Money Supply and Monetary Policy

Money Supply

• Money supply (M) is affected by the central bank, banks, and the public.
• $M = C + D$ where $C$ is currency and $D$ is demand deposits.

100% Reserve Banking

• Banks hold all deposits as reserves and make no loans.
• Money supply remains unchanged.

Fractional Reserve Banking

• Banks hold a fraction $r$ of deposits as reserves and loan out the rest.
• Banks create money through lending.
• New money supply: $D + (1-r)D + (1-r)^2D + … = (1/r) * D$

Money Multiplier

• Monetary base $B = C + R$ (currency plus reserves).
• Reserve-deposit ratio $r = R/D$.
• Currency-deposit ratio $c = C/D$.
• Money multiplier $m = (1+c) / (r+c)$.
• $M = m * B$

Factors Affecting Money Supply

• Increase in $r$ or $c$ decreases the money multiplier $m$, thus reducing the money supply.

Instruments of Money Supply Control

• Open Market Operations: Fed buys or sells bonds to influence the money supply.
• Reserve Requirements: Fed sets the minimum reserve ratio $r_{min}$.
• Discount Rate: Interest rate at which banks can borrow from the Fed.
• Federal Funds Rate: Interest rate at which banks lend to each other; market-determined.

Great Depression

• Bank failures significantly reduced the money supply.
• Economists like Friedman and Schwartz argue the Federal Reserve could have prevented the severity of the Great Depression by lending to weak banks and conducting open market operations.