chapter 16 Determinants of the Money Supply

Copyright © 2002 Pearson Education Canada Inc The Simple Deposit Multiplier (from Chapter 15) Simple Deposit Multiplier 1  D =   R r D Deriving the formula R = DR = r D  D 1 D =  R r D 1  D =   R r D

Copyright © 2002 Pearson Education Canada Inc Critique of the Simple Model The simple model of multiple deposit creation shows how the Bank of Canada can control D by setting R. That simple model however, ignores 1. the public’s decisions regarding how much C to hold, 2. the banks’ decisions regarding the amount of R they wish to hold, and 3. borrowers’ decisions on how much to borrow from banks. Recall also that the Bank of Canada can exert more precise control over MB ( = C + R) than over R.

Copyright © 2002 Pearson Education Canada Inc The Money Supply Model Because the Bank of Canada can exert more precise control over MB than it can over R, in Chapter 16 we derive a multiplicative relation between M and MB, M = m  MB, where m is the money multiplier. m relates the change in M to a given change in MB.

Copyright © 2002 Pearson Education Canada Inc M = m  MB Deriving Money Multiplier R = DR DR = r D  D R = (r D  D) Adding C to both sides R + C = MB = C + (r D  D) 1. Tells us amount of MB needed support D and C 2. An extra $1 of MB that arises from an extra $1 of C does not support any additional D. That is, the C component of MB does not lead to a multiple deposit creation as the R component does. Money Multiplier

Copyright © 2002 Pearson Education Canada Inc To put it differently, An  in MB that goes into C is not multiplied, whereas an  that goes into supporting deposits is multiplied. We have MB = C + (r D  D) To deal with currency drains, we also assume that C = c  D where c is the currency ratio. Hence, MB = (c  D) + (r D  D) = (c + r D )  D Money Multiplier (continued)

Copyright © 2002 Pearson Education Canada Inc M = (c  D) + D = (1 + c)  D m < 1/r D because no multiple expansion for currency and because as D  ER 

Copyright © 2002 Pearson Education Canada Inc r D = 5% C = $40 billion D = $160 billion M (= M1+) = C + D = $200 billion The money multiplier tells us that, given the behaviour of the public as represented by c = 0.25 and that of banks as represented by r D = 5%, a $1  in MB will lead to a $4.2  in M. If c = 0 (no currency drains), then m = 20. An Example

Copyright © 2002 Pearson Education Canada Inc Also notice that This is the deposit multiplier when c = 25% and r D = 5%. It tells us that, given the behaviour of the public as represented by c = 25% and that of banks as represented by r D = 5%, a $1  in MB will lead to a $3.3  in D. An Example (continued)

Copyright © 2002 Pearson Education Canada Inc So far we have been assuming that the Bank has complete control over MB. This is not the case. The Bank lacks complete control over MB because it cannot unilaterally determine the amount of borrowing by banks from the Bank. Here we split MB into two components: nonborrowed monetary base (MB n ). This component of the MB is directly under the Bank’s control because it results from open market operations. borrowed monetary base (or advances A). This is the less tightly controlled component of the base, because it is influenced by banks’ decisions. The Full Model

Copyright © 2002 Pearson Education Canada Inc Hence, MB = MB n + A To complete the money supply model, we rewrite it as M = m  MB = m  ( MB n + A) where m is defined as before. Thus, in addition to the effects on M of c and r D, the expanded model stipulates that M is also affected by changes in MB n and A. In fact, because m > 0, there is a positive relation between M and each of MB n and A. The Full Model (continued)

Copyright © 2002 Pearson Education Canada Inc M = m  ( MB n + A) Open market purchases  MB n and for given c, r D, and A lead to an  in M. Open market sales  MB n and for given c, r D, and A lead to a  in M. Hence M is positively related to MB n. For given MB n, c, and r D, an  in A will  MB and lead to a multiple  in M. For given MB n, c, and r D, an  in A will  MB and lead to a multiple  in M. Hence M is positively related to A. Overview of the Money Supply Process

Copyright © 2002 Pearson Education Canada Inc Factors Determining Money Supply

Copyright © 2002 Pearson Education Canada Inc M2+ Money Supply Model M2+ = C + D + T + MMF C = currency in circulation, D = all chequable deposits, T = all time and savings deposits, and MMF = money market mutual funds. Assume that C = c  D, T = t  D, and MMF = f  D. Hence M2+ = (c  D) + D + (t  D) + (f  D) where c is the currency ratio, t is the time deposit ratio, and f is the money market fund ratio.

Copyright © 2002 Pearson Education Canada Inc M2+ Money Multiplier M2+ = (c  D) + D + (t  D) + (f  D) = (1 + c + t + f )  D Recall that

Copyright © 2002 Pearson Education Canada Inc r D = 5% C = $40 billion D = $160 billion T = $320 billion MMF = $80 billion M2+ = C + D + T + MMF = $600 billion, c = 0.25, t = 2, f = 0.5. The money multiplier tells us that, given the behaviour of the public as represented by c = 0.25, t = 2, and f = 0.5 and that of banks as represented by r D = 5%, a $1  in MB will lead to a $12.5  in M2+. An Example

Copyright © 2002 Pearson Education Canada Inc Factors Determining M2+

Copyright © 2002 Pearson Education Canada Inc Let’s use the money supply model to explain the collapse in the U.S. during the Great Depression, Between October 1930 and March 1933 there were a number of bank failures in the U.S. For example, in the first bank crisis (from October 1930 to January 1931), 256 banks failed in November 1930 with $180 million of deposits, and another 532 banks failed in December 1930 with over $370 million of deposits. The most dramatic failure was that of the Bank of the United States (with over $200 million in deposits), which many people associated with a central bank. Application: The Great Depression Bank Panics

Copyright © 2002 Pearson Education Canada Inc Deposits at Failed Banks: 1929–33 Figure 16-1

Copyright © 2002 Pearson Education Canada Inc Because there was no deposit insurance (the FDIC wasn’t established until 1934), worries about bank solvency caused people to hold more money in the form of C rather than D and T, and banks to hold more deposits in the from of ER rather than loans. These actions reduced the amount of bank lending, and although MB continued to grow, the quantity of money as measured by broader monetary aggregates plunged. For example, M1  by 25% from 1929 to 1933 (the largest  in all of U.S. history). As a result, real GDP  by 27% and u  to 25% in The Great Depression Bank Panics (continued)

Copyright © 2002 Pearson Education Canada Inc ER/D, C: 1929–33

Copyright © 2002 Pearson Education Canada Inc Money Supply and Monetary Base: 1929–33 Figure 16-3

Copyright © 2002 Pearson Education Canada Inc The Great Depression Bank Panics (continued) If the Fed had been committed to stable growth in M rather than MB, it would have pursued a more expansionary monetary policy than it did, and perhaps the collapse in the Great Depression would have been avoided!