Money Supply & Creation – Quick Review Notes

Money Supply Definitions

  • Money supply (Ms): total money available at a point in time.

  • Hong Kong aggregates:
    • M1 = Cp + Dd (currency with public + demand deposits).
    • M2 = M1 + Ds + Dt + NCD{lb} (adds savings/time deposits & negotiable CDs of licensed banks). • M3 = M2 + D{rlb} + D{dtc} + NCD{rlb} + NCD_{dtc} (adds time deposits & CDs of restricted-licence banks & deposit-taking companies).

  • Hierarchy: M1 \subset M2 \subset M3.

Monetary Base vs. Money Supply

  • Monetary base M0 = Cp + R (public cash + bank reserves).

  • Money supply Ms = Cp + D (public cash + deposits).

  • R not in Ms; D not in M0 ➔ different concepts; both are stocks.

Banking Balance Sheet Basics

  • Identity: Assets = Liabilities.

  • Main items:
    • Assets: Reserves R, Loans L, Investments.
    • Liabilities: Deposits D.

  • Typical immediate effects:
    • Cash deposit ↑ ⇒ R, D ↑ equal amount.
    • Cash withdrawal ↓ ⇒ R, D ↓.
    • New loan ⇒ L ↑, R ↓.
    • Loan repayment ⇒ L ↓, R ↑.

Fractional Reserve Banking

  • Required reserve ratio rr = \frac{Required\;R}{D}.

  • Required reserves = D \times rr.

  • Excess reserves ER = R - Required\;R.

  • Actual reserve ratio = \frac{R}{D}.

  • States:
    • Fully loaned up: ER = 0.
    • Reserve shortage: R < Required\;R.

  • Holding ER incurs opportunity cost (lost loan interest).

Multiple Deposit Creation & Multipliers

  • Maximum creation assumptions: ER=0, full loan demand, no cash leakage.

  • Formulas:
    • Max\;Deposits = \frac{Total\;R}{rr}.
    • Max\;Loans = Max\;Deposits - Total\;R.
    • Maximum multiplier K{max} = \frac{1}{rr}. • Actual multiplier K{actual} = \frac{1}{Actual\;rr}.
    • Money-supply change: \Delta Ms = \Delta Cp + \Delta D.
    • These formulas also apply to deposit contraction. When there is an initial decrease in reserves (\Delta R < 0), the change in deposits and loans will be negative:
    • Max\;Contraction\;in\;Deposits = \Delta R \times \frac{1}{rr} (where \Delta R is the initial reduction in reserves).
    • Max\;Contraction\;in\;Loans = Max\;Contraction\;in\;Deposits - \Delta R.

Why Actual < Maximum

  • Banks keep excess reserves (↑ actual rr).

  • Insufficient loan demand.

  • Public holds part of loans as cash (cash leakage).

Open Market Operations (OMO)

  • Central bank buys bonds ⇒ R ↑ (expansionary).

  • Central bank sells bonds ⇒ R ↓ (contractionary).

  • With public: deposits may also change, but direction of R follows bond flow.

Liquidity vs. Profitability

  • Banks: more loans = ↑ profit & ↓ liquidity; more reserves = ↑ liquidity & ↓ profit.

  • Depositor ranking: Liquid Dd > Ds > Dt; Interest Dt > Ds > Dd.

  • Liquidity and profitability generally trade-off.

Deposit Contraction

  • Cash withdrawal in fully loaned system → reserve shortage → banks call loans/sell assets → deposits & loans contract by multiplier until reserves meet requirement.

  • M1 \subset M2 \subset M3 .