Lecture 4: The Supply of Money and the Banking System

What makes up the banking system?

central bank, commercial banks, depositors (lenders), borrowers

What are the assets of the central bank?

government debt (bonds, securities, T-bills, CDs)

loans to banks (discount loans to banks and other financial institutions)

What are the liabilities of the central bank?

currency in circulation

reserves (required reserves + excess reserves)

what are required reserves?

the amount commercial banks are required to hold at the central bank

what does the simple deposit multiplier do?

examines how change in MB affects total deposits

shows the multiple increase in deposits generated from an increase in reserves in the banking system

What are some criticisms of the simple deposit multiplier?

assumes that all ER are used in deposit creation

neglects currency

therefore, if some proceeds from loans are kept in currency or excess reserves, deposits will not increase as much as the simple deposit multiplier suggest

What are the central bank’s assets under quantitative easing?

government debt

selected financial assets from private sector institutions

loans (direct lending to banks and private institutions, and discount loans to banks)

What is quantitative easing?

purchases of longer-term bonds and financial assets from commercial banks and other institutions (pension funds, insurance companies, non-financial firms)

What does quantitative easing aim to do?

increase the monetary base

what is currency in circulation (C)

notes and coins held by the public, not including reserves at the CB or in cash vaults

what is the monetary base?

currency + reserves, ie high-powered money

what do changes in the CB’s assets also change?

the monetary base

what are open market operations?

purchases or sales of securities by the CB in the open market

how do OMO purchases expand reserves?

because the CB buys securities using reserves,

what amount does the OMO purchase increase the MB by?

by the size of the purchase, because it creates new reserves to purchase

what is the limit of a loan the CB can make?

the level of excess reserves

what is the formula for the simple deposit multiplier?

change in total checkable deposits in the banking system = 1/ required reserves ratio * change in reserves

what is the required reserves ratio?

rr = RR/D

what is the currency ratio?

c = C/D

what is the excess reserves ratio?

e = ER/D

what is the M1 money supply?

M = C + D

how can we write the monetary base/deposit multiplier?

D = 1/ (rr+e+c) MB

what is the difference between the deposit multiplier and the simple deposit multiplier?

Simple multiplier = theoretical maximum expansion of deposits.

Actual deposit multiplier = real-world expansion after leakages/frictions.

how can we split MB, based on non-borrowed reserves and borrowed reserves?

MB = MBn + BR or MB = NBR + BR and in terms of the money supply, M = mMB = m(NBR+BR)

what is the chain of reasoning behind quantitative easing?

QE
→ central bank buys bonds
→ reserves/MB rise
→ banks have more liquidity
→ more lending
→ more deposits created
→ money supply rises
→ spending/investment rises.

why and when has QE not worked?

if banks dont turn ER into loans then no money multiplier and it doesnt work, eg in 2008, much liquidity from QE and direct lending was returned as reserves to the CB. US experienced similar 2007-9