EC1008- Chapter 15

What does the Government's bank do?

- Manage finances of government

- Creates money - prints currency

- Controls availability of money and credit through IR

What does the Bankers' bank do?

- Operates interbank payments network

- Provides financial loans

- Oversees financial intermediaries ro ensure safety and soundness

Who are the key players in the Money supply process?

- Central Bank: conducts monetary policy

- Banks: accept deposits and make loans

- Depositors: hold deposits in banks

- Borrowers: borrow from banks

What is on a central bank's balance sheet?

Asset

Liabilities

What counts as an asset for CB?

- Securities

- Loans to Financial Institutions: provide reserves ti banks and earn the discount rate.

What counts as a liability?

- Currency in circulation:

- Reserves:

Total = required + excess

Are assets and liabilities sources or uses of funds?

Assets: uses

Liabilities: sources

How to calculate the Monetary base?

MB = C + R

C-> currency in circulation

R-> reserves in banking system

What is an open market purchase from a bank?

When CB buys government bonds or securities from commercial bank.

example: £100 bond is bought with an £100 check.

Net result is that reserves increased by £100 (CB & bank)

Monetary base risen by £100.

What is an open market purchase from a nonbank public?

CB buys bonds from firms or individuals

Person selling bond deposits the CB check in a bank

Net result is that reserves have increased, monetary base has risen by amount paid.

What happens when the individual selling bond does not deposit check?

If individual instead cashes the check

Reserves are unchanged

Currency in circulation and monetary base increases by amount of open market purchases

What does the effect of an open market purchase depend on?

Effect on reserves: whether seller of bonds cashes or deposits the check

Effect on base: it will always increase the base

What is an open market sale?

When CB sells gov bond

Monetary base gets reduced by amount of sale

Removes reserves from banking system

Reduces money supply and raises interest rates

currency in circulation falls

Explain what happens when non-bank public change deposits to currency?

Nonbank public:

Checkable deposits fall

Currency increases (by that amount)

Banking system:

Reserves fall

Checkable deposits fall

Central Bank:

currency increases

Reserves decrease

net change in monetary liability = 0

Why does the monetary base not change when deposits shift into currency?

Because:

Monetary Base = Currency + Reserves

Currency increases while reserves decrease by the same amount, so the total stays the same.

How can CB change the monetary base?

By making discount loans to banks

example: of £100, liabilities have increased by £100

--> Monetary base increases by this amount

What happens to monetary base when Bank pays off discount loan?

- Monetary base decreases

Changes one-for-one with a change in borrowing from CB

What else affects monetary base but isn't under CB control?

- Float: temporary excess reserves

Banks are credited before others are debited

Increases monetary base

- Treasury:

Transfer funds from commercial banks to CB

Reduces amount of reserves

Monetary base falls

Another way to calculate monetary base?

MB = MBn + BR

MBn= nonborrowed monetary base

BR = borrowed reserves

Why can it be said that CB directly controls monetary base?

Always has complete control of MBn through market operations so able to adjust for fluctuations in BR.

What is the multiplier effect?

process by which an initial increase in reserves leads to a larger increase in deposits and the money supply through repeated lending by banks.

How does multiplier effect work if bank used excess reserves to buy securities?

Exactly same way

Securities used to open new deposits--> creation of new reserves; excess reserves used to buy securities --> creation of new deposits...

Single bank cannot grant loans > than its excess reserves

What is the deposit multiplier?

change in D = 1/rr x change in R

Assume ER is 0 to get to this

D: change in checkable deposits

R: change in reserves in banking system

rr: required reserve ratio

change in D> change in R

How to calculate total reserves?

R = RR + ER

How to calculate required reserves?

RR = rr x D

D: checkable deposits

rr: required reserve ratio

When does deposit creation stop?

When all excess reserves have been used

What are the assumptions of the simple model?

- Individuals do not hold currency but only deposit

- banks do not hold excess reserves but always use them

What is the critique of the simple model?

- Individuals increase their holdings of currency

- Commercial banks not using all their excess reserves to buy securities or make loans limits expansion of deposits

-Limits money creation

How to work out money supply?

M = m x MB

Money supply (M)

Monetary base (MB)

Money multiplier (m)

What is another equation to work out monetary base?

MB = C + rrD + ER

Does currency create a money multiplier effect?

No -

It doesn't enter banking system

Money is not deposited so it cannot be lent out.

Does supporting deposits create a money multiplier effect?

Yes -

Allows banks to make loans, creating new deposits

Why are deposits multiplied?

Deposits create reserves, allowing banks to make loans = new deposits.

Do excess reserves create additional deposits?

No-

ER are not loaned, banks hold them

so they do not multiply money.

What determines how much monetary base is needed to support deposits?

Required reserves = rr × D

What happens to money multiplier if people hold more currency instead of deposits?

It becomes weaker

What happens to money multiplier if banks increase excess reserves?

Money multiplier decreases since fewer loans are made

What is the equation for the money multiplier?

m = c+1/ c + rr + e

How to work out the currency ratio for public?

c = C/D

C = c x D

Desired currency grows with deposits

What is the relationship between desired excess reserves and deposits?

Desired excess reserves grow with deposits

ER = e x D

e =ER/D

What is the relationship between required reserves and deposits?

Required reserves grow with deposits.

rr= RR/D -> required reserves ratio.

What is the money multiplier?

m = c + 1/c+ rr + e

c = currency ratio

e = excess reserve ratio

rr= required reserve ratio

How does money supply respond to changes in required reserve ration?

Money multiplier is -ve related to rr

How does money supply change in response to changes in currency ratio?

-ve related when rr + e < 1

+ve related when rr + e > 1

How does money supply change in response to changes in excess reserve ratio?

Money multiplier -ve related to e

How is e related to market interest rate?

Negatively related

How is e related to expected deposit outflows?

Positively related

What is the equation for the simple deposit multiplier?

m(d) = 1/rr

How to work out money supply?

Multiplier x Monetary base

What is the expanded monetary base equation?

MB = MBn + BR

What happens to money supply when nonborrowed monetary base (MBₙ) increases?

Money supply increases

More monetary base -> more deposit creation

What happens to money supply when required reserve ratio (rr) increases?

Money supply decreases

Banks must hold more reserves -> less lending -> smaller multiplier

What happens to money supply when borrowed reserves increase?

Money supply increases

More reserves available -> more deposit creation

What happens to money supply when excess reserves increase?

Money supply decreases

Banks hold reserves instead of lending

What happens to money supply when currency holdings increase?

Money supply decreases

More cash held-> fewer deposits -> less deposit expansion

Over long periods, what is primary determinant of movements in the money supply?

Nonborrowed monetary base

Controlled by open market operations

What does OMO stand for?

Open Market operations

CB buys or sells gov securities to change monetary base.

Who controls the non-borrowed monetary base?

CB through OMO

What does CB control in money supply process?

Required reserve ratio

Discount rate

OMO

What do depositors control in money supply process?

Currency ratio

What do banks control in money supply process?

Excess reserve ratio

Borrowings from CB

How do borrowers affect money supply?

indirectly impact excess reserves and borrowed reserves through effect on market interest rates