Group2

1.3 THE SUPPLY OF MONEY

Introduction

• Exploration of how changes in money quantity occur.

• Growth of money supply is vital for:

  • Economic development acceleration.

  • Achievement of price stability.

• Controlled expansion of money supply is essential for development and stability.

• Economic health requires balance: no inflation or deflation.

• Inflation impacts developing economies significantly:

  • Mild inflation can stimulate investments by increasing profit expectations.

  • Runaway inflation, however, hampered economic growth.

• Developing economies face resource inadequacies, can address through deficit financing, but must be cautious.

• Management of money supply is crucial for steady economic growth.

• Central banks control money supply and issuance of domestic currency which influences:

  • Interest and inflation rates.

  • Aggregate output.

• Good central bank policy creates stable economic growth, while poor policies can lead to economic crises.

Learning Objectives

• Explain Money Supply/Stock (with financial innovations).

• Describe Endogenous Money Supply: Credit Creation Process.

• Explain the Monetary Base Model of Money Supply.

• Distinguish between Flow of Funds Approach and Base Multiplier Approach to Money Supply.

• Describe relationship between Fiscal Balance and Money Supply Process.

• Explain empirical studies regarding Money Supply.

1.3.1 Money Supply/Stock

Definition

• Money is a good, which is demanded and supplied by economic agents.

Determinants of Money Demand and Supply

• Demand Determinants:

  • National income, price level, interest rates.

• Supply Determinants:

  • Central bank behavior controlling money supply.

Equilibrium of Money Market

• Equilibrium amount specifies money stock where money demand equals supply.

• Money supply often set exogenously by central bank policy.

• Nominal vs. Real Value of Money Stock:

  • Nominal: value in terms of money itself.

  • Real: purchasing power of money, equal to 1/P (P = average price level).

Money and Bond Markets

• Money market defined as the market where money demand and supply interact for equilibrium.

• Commonly referred to in English as short-term bonds market but this text adheres to macroeconomic definitions.

Financial Innovations

• Rapid financial innovations since the 1960s:

  • Automatic transactions: ATMs, phone, online banking.

  • Creation of new assets: Money Market Mutual Funds (MMMFs).

• Increased competition among financial intermediaries has blurred the distinctions between banks and other providers.

• Innovations reduce demand for money/reduce need to hold currency:

  • Credit/Debit cards, electronic money cards, and online transfers have transformed payment systems and deposit dynamics.

1.3.2 Endogenous Money Supply: Credit Creation Process

Interaction of Key Players

• Money supply determined by:

  • Commercial banks, depositors, borrowers, and central bank interactions.

• Central bank balance sheet consists of assets (similar to common banks) and liabilities (currency in circulation, reserves).

Monetary Base (MB)

• MB = Currency in circulation (C) + Reserves (R).

  • Reserves include required and excess reserves (mandated by central bank).

Credit Creation Process

• T-Accounts: Utilized to illustrate changes in balance sheets for monetary transactions.

  • Example: Central Bank purchases a bond which changes reserves and securities in the banking system.

• The core processes change MB, which leads to changes in the money supply.

Multiple Deposit Creation Model

• Central bank influences MS through the monetary base.

• Each $1 MB generates multiple new deposits (ratio >1).

• Several banks create deposits through loans made from excess reserves, expanding the money supply further.

• Simple Model:

  • △D = (1/rr) × △R relation for calculating deposit changes based on changes in reserves, demonstrating the multiplier effect.

Limitations & Considerations

• Deposit creation can be impacted by excess reserves held, preference for cash by the public, and various financial decisions made by banks.

• Practical scenarios show that banks may choose not to lend, affecting overall credit creation.

1.3.3 Monetary Base Model

• Focuses on stocks of the monetary base and its direct influence on the supply of money.

  • Highlights stability in ratios. Money stock correlates with monetary base size, a function of central bank control.

• Encourages understanding of monetary authorities' control over money supply viewed through stock variables.

1.3.4 Flow of Funds Approach to Money Supply

• Contrasts with the Base-Multiplier approach, focusing on the flow of bank loans instead of stock relationships.

• Essential focus on new lending flows directly influences changes in deposits.

• Emphasizes impacts of lending and borrowing behavior on money stock changes.

Key Components

• Coinciding equations elucidate relationships between monetary flows and state of bank lending.

Comparison Insights

• Both approaches yield valuable insights under different economic conditions but reflect fundamentally different processes of money supply determination.

1.3.5 Fiscal Balance and the Money Supply Process

Connection to Money Supply Expansion

• Budget deficits can expand money supply if financed by borrowing or central bank purchases of securities.

Central Bank Dilemma

• Balancing act between preventing crowding out of private investment and monetizing government deficits.

• Decision to control inflation when approaching full employment levels versus countering recession effects through monetary expansion.

1.3.6 Empirical Studies of Money Supply

Cointegration and Error-Correction Models

• Studies reveal issues in estimating a money supply function because of monetary policy shifts.

  • Regional case studies like Ghana highlight unique monetary behavior throughout periods of change.