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

2. Copyright  2011 Pearson Canada Inc. 16- 2 Players in the Money Supply Process Central bank (Bank of Canada) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions)

3. Copyright  2011 Pearson Canada Inc. 16- 3 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 AssetsLiabilities Government securitiesNotes in circulation Advances to banksReserves

4. Copyright  2011 Pearson Canada Inc. 16- 4 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)

5. Copyright  2011 Pearson Canada Inc. 16- 5 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

6. Copyright  2011 Pearson Canada Inc. 16- 6 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

7. Copyright  2011 Pearson Canada Inc. 16- 7 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 SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Reserves+$100 Reserves+$100 Bank of Canada purchases $100 of bonds from a bank and pays them with a $100 cheque

8. Copyright  2011 Pearson Canada Inc. 16- 8 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 Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Securities+$100Reserves+$100 Non bank public sells $100 of bonds to the Bank of Canada and deposits the Bank’s cheque in the local bank

9. Copyright  2011 Pearson Canada Inc. 16- 9 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 PublicBank of Canada AssetsLiabilitiesAssetsLiabilities Securities-$100Securities+$100Currency in circulation +$100 Currency+$100 The person selling the bonds cashes the Bank’s cheque

10. Copyright  2011 Pearson Canada Inc. 16- 10 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

11. Copyright  2011 Pearson Canada Inc. 16- 11 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 PublicBank of Canada AssetsLiabilitiesAssetsLiabilities Securities+$100Securities-$100Currency in circulation -$100 Currency-$100 Bank of Canada sells $100 of bonds to a bank or the non- bank public

12. Copyright  2011 Pearson Canada Inc. 16- 12 Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Chequable deposits -$100Reserves-$100Cheqeable deposits -$100 Currency+$100 Bank of Canada AssetsLiabilities Currency in circulation +$100 Reserves-$100 Net effect of monetary liabilities is zero. Reserves are changed by random fluctuations. Monetary base is more stable

13. Copyright  2011 Pearson Canada Inc. 16- 13 Bank of Canada Advances Monetary liabilities of the Bank of Canada have increased by $100 Monetary base also increases by this amount Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100Advances+$100Advances+$100Reserves+$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

14. Copyright  2011 Pearson Canada Inc. 16- 14 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 Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves-$100Advances-$100Advances-$100Reserves-$100 A loan is from the Bank of Canada is paid off by a bank

15. Copyright  2011 Pearson Canada Inc. 16- 15 Other Factors Affecting the Monetary Base 1.Float 2.Government deposits at the Bank of Canada Overview of the Bank’s Ability to Control the Monetary Base MB n =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

16. Copyright  2011 Pearson Canada Inc. 16- 16 Deposit Creation: Single Bank First Bank AssetsLiabilitiesAssetsLiabilities Securities-$100Securities-$100Chequable deposits +$100 Reserves+$100Reserves+$100 Loans+$100 First Bank AssetsLiabilities 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

17. Copyright  2011 Pearson Canada Inc. 16- 17 Deposit Creation: The Banking System Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves+$10Chequable deposits +$100 Loans+$90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90Chequable deposits +$90Reserves+$9Chequable 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

18. Copyright  2011 Pearson Canada Inc. 16- 18 Creation of Deposits

19. Copyright  2011 Pearson Canada Inc. 16- 19 The Formula for Multiple Deposit Creation

20. Copyright  2011 Pearson Canada Inc. 16- 20 Simple Deposit Multiplier

21. Copyright  2011 Pearson Canada Inc. 16- 21 Multiple Deposit Creation: The Banking System Banking System Assets Liabilities Securities - $100 Deposits+ $1000 Reserves + $100 Loans + $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

22. Copyright  2011 Pearson Canada Inc. 16- 22 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

23. Copyright  2011 Pearson Canada Inc. 16- 23 Changes in the Non-borrowed monetary base (MB n ) - the money supply is positively related to the non-borrowed monetary base (MB n ) 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

24. Copyright  2011 Pearson Canada Inc. 16- 24 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

25. Copyright  2011 Pearson Canada Inc. 16- 25 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

26. Copyright  2011 Pearson Canada Inc. 16- 26 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

27. Copyright  2011 Pearson Canada Inc. 16- 27 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

28. Copyright  2011 Pearson Canada Inc. 16- 28 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

29. Copyright  2011 Pearson Canada Inc. 16- 29 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

30. Copyright  2011 Pearson Canada Inc. 16- 30 Split the monetary base into two components M = m x (MB n + BR) The money supply is positively related to both the non-borrowed monetary base MB n and to the level of borrowed reserves, BR, from the Bank of Canada Money Supply Response to Changes in the Factors

31. Copyright  2011 Pearson Canada Inc. 16- 31 Desired Reserve Ratio and Currency Ratio 1929-1933

32. Copyright  2011 Pearson Canada Inc. 16- 32 M1 and the Monetary Base, 1929-1933