?what affects e?
• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)
• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)
higheri
ERfall
• expected deposit outflows• must hold more ER
• expected deposit outflows• must hold more ER
Factors affecting MBFactors affecting MBFactors affecting MBFactors affecting MB
• MB = MBn + DL• MBn is nonborrowed MB
-- open market purchase will
increase MBn
-- open market sale will
decrease MBn• increase MBn will increase M
• MB = MBn + DL• MBn is nonborrowed MB
-- open market purchase will
increase MBn
-- open market sale will
decrease MBn• increase MBn will increase M
• DL is discount loans
-- increase as banks borrow from
the Fed
-- increase as spread between
market interest rate and discount
rate increases
• DL is discount loans
-- increase as banks borrow from
the Fed
-- increase as spread between
market interest rate and discount
rate increases
Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33
• big contraction in M1
• big increases in c, e• depositors withdrew cash• banks increase ER due to increase
in deposit outflow
• big contraction in M1
• big increases in c, e• depositors withdrew cash• banks increase ER due to increase
in deposit outflow
• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33
• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33