Lecture 7 Money supply Money and Credit

Content 1. Money supply 1.1. Concept of money supply 1.2. Formation of the money supply and its factors 2. The mechanism of change in volume of money in circulation 3. Factors and the structure of monetary multiplier

Main definitions: o money supply o interest rate o reserve requirements o monetary base o monetary multiplier o bank reserves o …………..

1. Money supply 1.1. Concept of money supply The essence of the money supply is that economic agents at any time have a certain stock of money that they can under favorable circumstances direct into traffic. Money supply Microlevel Demand and supply are constantly alternating - with an increase of interest economic entity will act on the market with the money supply, while reducing – with the demand for money Macrolevel issue of money is considered as money supply growth on the money market and the withdrawal of money from circulation - a contraction of the money supply

As between the two forces of money market the money demand changes primarily under the influence of factors that are formed within the real economy and money supply has largely exogenous nature, only the demand for money can be a primary factor in the interaction with the money supply. Money supply in its dynamics must constantly navigate and adapt to changes in money demand.

1.2 Formation of the money supply and its factors As the factors of forming the money supply can be changes of: reserve requirements; discount rate; typical market interest rates; interest rates on demand deposits; amount of wealth of economic subjects; shadow entrepreneurship; state of confidence in banks, banking panic.

Reserve requirements causes opposite change of factor (t) multiplication of money because it is determined by m = l / r, where r - required reserve rate. The lower rate (r), the higher the multiplier factor, and thus more total money supply, and vice versa.

Discount rate affect the monetary base. When the interest rate decreases the demand of commercial banks on refinancing loans decreases, as a result balances on their correspondent accounts at the central bank decrease, i.e. the monetary base, excess reserves of banks and their ability to lend are also decreasing and thus the level of the multiplier.

Typical market interest rates With the growth of interest rates on loans from commercial banks opportunities to get refinancing loans extend even with within an increase in the discount rate, resulting in increasing the monetary base and bank reserves ratio and multiplication ratio that promotes the money supply. However, in this situation the demand for bank loans can decrease, the excess reserves increase and multiplication of deposit money shorten.

Amount of wealth of economic subjects Lead to changes of relationship between deposit and cash components of money supply: the poorer economic actors, the greater part of the money they hold in cash and vice versa. As part of the deposit causes multiplier process and cash – does not, change of their ratio leads to a change in total money supply. Thus, with the increase of wealth deposit component of the money supply will grow faster than cash, which will increase the multiplier effect and increase the money supply. Reduction of wealth has the opposite effect on the money supply.

Shadow entrepreneurship causes changes in the structure of monetary reserves for cash. This weakens the multiplicative increase in deposits as cash proceeds from the sales of bank and is not used for the purpose of lending. The fall of multiplication reduces the supply of money in the form of deposit is much larger than the mass of cash increases. Therefore, the total money supply is shrinking with the growth of the shadow economy.

State of confidence in banks, banking panic Negatively influences on multiplicative increase in deposits, as causes the withdrawal of money from deposits or hinder their growth. The increase of cash component of the money supply does not compensate for the loss of the deposit component, because of the multiplier effect they far exceed the amount of cash withdrawals. In the increasing of distrust in banks multiplication rate can be reduced and that`s why banks are forced to increase their excess reserves and reduce lending in order to enhance its liquidity in case the outflow of deposits. Thus, the total money supply reduces in proportion to the fall of confidence in banks, and during periods of panic such reduction becomes avalanche that can paralyze the entire country's payment system.

Interest rates on demand deposits; encourages banks to attract cash on current deposits and expansion of deposit multiplier process, resulting in increase of the money supply. Basically for demand deposits banks can not pay the interest income as they are "short" money, which brings banks limited revenues. But modern banking practice has proved feasibility and benefits of income for such deposits, which leads to opening of special deposit accounts.

2. The mechanism of changing the volume of money in circulation The issue of cash is a monopoly of the NBU, although the production of cash into circulation may be carried out not only by the NBU, but the commercial banks too. But if the commercial bank does not cover the issue of cash proceeds in cash from its customers, then to cover the deficit it can not issue money, but can purchase it from the central bank. The issue of non-cash money by the central bank is made in the following ways:  providing loans to commercial banks by its refinancing;  through the purchase of securities from commercial banks;  through the purchase of foreign currency from commercial banks and their customers to replenish gold reserves.

The mechanism of money creation by commercial banks is slightly more complicated than the issue mechanism of the NBU and implies the monetary multiplication of free reserves and deposits. Monetary multiplier - the process of creating new bank deposits (non-cash money) with lending customers by banks on the basis of additional (free) reserves received by the bank from the outside.

Free reserve - a combination of cash of commercial bank that is currently available for the bank and can be used for active operations. In addition to free, there is a total banking reserve, which is the full amount of money funds that are currently available for the bank and are not used for active operations. Some general reserve banks must keep in cash and do not use for current needs. This part is called as required reserve. Its volume is determined under the reserve requirements rates set by the NBU in percentage to total bank liabilities. The difference between total and required reserves is a free reserve of bank.

3. Factors and the structure of monetary multiplier Monetary base - is the consolidated rate of reserve money of the banking system, on which through the monetary multiplier the money supply is formed. Then the money supply (Ms) is directly proportional to the monetary base (Mh) and depends on the monetary multiplier (Mi): Ms = Mh*m