## Presentation on theme: "Chapter 16 Determinants of the Money Supply. © 2004 Pearson Addison-Wesley. All rights reserved 16-2 Deriving a model of the money supply process Because."— Presentation transcript:

Chapter 16 Determinants of the Money Supply

© 2004 Pearson Addison-Wesley. All rights reserved 16-2 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.

© 2004 Pearson Addison-Wesley. All rights reserved 16-3 Deriving the Money Multiplier M = m  MB m 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 × D C = desired level of currency D = checkable deposits c = C/D = currency ratio e = ER/D = excess reserves ratio

© 2004 Pearson Addison-Wesley. All rights reserved 16-4 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

© 2004 Pearson Addison-Wesley. All rights reserved 16-5 1 D =  MB r + e + c M = D + (c  D ) = (1 + c)  D 1 + c M =  MB r + e + c 1 + c m = r + e + c m < 1/r because no multiple expansion for currency and because as D  ER  Full Model M = m  (MB n + DL)

© 2004 Pearson Addison-Wesley. All rights reserved 16-6 Factors that Determine the Money Multiplier 1.Changes in the required reserve ratio r 2.Changes in the currency ratio c 3.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 e 1.i , relative R e on ER  (opportunity cost  ), e  2.Expected deposit outflows, ER insurance worth more, e 

© 2004 Pearson Addison-Wesley. All rights reserved 16-8 Additional Factors that Determine the Money Supply MB = MB n + DL MB: monetary Base MB n : nonborrowed monetary Base DL: discount loans from the central bank M = m × (MB n + DL) 1.Changes in the MB n : the money supply is positively related to the MB n. 2.Changes in the DL: the money supply is positively related to the level of DL from the central bank.