1. Copyright © 2014 Pearson Canada Inc. Chapter 16 THE MONEY SUPPLY PROCESS Mishkin/Serletis The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

2. Copyright © 2014 Pearson Canada Inc. 16-2 Learning Objectives 1.Characterize the framework for the implementation of monetary policy in Canada 2.Explain the market for reserves and the channel/corridor system for setting the overnight interest rate in Canada 3.Identify the Bank of Canada’s approach to monetary policy and the tools of policy

3. Copyright © 2014 Pearson Canada Inc. 16-3 Three Players in the Money Supply Process 1.The central bank –the government agency that oversees the banking system and is responsible for the conduct of monetary policy 2.Banks (depository institutions) –the financial intermediaries that accept deposits from individuals and institutions and make loans 3.Depositors –individuals and institutions that hold deposits in banks

4. Copyright © 2014 Pearson Canada Inc. 16-4 The Bank of Canada’s Balance Sheet Liabilities –currency in circulation: in the hands of the public –reserves: deposits (settlement balances) at the Bank of Canada and vault cash Assets –government securities: holdings by the Bank of Canada that affect money supply and earn interest –loans to financial institutions: provide loans (advances) to banks and charge the bank rate Bank of Canada AssetsLiabilities SecuritiesCurrency in circulation Loans to financial institutionsReserves

5. Copyright © 2014 Pearson Canada Inc. 16-5 Reserves Banks (LVTS participants), have an account at the Bank of Canada in which they hold deposits (also called settlement balances ) Reserves consist of settlement balances at the Bank of Canada plus vault cash Banks hold reserves in order to manage liquidity

6. Copyright © 2014 Pearson Canada Inc. 16-6 Reserves (cont’d) Desired reserves –reserves that are held to meet the central bank’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves Desired reserve ratio –the fraction of deposits that the bank desires be kept as reserves Excess reserves –reserves in excess of desired reserves

7. Copyright © 2014 Pearson Canada Inc. 16-7 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

8. Copyright © 2014 Pearson Canada Inc. 16-8 Open Market Purchase from a Bank Bank of Canada purchases $100m of bonds from a bank and pays them with a $100m cheque Net result is that reserves have increased by $100m No change in currency Monetary base has risen by $100m Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Securities$100mSecurities+$100mReserves+$100m Reserves+$100m

9. Copyright © 2014 Pearson Canada Inc. 16-9 Open Market Purchase from the Nonbank Public Non bank public sells $100m of bonds to the Bank of Canada and deposits the Bank’s cheque in the local bank 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+$100mChequable deposits +$100mSecurities+$100mReserves+$100m

10. Copyright © 2014 Pearson Canada Inc. 16-10 Open Market Purchase from the Nonbank Public (cont’d) The person selling the bonds cashes the Bank’s cheque 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-$100mSecurities+$100mCurrency in circulation +$100m Currency+$100m

11. Copyright © 2014 Pearson Canada Inc. 16-11 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 always increases the monetary base by the amount of the purchase

12. Copyright © 2014 Pearson Canada Inc. 16-12 Open Market Sale Bank of Canada sells $100 of bonds to a bank or the non-bank public 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

13. Copyright © 2014 Pearson Canada Inc. 16-13 Shifts from Deposits into Currency Net effect on monetary liabilities is zero Reserves are changed by random fluctuations Monetary base is a more stable variable Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Chequable deposits +$100mReserves+$100mChequeable deposits -$100m Currency-$100m Bank of Canada AssetsLiabilities Currency in circulation +$100m Reserves-$100m

14. Copyright © 2014 Pearson Canada Inc. 16-14 Loans to Financial Institutions When the Bank makes a $100m loan to a bank, the bank is credited with $100m of reserves (settlement balances) from the proceeds of the loan Monetary liabilities of the Bank of Canada have increased by $100m Monetary base also increases by this amount Banking SystemBank of Canada AssetsLiabilitiesAssetsLiabilities Reserves+$100mAdvances+$100mAdvances+$100mReserves+$100m

15. Copyright © 2014 Pearson Canada Inc. 16-15 Other Factors that Affect the Monetary Base Float Government deposits at the Bank of Canada Interventions in the foreign exchange market 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 © 2014 Pearson Canada Inc. 16-16 Overview of the Bank of Canada's Ability to Control the Monetary Base Open market operations are controlled by the Bank of Canada The Bank of Canada cannot determine the amount of borrowing by banks from the Bank of Canada Split the monetary base into two components MB n = MB - 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

17. Copyright © 2014 Pearson Canada Inc. 16-17 Multiple Deposit Creation: A Simple Model First National Bank AssetsLiabilitiesAssetsLiabilities Securities-$100mSecurities-$100mChequable deposits +$100m Reserves+$100mReserves+$100m Loans+$100m First National Bank AssetsLiabilities Securities-$100m Loans+$100m Deposit Creation: Single Bank Excess reserves increase Bank loans out the excess reserves Creates a chequing account Borrower makes purchases Money supply increases

18. Copyright © 2014 Pearson Canada Inc. 16-18 Bank A AssetsLiabilitiesAssetsLiabilities Reserves+$100 m Chequable deposits +$100mReserves+$10mChequable deposits +$100m Loans+$90m Bank B AssetsLiabilitiesAssetsLiabilities Reserves+$90mChequable deposits +$90mReserves+$9mChequable deposits +$90 Loans+$81m Deposit Creation: The Banking System $100m of deposits created by First Bank’s loan is deposited at Bank A. This bank and all other banks hold no excess reserves

19. Copyright © 2014 Pearson Canada Inc. 16-19 Creation of Deposits (assuming 10% reserve requirement and a $100 million increase in reserves)

20. Copyright © 2014 Pearson Canada Inc. 16-20 The Formula for Multiple Deposit Creation

21. Copyright © 2014 Pearson Canada Inc. 16-21 Simple Deposit Multiplier

22. Copyright © 2014 Pearson Canada Inc. 16-22 Multiple Deposit Creation: The Banking System Desired reserve ratio = 10% If reserves increase by $100m, chequable deposits rise to $1000m in order for total desired reserves to also increase by $100m Banking System Assets Liabilities Securities - $100m Deposits+ $1000m Reserves + $100m Loans + $1000m

23. Copyright © 2014 Pearson Canada Inc. 16-23 Critique of the Simple Model Holding cash stops the process –Currency has no multiple deposit expansion Banks may not use all of their excess reserves to buy securities or make loans Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess reserves to hold) also cause the money supply to change

24. Copyright © 2014 Pearson Canada Inc. 16-24 Factors that Determine the Money Supply Changes in the nonborrowed monetary base MB n –the money supply is positively related to the non-borrowed monetary base MB n Changes in borrowed reserves from the Bank of Canada –the money supply is positively related to the level of borrowed reserves, BR, from the Bank of Canada

25. Copyright © 2014 Pearson Canada Inc. 16-25 Factors that Determine the Money Supply (cont’d) Changes in the desired reserves ratio –the money supply is negatively related to the required reserve ratio Changes in currency holdings –the money supply is negatively related to currency holdings Changes in excess reserves –the money supply is negatively related to the amount of excess reserves

26. Copyright © 2014 Pearson Canada Inc. 16-26 Money Supply Response

27. Copyright © 2014 Pearson Canada Inc. 16-27 The Money Multiplier Define money as currency plus chequable deposits: M1+ Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

28. Copyright © 2014 Pearson Canada Inc. 16-28 Deriving the Money Multiplier Assume that the desired holdings of currency (C) and excess reserves (ER) grow proportionally with chequable deposits (D) Then, c = {C/D} = currency ratio e = {ER/D} = excess reserves ratio

29. Copyright © 2014 Pearson Canada Inc. 16-29 Deriving the Money Multiplier (cont’d) The total amount of reserves (R) equals the sum of desired reserves (DR) and excess reserves (ER) R = DR + ER The total amount of desired reserves equals the desired reserve ratio times the amount of chequable deposits DR = r d x D Substituting for DR R = ( r d x D) + ER The banks set r d to be less than 1

30. Copyright © 2014 Pearson Canada Inc. 16-30 Deriving the Money Multiplier (cont’d) The monetary base MB equals currency (C) plus reserves (R): MB = C + R = C + (r d x D) + ER Equation reveals the amount of the monetary base needed to support the existing amounts of chequable deposits, currency and excess reserves An increase in MB going into C is not multiplied, but an increase in MB going into D is multiplied

31. Copyright © 2014 Pearson Canada Inc. 16-31 Deriving the Money Multiplier (cont’d)

32. Copyright © 2014 Pearson Canada Inc. 16-32 Application: The Great Depression Bank Panics, 1930–1933, and the Money Supply Bank failures (and no deposit insurance) determined: –increase in deposit outflows and holding of currency (depositors) –an increase in the amount of excess reserves (banks) For a relatively constant MB, the money supply decreased due to the fall of the money multiplier

33. Copyright © 2014 Pearson Canada Inc. 16-33 Deposits of Failed Commercial Banks, 1929–1933

34. Copyright © 2014 Pearson Canada Inc. 16-34 Excess Reserves Ratio and Currency Ratio, 1929– 1933

35. Copyright © 2014 Pearson Canada Inc. 16-35 M1 and the Monetary Base, 1929–1933

36. Copyright © 2014 Pearson Canada Inc. 16-36 APPLICATION The 2007-2009 Financial Crisis and the Money Supply During the recent financial crisis the monetary base more than tripled as a result of the Fed's purchase of assets and new lending facilities to stem the financial crisis The currency ratio fell during this period Money supply model suggests that would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e

37. Copyright © 2014 Pearson Canada Inc. 16-37 M1 and the Monetary Base, 2007-2009

38. Copyright © 2014 Pearson Canada Inc. 16-38 Excess Reserves Ratio and Currency Ratio, 2007-2009