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).
  • $M2 = M1 + Ds + Dt + NCD<em>{lb}$ (adds savings/time deposits & negotiable CDs of licensed banks). • $M3 = M2 + D</em>{rlb} + D<em>{dtc} + NCD</em>{rlb} + NCD_{dtc}$ (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 $K<em>{max} = \frac{1}{rr}$. • Actual multiplier $K</em>{actual} = \frac{1}{Actual\;rr}$.
  • 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.

• $M1 \subset M2 \subset M3$ .