Copyright 2011 Pearson Canada Inc. 16- 1 Chapter 16 The Money Supply Process

Copyright 2011 Pearson Canada Inc.16- 1

Chapter 16

The Money Supply Process


Players in the Money Supply Process

• Central bank (Bank of Canada)

• Banks (depository institutions; financial intermediaries)

• Depositors (individuals and institutions)


Bank of Canada’s Balance Sheet I

• Monetary Liabilities– Notes in circulation—in the hands of the public– Reserves - bank deposits at Bank of Canada and vault

cash• Assets

– Government securities - holdings by the Bank of Canada that affect money supply and earn interest

– Advances to banks - provide reserves to banks and earn the bank rate

Bank of Canada

Assets Liabilities

Government securities Notes in circulation

Advances to banks Reserves


Bank of Canada’s Balance Sheet II

• Monetary liabilities of the Bank = Notes in circulation + Settlement balances+ vault cash

• Monetary base = Bank of Canada’s monetary liabilities + Royal Canadian Mint’s monetary liabilities (coins in circulation)


Bank of Canada’s Balance Sheet III

• Define:– Currency = Notes + Coins– Reserves = Vault cash + Settlement balances

• Banks hold desired reserves to manage their short term liquidity requirements and respond to clearing drains and currency drains

• Reserves above that desired are known as excess reserves


Monetary Base

• MB = C + R– MB: monetary base (high-powered money)– C: currency in circulation (notes and coins held by

the public outside banks)– R: total reserves in the banking system (vault cash

+ settlement balances)• The Bank of Canada controls the monetary

base through open market operations and advances to banks


Open Market Purchase from a Bank

• Net result is that reserves have increased by $100

• No change in currency• Monetary base has risen by $100

Banking System Bank of Canada

Assets Liabilities Assets Liabilities

Securities -$100 Securities +$100 Reserves +$100

Reserves +$100

Bank of Canada purchases $100 of bonds from a bank and pays them with a $100 cheque


Open Market Purchase from Nonbank Public I

• Person selling bonds to the Bank of Canada deposits the Bank’s cheque in the bank

• Identical results as the purchase from a bank



Reserves +$100 Chequable deposits

+$100 Securities +$100 Reserves +$100

Non bank public sells $100 of bonds to the Bank of Canada and deposits the Bank’s cheque in the local bank


Open Market Purchase from Nonbank Public II

• Reserves are unchanged• Currency in circulation increases by the amount of

the open market purchase• Monetary base increases by the amount of the open

market purchase

Nonbank Public Bank of Canada


Securities -$100 Securities +$100 Currency in circulation

+$100

Currency +$100

The person selling the bonds cashes the Bank’s cheque


Open Market Purchase: Summary

• The effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits

• The effect of an open market purchase on the monetary base (MB) always increases the base by the amount of the purchase


Open Market Sale

• Reduces the monetary base by the amount of the sale• Reserves remain unchanged• The effect of open market operations on the monetary

base is much more certain than the effect on reserves

Nonbank Public Bank of Canada


Securities +$100 Securities -$100 Currency in circulation

-$100

Currency -$100

Bank of Canada sells $100 of bonds to a bank or the non-bank public


Shifts from Deposits into Currency

Nonbank Public Banking System


Chequable deposits

-$100 Reserves -$100 Cheqeable deposits

-$100

Currency +$100

Bank of Canada

Assets Liabilities

Currency in circulation

+$100

Reserves -$100

•Net effect of monetary liabilities is zero.

• Reserves are changed by random fluctuations.

•Monetary base is more stable


Bank of Canada Advances

• Monetary liabilities of the Bank of Canada have increased by $100

• Monetary base also increases by this amount



Reserves +$100 Advances +$100 Advances +$100 Reserves +$100

When the Bank makes a $100 loan to the First Bank, the bank, the bank is credited with $100 of reserves (settlement balances) from the proceeds of the loan


Paying Off a Loan from the Bank of Canada

• Net effect on monetary base is a reduction• Monetary base changes one-for-one with a change in

the borrowings from the Bank of Canada



Reserves -$100 Advances -$100 Advances -$100 Reserves -$100

A loan is from the Bank of Canada is paid off by a bank


Other Factors Affecting the Monetary Base

1. Float2. Government deposits at the Bank of CanadaOverview of the Bank’s Ability to Control the Monetary Base• MBn=MB - BR

• Although technical and external factors complicate control of the monetary base, they do not prevent the Bank of Canada from accurately controlling it


Deposit Creation: Single BankFirst Bank First Bank


Securities -$100 Securities -$100 Chequable deposits

+$100

Reserves +$100 Reserves +$100

Loans +$100

First Bank

Assets Liabilities

Securities -$100

Loans +$100

Excess reserves increase

Bank loans out the excess reserves

Creates a chequing account

Borrower make purchases

The money supply has increased


Deposit Creation: The Banking System

Bank A Bank A



+$100 Reserves +$10 Chequable deposits

+$100

Loans +$90

Bank B Bank B



+$90 Reserves +$9 Chequable deposits

+$90

Loans +$81

$100 of deposits created by First Bank’s loan is deposited at Bank A. This bank and all other banks hold no excess reserves


Creation of Deposits


The Formula for Multiple Deposit Creation

R

R

r

1 D

:yields sidesboth in change theTaking

r

1 D

rby sidesboth Dividing

R Dr x ngSubstituti

(D) deposits chequable of

amount total the times(r) Ratio Reserve Desired DR

(R) Reserves Total (DR) Reserves Desired

reserves excess holdnot do banks Asssuming


Simple Deposit Multiplier

r

1 MultiplierDeposit Simple


Multiple Deposit Creation: The Banking System

Banking System Assets LiabilitiesSecurities - $100 Deposits + $1000Reserves + $100Loans + $1000

Desired reserve ratio = 10%. If reserves increase by $100, chequable deposits rise to $1000 in order for total desired reserves to also increase by $100


Critique of the Simple Model

• Holding cash stops the process• Banks may not use all of their excess reserves

to buy securities or make loans


• Changes in the Non-borrowed monetary base (MBn)- the money supply is positively related to the

non-borrowed monetary base (MBn) • Changes in advances from the Bank of Canada

- the money supply is positively related to the level of borrowed reserves (BR) from the Bank of Canada

Factors that Determine the Money Supply


Factors that Determine the Money Supply II

• Changes in the Desired Reserve Ratio, r– The money supply is negatively related to the

desired reserve ratio• Changes in Currency Holdings

– The money supply is negatively related to the currency holdings


The Money Multiplier

• Define money as currency plus chequable deposits: M1+

• The Bank of Canada can control the monetary base better than it can control reserves

• Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

M = m x MB


Deriving the Money Multiplier I

• Assume the desired level of currency (C) and desired reserves (DR) grows proportionately with chequable deposits (D)

Then: c = (C/D) = currency ratio

r = (DR/D) = desired reserve ratio


Deriving the Money Multiplier II

• The total amount of reserves (R) equals the sum of desired reserves (DR). Assume excess reserves are zero at the equilibrium.

R = DR• The total amount of desired reserves equals the desired

reserve ratio times the amount of chequable deposits DR = r x D

• Substituting for DR R = (r x D)

The banks set r to be less than 1


Deriving the Money Multiplier III

• The monetary base (MB) equals currency (C) plus reserves (R)

MB = R + C = (r x D) + C• Shows the monetary base needed to support existing

amounts of D and C• An increase in MB going into C is not multiplied, but

an increase in MB going into D is multiplied


The Money Multiplier in Terms of the Currency Ratio

• MB = (c x D) + (r x D) = (c + r) x D • D = 1/(c+r) x MB• M = C + D• M = (c x D) + D = (1 + c)D• M = (1+c)/(c+r) x MB• m= (1+c)/(c+r) • While there is a multiple expansion of

deposits, there is no such expansion for currency


Split the monetary base into two components M = m x (MBn + BR)

• The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Bank of Canada

Money Supply Response to Changes in the Factors


Desired Reserve Ratio and Currency Ratio 1929-1933


M1 and the Monetary Base, 1929-1933

Documents

Copyright 2011 Pearson Canada Inc. 16- 1 Chapter 16 The Money Supply Process