MACROECONOMICS II MONEY SUPPLY · MACROECONOMICS II MONEY SUPPLY Lecture Material on Money Supply...

MACROECONOMICS II

MONEY SUPPLY

1 Lecture Material on Money Supply Prepared by Dr. Emmanuel Codjoe

MONEY SUPPLY


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The central objectives we consider in this

section are:

• To explain the key determinants of

money supply

• The instruments of monetary policy

• Further aspects of money supply and

monetary policy


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• We are aware of the role monetary policy

plays in affecting macroeconomic variables.

• In this section we look more closely at

monetary policy, particularly how a nation’s

money supply is determined.

• Whilst central banks play an important role,

we note that the nation’s money supply is

affected by banks and individuals.


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• Earlier we have seen that money (and therefore the money stock) can have different definitions, largely based on what we consider useful to carry out transactions.

• In this section we limit our definition of the money stock to M1, which has two important characteristics that separate it from other definitions of money.


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• M1 is the most liquid, and in addition is

generally accepted as a medium of

exchange and do not earn interest.

• Thus, Money Supply = Currency in

Circulation + Demand Deposits. That

is, M = CC + DD


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• Consequently, the money supply is

determined by three economic agents:

–The central bank

–The behaviour of households (holding

money)

–Deposit money banks/Commercial banks

(in which money is held)


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• In the case of the behaviour of

households, we can distinguish

between two types:

–Depositors: individuals and institutions

that hold deposits in banks

–Borrowers: individuals and institutions

that borrow from banks.


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• Of the three main actors in the money

supply process, by far the central bank

is the most important and influential in

the process.

• To understand why the central bank is

the most influential, we take a look at

the central bank and its balance sheet.


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The Central Bank

• In nearly all countries with a developed financial system, the central bank carries out a number of functions, such as: –The conduct of monetary policy

–Regulation of banks

–Supervision of the financial system

–Ensures the efficient operations of the payments system


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The Central Bank’s Balance Sheet

• Like many firms and businesses, the central bank has a balance sheet, with liabilities (sources of funds) on one side and assets (uses of funds) on the other.

• Overall, the central bank’s balance sheet is quite complicated, but we utilise a simplified version to illustrate how it affects money supply.


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Assets Liabilities

Government

Securities

Currency in

Circulation

Discount Loans Reserves

International

Reserves

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• Like many firms and businesses, the central bank has a balance sheet, with liabilities (sources of funds) on one side and assets (uses of funds) on the other.

• Overall, the central bank’s balance sheet is quite complicated, but we utilise a simplified version to illustrate how it affects money supply.


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The Central Bank’s Liabilities

• The liabilities of the central bank

together define the Monetary Base

(High Powered Money):

Monetary Base = Currency in Circulation +

Reserves


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• An increase in either Currency in Circulation (CC) or Reserves (R) will lead immediately to an increase in the monetary base and eventually to an increase in the total money supply.

• CC, which is issued by the central bank, is defined as the amount of currency circulating outside banks (it pays no interest).


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The Central Bank and Money Supply- A digression

• Without banks, the central bank convinces the public to hold on to paper money by trading it in exchange for assets of the public.

• Thus, the total money supply is the currency held by the public. Hence, in an all-currency economy (with no banks) the money supply equals the monetary base.


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• R includes currency held by banks (vault cash) and deposits by banks at the central banks.

• R can be broken down into Required Reserves, which the law requires banks to hold, and Excess Reserves.


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• The required reserve ratio is the fraction (#%) of the value of a bank’s deposits that must be held as required reserves.

• Also note that reserves do not pay interest.


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• Where banks are introduced, we suppose that they only accept deposits but make no loans. Banks are therefore safe deposits, and may charge a small fee for this service.

• The banks maintain reserves, deposits that are received but not lent out. Reserves may be held in the vaults of the banks, but most are held at the central bank.


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• But in our illustration, all deposits are held as

reserves. Why? Because no loans are made

and banks hold on to deposits until an

individual makes a withdrawal.

• This system is called 100-percent-reserve

banking.


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• If this applies, the banking systems does not

affect the money supply. Why? This is

because a cedi deposited in a bank reduces

currency in circulation by a cedi: a cedi

decline in currency in circulation raises

deposits by the same amount, thus leaving the

money supply unchanged.


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Consolidated Balance Sheet of Banks

Assets Liabilities

Currency ¢1,000 Deposits ¢1,000

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• If we consider the case where banks are now

able to make loans, then banks must keep a

proportion of deposits (reserves) on hand so

that whenever depositors want to make

withdrawals their demands can be met.

• This type of system is called fractional-

reserve banking.


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• In a system of fractional-reserve banking, banks create money. But banks cannot create an infinite amount of money.

• The reserve-deposit ratio (rr) is the ratio of reserves to deposits, measures the fraction of deposits kept in reserve.

• Hence, in a fractional-reserve banking system, rr is less than 1.


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• Given this characteristic, each ¢1 of

reserves generates ¢(1/rr) of money.

Thus in our example of ¢1,000 of

deposits, if rr = 20%, then the banking

system creates ¢5,000.


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• The banking system’s ability to

create money is the primary

difference between banks and other

financial institutions: banks therefore

directly influence the money supply.


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• Note that banks create money, not

wealth. In other words the money

creation ability of the banking system

increases the economy’s liquidity, not

its wealth.


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• What is the relationship between the money supply and the monetary base?

• Suppose M = money supply;

BASE = monetary base;

DD = total bank deposits

R = total bank reserves

rr = banks’ desired reserve-deposit

ratio


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• Then with no currency held by the public, the

money supply equals the quantity of bank

deposits: M = DD

• For any level of deposits, the amount of reserves

banks want to hold is rr (DD). At the end of the

money creation process, bank reserves must

equal the amount of currency distributed by the

central bank: rr (DD) = BASE


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• Because the money supply equals deposits in

this example, solving for deposits gives us:

M = DD = (BASE/rr)

• Hence in an economy with fractional-reserve

banking and no currency held by the public,

the money supply equals the monetary base

divided by the reserve-deposit ratio.


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• In other words, the ability of banks to create

money allows the money supply to be much

larger than the monetary base.

• Because each unit of monetary base allows

the creation of several units of money supply,

the monetary base is also called high-

powered money.


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• We can now examine in detail what

determines the money supply: here we allow

the public to also hold currency.

• In this framework, there are three exogenous

variables: the Monetary Base (CC + R); the

reserve-deposit ratio (rr); and the currency-

deposit ratio (cr).


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• Based on this we can define the following:

Money Supply (M1) = CC + D

Monetary Base (BASE) = CC + R

• To determine the factors affecting money

supply, we solve for M as a function of

BASE, rr and cr.


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• To do this we divide, M by BASE:

• We then divide the right-hand side numerator

and denominator by DD


RCC

DDCC

BASE

M

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• This gives us:

• But CC/DD = cr, and R/DD = rr. Thus,

making this substitutions and solving for M:


DDRDDCC

DDCC

BASE

M

//

1/

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• This gives us:

• This shows that the money supply depends on the three exogenous variables: money supply is proportional to the monetary base.


BASErrcr

crM

1

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• The factor of proportionality:

• is denoted by m, and is called the money

multiplier. We can write this as M = m x B


rrcr

cr 1

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• The money multiplier will be greater than

1 as long as rr is less than 1.

• If the public holds no currency the money

multiplier equals 1/rr.

• A decrease in (rr) raises the money

multiplier and the money supply.


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• A decrease in cr raises the money multiplier

and money supply.

• An increase in the monetary base increases

money supply by the same percentage.

• The money multiplier decreases when either

the currency-deposit ratio (cr) or the reserve-

deposit ratio (rr) increases.


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The Central Bank’s Assets

• Government securities: the central bank buys and sells government securities. These pay interest.

• Discount loans: the central bank makes discount loans to banks; the interest charged on these loans is called the discount rate.


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The Central Bank’s Assets

• International reserves: the central bank usually holds foreign exchange reserves is various reserve currencies, typically the US dollar, British Pound, Euro, and other major currencies.

• International reserves may be held in various forms; notes, deposits, treasury bills, government bonds, as well as in gold and Special Drawing Rights (SDRs).


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The Central Bank and the Money Supply

• So far we have noted how the monetary

base and money multiplier determine

the money supply.

• Earlier we also noted that the central

bank is the most influential actor in the

money supply process.


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• Hence, to affect the money supply, the central bank can change the amount of monetary base or change the money multiplier.

• But changes in the monetary base is the direct channel by which the central bank affects money supply.


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• Open Market Operations: this is the purchase or sale of assets, typically government securities, that result in an increase or decrease in the money supply, respectively.

• All this of course contingent on the behaviour of the money multiplier. The presumption is that the money multiplier is stable.


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• Open Market Operations: open

market operations are the most direct

way for central banks to change the

money supply.


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• Open Market Operations:



Assets Liabilities

(+)/(-) Government Securities

(+)/(-) Currency in Circulation

Discount Loans Reserves

International Reserves

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• Reserve Requirements: the central bank can also affect the money supply by altering the fraction of deposits held by banks as reserves.

• Changes in the reserve requirements, which affects the reserve-deposit ratio leads to a change in the money multiplier, and hence the money supply.


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• Discount Loans: the central bank can lend reserves to banks and other credit institutions, which can affect the monetary base.

• Typically, this involves the purchase of bills of exchange from banks or the extension of credit to banks because of emergency liquidity problems.


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• Discount Loans: the rate of interest

rate charged by the central bank on

rediscount loans is called the discount

rate, and is traditionally the lowest

interest rate at which credit institutions

can borrow reserves.


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• Discount Loans: depending on how this is conducted, it allows the central bank to inject liquidity directly towards specific institutions, instead of increasing the monetary base for the entire system.

• However, an institution demanding funds directly on the discount window might send a negative signal to the markets.


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• Discount Loans: besides, unlike OMOs, it is the private sector (credit institutions) that decides indirectly whether the monetary base will expand, bearing in mind that the central bank is already committed to providing loans upon request at the discount rate.


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• International Reserves: these represent the foreign assets of the central bank and may be held in foreign currency bonds as well as in gold.

• Because the central bank’s net worth is constant, changes in the assets cause equal changes in its liabilities.


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• International Reserves: thus, where there

is the purchase of assets, which results in

an increase in international reserves, this

causes domestic money supply to increase.

• The central bank can negate this effect of

changes in international reserves through

sterilization.


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• International Reserves: central banks

sometimes carry out equal foreign and

domestic asset transactions in opposite

directions to nullify the impact of their

foreign exchange operations on the

money supply.


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• International Reserves: without

sterilization, an increase in foreign

assets, because of a balance of

payments surplus, implies an increase

in the money supply.


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• Fiscal Deficits: remember the central bank in most cases is a banker to the government, hence the state makes payments by writing cheques on its central bank account.

• When the government budget is in deficit, there are several ways to finance this.


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• Fiscal Deficits: the government can finance the deficit by selling bonds to the public. In this case, there is no effect on the monetary base, except for the short period when the government moves money from its account in DMB to the central bank and then pays its out from its account at the central bank.


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• Fiscal Deficits: alternatively, the

government can finance this deficit by

borrowing from the central bank

(which is similar to the central bank

buying the bonds of government).


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• Fiscal Deficits: the purchase of the bonds by the central bank increases its holdings of government securities (asset). This can be offset by a simultaneous decrease in other assets, because government deposits (a liability) would have risen.


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• Fiscal Deficits: however, when the government makes payments using this borrowed money from the central bank, this increases the monetary base.

• In other words, central bank financing of the government deficit increases the stock of high powered money


MACROECONOMICS II MONEY SUPPLY · MACROECONOMICS II MONEY SUPPLY Lecture Material on Money Supply...

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