Chapter 16

Determinants of the Money Supply

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Deriving a model of the money supply process

• Because central bank can exert more precise control over the MB than total reserves alone (Chap. 15), we model the links between the money supply and MB.

• We shall derive a money multiplier (a ratio that relates the change in the money supply to a given change in in the MB)

• We focus on M1.

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Deriving the Money Multiplier

M = m MBm is the money multiplier, which tells us how much the money supply changes for a given change in the MB.

R = RR (required reserves) + ER (excess reserves)RR = r × DC = desired level of currencyD = checkable depositsc = C/D = currency ratioe = ER/D = excess reserves ratio

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Money Multiplier

M = m MB

Deriving Money Multiplier

R = RR + ER

RR = r D

R = (r D) + ER

Adding C to both sides

R + C = MB = (r D) + ER + C

1. Tells us amount of MB needed support D, ER and C

2. $1 of MB in ER, not support D or C

MB = (r D) + (e D) + (c D)

= (r + e + c) D

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1D = MB

r + e + c

M = D + (c D ) = (1 + c) D

1 + cM = MB

r + e + c

1 + cm =

r + e + c

m < 1/r because no multiple expansion for currency and because as D ER

Full Model

M = m (MBn + DL)

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Factors that Determine the Money Multiplier

1. Changes in the required reserve ratio r2. Changes in the currency ratio c3. Changes in the excess reserves ratio e

a. market interest rates: the banking system’s excess reserves ratio e is negatively related to the market interest rate i.b. expected deposit outflows: the excess reserves ratio e is positively related to expected deposit outflows.

16-7

Excess Reserves Ratio

Determinants of e1. i , relative Re on ER (opportunity cost ), e 2. Expected deposit outflows, ER insurance worth more, e

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Additional Factors that Determine the Money Supply

MB = MBn + DLMB: monetary BaseMBn : nonborrowed monetary BaseDL: discount loans from the central bank

M = m × (MBn + DL)

1. Changes in the MBn: the money supply is positively related to the MBn.

2. Changes in the DL: the money supply is positively related to the level of DL from the central bank.

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Factors Determining Money Supply

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Money Supply

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Determinants of the Money Supply

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Deposits at Failed Banks: 1929–33

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e, c: 1929–33

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Money Supply and Monetary Base: 1929–33