Chapter 15

The Money Supply Process

3 Players in the MS Process

1. Central Bank: gov. agency overseeing the banking system, responsible for conduct of monetary policy

2. Banks: depository institutions, financial intermediaries accepting deposits from individuals and institutions, makes loans

3. Depositors: individuals and institutions that hold deposits in banks

Player: Central Bank

gov. agency overseeing the banking system, responsible for conduct of monetary policy

Player: Banks

depository institutions, financial intermediaries accepting deposits from individuals and institutions, makes loans

Player: depositors

individuals and institutions that hold deposits in banks

BoC’s Balance Sheet

Assets: securities, loans to financial institutions

Liabilities: currency in circulation, reserves

Securities (BoC Balance Sheet)

primarily securities issued by the gov. of Canada

Loans to financial institutions (BoC Balance Sheet)

loans/advances made to banks and other financial institutions

AKA borrowings from the BoC or borrowed reserves

• Bank Rate: interest rate for these loans

Bank Rate

interest rate charged to banks for borrowed reserves

Currency in Circulation (BoC Balance Sheet)

BoC notes in circulation

Reserves / Settlement Balances (BoC Balance Sheet)

deposits of (large value transfer system) LVTS-associated banks held at the BoC + currency physically held by banks

Vault Cash

currency physically held by banks

Monetary Base

• “high-powered money”

• monetary liabilities of the BoC

• currency in circulation + reserves

• currency in circulation + (vault cash + settlement balances)

  • C + R

Types of Reserves

Reserves: desired reserves + excess reserves

Desired Reserves: reserves that banks desire to manage possible deposit outflows

Desired Reserve Ratio: for any individual bank, desired reserves expressed as a fraction of the deposits entrusted to the bank

• fraction of deposits that the bank desires to be kept as reserves, ie. 5%

Excess Reserves: reserves in excess of desired reserves

Reserves

desired reserves + excess reserves

Desired reserves

reserves banks desire to manage possible deposit outflows

Desired Reserve Ratio

fraction of deposits that the bank desires to be kept as reserves

Excess Reserves

reserves in excess of desired reserves

Open Market Operations

• Open market purchase: purchase of bonds by the BoC

• Open market sale: sale of bonds by the BoC

ex. open market purchase

BoC buys $100 m of bonds from a bank with reserves

Bank T-account:

• Assets: securities -100, reserves +100

• Liabilities: no change

BoC’s T-account:

• Assets: securities +100

• Liabilities: reserves +100m

Net result: reserves increased by 100m, no change in currency in circulation

Thus MB has risen by 100m

T-account

lists the changes that occur in the balance sheet items, starting from initial balance sheet position

ex. open market sale

BoC sells 100m of bonds to a bank

BoC’s T-account:

• Assets: securities -100

• Liabilities: reserves +100

Thus, MB reduced by 100m

ex. deposits shifts into currency

public withdraws $100m in cash from chequable deposits

Nonbank public T-account:

• Assets: chequable deposits -100, currency +100

• Liabilities: no change

Bank T-account:

• Assets: reserves -100m

• Liabilities: chequable deposits -100

  • from reserves

BoC T-account:

• Assets: no change

• Liabilities: currency in circulation +100, reserves -100

Thus, action of the public has not affected MB

• MB unaffected by public’s increased desire for cash

ex. Loans to Financial Institutions

BoC makes a $100m loan to a bank, bank is credited with $100m of reserves

Bank T-account:

• Assets: reserves +100

• Liabilities: loan +100

BoC T-account

• Assets: loan +100

• Liabilities: reserves +100

Monetary liabilities of the BoC have increased by $100m, and so has monetary base

Overview of the BoC’s ability to control the monetary base

• open market operations controlled completely by the BoC

• however, BoC cannot determine amt of borrowing done by banks from BoC

  • loans to banks: takes 2 parties to agree, not just BoC

  • BoC sets the bank rate (interest rate on loans to banks), banks ultimately make the decision about whether to borrow

• degree of control by the BoC gives another way to break down MB: MB = MB_n + BR

  • MB_n: nonborrowed monetary base (completely controlled by BoC)

  • BR = borrowed reserves from BoC (less tightly controlled by the BoC)

Simple Model: Multiple Deposit Creation

when BoC supplies banks with additional $1 reserves, deposits increase by a multiple of this amount

• Simple Deposit Multiplier: multiple increase in deposits generated from an increase in the banking system’s reserves

• ex. in examples, 10%

ex. Multiple Deposit Creation

BoC buys $100m in bonds from FNB (bank), FNB reserves increase by 100m and securities decrease by 100m

FNB T-account:

• Assets: securities -100, reserves +100

• Liabilities: no change

assume FNB does not want to hold excess reserves (earn more by loaning to public) → with new reserves, loans out excess 100m

• FNB sets up chequing account for borrower and puts 100m in account

• FNB alters balance sheet by increasing liabilities with 100m of chequable deposits, assets with 100m loans

FNB T-account (ctd):

• Assets: securities -100, reserves +100, loans +100

• Liabilities: chequable deposits +100

after 100m has been extended, reserves presumably will not remain in chequing deposit for long

• borrowers took out loans to use, not to sit idle

• borrowers use to purchase goods/services

when borrowers make purchases, cheques will be deposited to other banks, 100m reserves leaving FNB (chequable deposits at FNB also drops to 0)

FNB T-account (final):

• Assets: securities -100, loans +100

• Liabilities: gone

once deposited in bank A:

• Assets: reserves ++, loans ++

• Liabilities: chequable deposits (total reserves + loans) ++

they keep ex. 10% in reserves, the rest is loaned out again

rinse and repeat

Simple Deposit Multiplier

multiple increase in deposits generated from an increase in the banking system’s reserves

Formula for Multiple Deposit Creation

total reserves = desired reserves + excess reserves

R = DR + ER

• DR = r_d x D

• desired reserve = desired reserve ratio x amt of chequable deposits

  • banks set r_d < 1

alt ver:

change in desired reserves = simple deposit multiplier x change in total reserves

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 make loans

• BoC is not the only player with behaviour influencing level of deposits and therefore money supply

  • depositors’ decision (regarding how much currency to hold) and banks’ decisions (regarding amt of reserves to hold) can also affect MS

Factors Determining Money Supply (BECND)

1. Nonborrowed monetary base MB_n: money supply is positively related to MB_n

2. Borrowed reserves: MS positively related to BR from BoC

3. Desired Reserves Ratio: MS negatively related

4. Currency Holdings: MS negatively related, holding ER const

5. Excess Reserves: MS negatively related

Money Multiplier

m in MS = m x MB

Money Supply (MS)

MS = C + D

• sum of currency and chequable deposits

Deriving Money Multiplier

Assumptions:

• desired holdings of C grow proportionally with D

  • Currency Ratio: c = C/D

• ER grow proportionally with D

  • Excess Reserves Ratio: e = ER/D

• so assume c and e are constant in EQ

• there is sufficient demand for loans

M = 1+c / r_d + e + c x MB

• c: currency ratio, set by depositors

• e: excess reserves ratio, set by banks

• r_d: desired reserve ratio, set by banks

Currency Ratio

c = C/D

Excess Reserves Ratio

e = ER/D

Money Multiplier Relationships

• r_d and m: inversely related

• e and m: inversely related

• if (r_d + e) < 1

  • c and m: inversely related

Money Multiplier Application

• money multiplier suggests that decreasing c would raise money multiplier → increases MS by more than observed

• as it turns out, effects of c declining entirely offset by rise in e

• happens during/following global financial crisis and covid