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Determinants of the Money Supply

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1 Determinants of the Money Supply
Chapters 17

2 Overview Review of Simple Money Multiplier
Connect Monetary Base to Money Supply Factors influencing the sophisticated money multiplier Sophisticated money multiplier for M2

3 Review Assumptions So R = rr = rd * D and D = (1/rd) * R
All borrowed money gets spent and deposited at another bank Banks loan all excess reserves keeping only required reserves So R = rr = rd * D and D = (1/rd) * R 1/rd is simple money multiplier, implying Fed has all control (which it doesn’t)

4 Deriving a “Sophisticated” Money Multiplier
Depositer: how much currency they want to hold Bank How much excess reserves they wish to hold Also partly how much deposits are part of MS So, make connection between MB and money supply (MS)

5 Derivation MB = R + C = (rd * D + ER) + C
= (rd * D) + (ER/D)*D + (C/D)*D = [rd + (ER/D) + (C/D)]*D D = MB [1/(rd + ER/D + C/D)] Since M1 = D + C = (1 + C/D)*D M1 = MB*[(1+C/D)/(rd + ER/D + C/D)] M1 = MB*m m is ‘sophisticated money multiplier

6 Factors that affect m A change in rd (board of governors)
Negatively related to m and money supply RR declining importance: sweep accounts and ATMs A change in (C/D) The public’s preference for holding cash A change in (ER/D) The bank’s preference for holding excess reserves Link between interest rates and excess reserves Multiple expansion for deposits, not currency!!!

7 Ratios Represent Preferences
C/D represents people’s desire to hold cash ER/D represents banks desire to hold excess reserves Money multiplier is affected by changes in these behaviors, based on factors like interest rates, rates of consumption, etc. Ultimately, the state of the economy

8 Examples rd increases C/D change, or increase in currency
ER/D change, or increase in excess reserves Change from deposits to currency No effect! (MB = r + c)

9 Discount loans as part of MB
MB = MBN + DL Non-borrowed plus borrowed discount loans If private rates are high, nothing Fed can do Unless they close discount window, can’t control amount of loans being taken out

10 Adding M2 to m M2 is next level of what would be “money” Time Deposits
Money market deposit accounts Money market mutual funds

11 Historical Application
Great Depression MB increased 20% But MS decreased 25% Reason? Rise in C/D Rise in ER/D

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