Comprehensive Notes on Money Supply, Monetary Base, and Credit Creation

Money Supply M1 (HK $)</strong>: This category includes demand deposits. A transfer of funds within the same currency (HK$ ) from a savings deposit to a current (demand) deposit results in an immediate increase in M1. For example, transferring $\$5000$ from HK$ savings to HK$ current deposits increases M1 by $\$5000$ .
Money Supply M3 (HK$): This is the broadest measure of money supply. However, it does not include foreign currency deposits such as Renminbi (RMB) savings. If an individual converts $\$20000$ of HK$ savings deposits into RMB savings deposits, the HK$ money supply M3 decreases by $\$20000$ .

Monetary Base ( $MB$ ): Defined as the sum of cash held by the public and reserves held by the banking system. $MB = \text{Cash in Public Circulation} + \text{Reserves}$
Money Supply ( $MS$ ): Defined as the sum of cash held by the public and deposits in the banking system. $MS = \text{Cash in Public Circulation} + \text{Deposits}$
Required Reserve Ratio ( $RRR$ ): The fraction of total deposits that banks are legally required to hold as reserves. $RRR = \frac{\text{Required Reserves}}{\text{Total Deposits}}$ Alternatively, if the system is fully loaned up (no excess reserves): $RRR = \frac{\text{Total Reserves}}{\text{Total Deposits}}$
Excess Reserves: The difference between the actual reserves held by a bank and the required reserves. $\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$
Maximum Possible Deposits: The theoretical limit to which the banking system can expand deposits based on the reserve multiplier ( $\frac{1}{RRR}$ ). $\text{Maximum Deposits} = \text{Total Reserves} \times \frac{1}{RRR}$

Credit Creation Process: This occurs when reserves are injected into the banking system, for instance, when a central bank purchases government bonds from commercial banks.
1. The central bank injects cash into the banks as reserves, creating excess reserves.
2. Banks lend out these excess reserves to borrowers.
3. The proceeds of these loans are re-deposited back into the banking system.
4. This cycle continues, resulting in a multiple increase in total deposits.
Credit Contraction Process: This occurs when there is a net withdrawal of deposits from the system, such as when citizens withdraw money to purchase government bonds (e.g., Silver Bonds).
1. Withdrawal of bank deposits creates a reserve shortage relative to legal requirements.
2. Banks are forced to call back loans to restore their required reserve levels.
3. If the public maintains a constant ratio of cash, further withdrawals may be triggered to compensate for the reduced credit available.
4. This cycle continues, resulting in a multiple decrease in total deposits.
Impact on Monetary Base: The credit creation or contraction process itself does not affect the monetary base. The monetary base remains constant at the sum of cash in circulation and reserves in the banking system regardless of how much credit is generated within the system.

The Banking Multiplier: The money supply is typically several times larger than the monetary base. This is due to the fractional reserve banking system, which enables banks to lend out a portion of their deposits. These loans return to the system as new deposits, creating a multiplier effect that is larger than unity.
Equivalence of Money Supply and Monetary Base: Money supply and the monetary base will be equal only under two specific conditions:
1. The legal reserve ratio is set at $100\%$ .
2. Banks choose not to lend out any of their excess reserves (all money stays in reserves or cash).
Assumptions for Maximum Possible Change in Money Supply: For the actual change in money supply to reach its theoretical maximum, two conditions must be met:
1. Banks do not hold any excess reserves (they are fully loaned up) and there is sufficient demand for loans.
2. There is no cash leakage (the public does not increase their cash holdings during the process).

Central Bank Bond Operations: When a central bank buys bonds from the public, the monetary base increases by the value of the purchase. For example, if the central bank buys $\$40\,\text{million}$ in bonds, the new monetary base increases by that same $\$40\,\text{million}$ .
International Capital Flows: If firms withdraw funds from a domestic banking system and remit them overseas (e.g., $\$700\,\text{million}$ ), the domestic monetary base decreases by the full amount of the remittance ( $-\$700\,\text{million}$ ).
Adjustment of Reserve Ratios: Decreasing the $RRR$ allows for greater deposit expansion. If the initial $RRR$ is $20\%$ and it is reduced by $5$ percentage points to $15\%$ , the new deposit limit is calculated as: $\text{New Deposits} = \frac{\text{Actual Reserves}}{0.15}$
Reserve Shortage Calculations: If a banking system faces a reserve shortage of $\$100\,\text{million}$ with reserves of $\$600\,\text{million}$ and deposits of $\$3500\,\text{million}$ , the original required reserves were $\$700\,\text{million}$ ( $600 + 100$ ). Thus, the $RRR$ was: RRR = \frac{\700\,\text{million}}{\3500\,\text{million}} = 20\%
Real-World Deviations: In reality, deposit contraction does not always follow a withdrawal because:
1. Banks may have sufficient excess reserves to cover the withdrawal without calling back loans.
2. The public might choose to reduce their cash holdings instead of withdrawing further deposits when banks call back loans.