Determinants of the Money Supply

Determinants of the Money Supply

Chapters 17Chapters 17

OverviewOverview

Review of Simple Money Multiplier Connect Monetary Base to Money Supply Factors influencing the sophisticated money

multiplier Sophisticated money multiplier for M2

Review of Simple Money Multiplier Connect Monetary Base to Money Supply Factors influencing the sophisticated money

multiplier Sophisticated money multiplier for M2

ReviewReview

Assumptions All borrowed money gets spent and deposited

at another bank Banks loan all excess reserves keeping only

required reserves

So R = rr = rd * D and D = (1/rd) * R

1/rd is simple money multiplier, implying Fed has all control (which it doesn’t)

Assumptions All borrowed money gets spent and deposited

at another bank Banks loan all excess reserves keeping only

required reserves

So R = rr = rd * D and D = (1/rd) * R

1/rd is simple money multiplier, implying Fed has all control (which it doesn’t)

Deriving a “Sophisticated” Money MultiplierDeriving a “Sophisticated” Money Multiplier

Depositer: how much currency they want to hold

Bank How much excess reserves they wish to hold Also partly how much deposits are part of MS

So, make connection between MB and money supply (MS)

Depositer: how much currency they want to hold

Bank How much excess reserves they wish to hold Also partly how much deposits are part of MS

So, make connection between MB and money supply (MS)

DerivationDerivation

MB = R + C = (rd * D + ER) + C

= (rd * D) + (ER/D)*D + (C/D)*D

= [rd + (ER/D) + (C/D)]*D

D = MB [1/(rd + ER/D + C/D)]

Since M1 = D + C = (1 + C/D)*D

M1 = MB*[(1+C/D)/(rd + ER/D + C/D)]

M1 = MB*m m is ‘sophisticated money multiplier

MB = R + C = (rd * D + ER) + C

= (rd * D) + (ER/D)*D + (C/D)*D

= [rd + (ER/D) + (C/D)]*D

D = MB [1/(rd + ER/D + C/D)]

Since M1 = D + C = (1 + C/D)*D

M1 = MB*[(1+C/D)/(rd + ER/D + C/D)]

M1 = MB*m m is ‘sophisticated money multiplier

Factors that affect mFactors that affect m

A change in rd (board of governors) Negatively related to m and money supply RR declining importance: sweep accounts and ATMs

A change in (C/D) The public’s preference for holding cash Negatively related to m and money supply

A change in (ER/D) The bank’s preference for holding excess reserves Negatively related to m and money supply Link between interest rates and excess reserves

Multiple expansion for deposits, not currency!!!

A change in rd (board of governors) Negatively related to m and money supply RR declining importance: sweep accounts and ATMs

A change in (C/D) The public’s preference for holding cash Negatively related to m and money supply

A change in (ER/D) The bank’s preference for holding excess reserves Negatively related to m and money supply Link between interest rates and excess reserves

Multiple expansion for deposits, not currency!!!

Ratios Represent PreferencesRatios Represent Preferences

C/D represents people’s desire to hold cash ER/D represents banks desire to hold excess

reserves Money multiplier is affected by changes in

these behaviors, based on factors like interest rates, rates of consumption, etc.

Ultimately, the state of the economy

C/D represents people’s desire to hold cash ER/D represents banks desire to hold excess

reserves Money multiplier is affected by changes in

these behaviors, based on factors like interest rates, rates of consumption, etc.

Ultimately, the state of the economy

ExamplesExamples

rd increases

C/D change, or increase in currency ER/D change, or increase in excess reserves Change from deposits to currency

No effect! (MB = r + c)

rd increases

C/D change, or increase in currency ER/D change, or increase in excess reserves Change from deposits to currency

No effect! (MB = r + c)

Discount loans as part of MBDiscount loans as part of MB

MB = MBN + DL Non-borrowed plus borrowed discount loans If private rates are high, nothing Fed can do Unless they close discount window, can’t

control amount of loans being taken out

MB = MBN + DL Non-borrowed plus borrowed discount loans If private rates are high, nothing Fed can do Unless they close discount window, can’t

control amount of loans being taken out

Adding M2 to mAdding M2 to m

M2 is next level of what would be “money” Time Deposits Money market deposit accounts Money market mutual funds

M2 is next level of what would be “money” Time Deposits Money market deposit accounts Money market mutual funds

M2 1 CD

SD

TimeD

MMDAD

MMMFD

*MB

rd ERD

CD

Historical ApplicationHistorical Application

Great Depression MB increased 20% But MS decreased 25% Reason?

Rise in C/D Rise in ER/D

Great Depression MB increased 20% But MS decreased 25% Reason?

Rise in C/D Rise in ER/D