Lecture 11 - The money supply process

Question 1

What are the three main groups that form part of the money supply?

Answer 1

The central bank, banks (depository institutions), depositors.

Question 2

Why are monetary liabilities important?

Answer 2

An increase in either or both will lead to an increase in the money supply (everything else being constant).

Question 3

The sum of the central bank’s monetary liabilities make up the…

Answer 3

Monetary base.

Question 4

What is the currency in circulation?

Answer 4

Issued by the central bank, currency in circulation is the amount of currency in the hands of the public. Currency held by depository institutions is also a liability of the central bank, but is counted as part of the reserves. Central banks’ notes are IOUs from the central bank to the bearer and are also liabilities, but unlike most, they promise to pay back the bearer solely with banknotes; that is, they pay off IOUs with other IOUs. People are more willing to accept IOUs from the central bank because central bank notes are a recognised medium of exchange.

Question 5

What are reserves?

Answer 5

Reserves consist of deposits at the central bank plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities for the central banks, because the banks can demand payment on them at any time and the central bank is required to satisfy its obligation by paying notes. An increase in reserves leads to an increase in the level of deposits and hence in the money supply. Total reserves can be divided into two categories; reserves that the central bank requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves).

Question 6

Why are assets on a central bank’s balance sheet particularly important?

Answer 6

Changes in the asset items lead to changes in reserves, the monetary base and consequently to changes in the money supply.

Question 7

What are government securities?

Answer 7

This category of assets covers the central bank’s holdings of securities issued by the government. One way the central bank can provide reserves to the banking system is by purchasing bonds, thereby increasing its holdings of these assets.

Question 8

How else can the central bank provide reserves to the banking system?

Answer 8

By making loans to banks. For these banks, the loans they have taken out are referred to as borrowings from the central bank or alternatively as borrowed reserves. These loans appear as a liability on banks’ balance sheets. An increase in loans can also be the source of an increase in the money supply. When commercial banks need liquidity, the central bank can provide reserves to them by making discount loans. Central banks charge an interest rate to banks for these loans while its liabilities essentially cost nothing. Central banks make billions every year this way (Seigniorage). Most of their earnings are returned to their countries’ Treasuries.

Question 9

What equals the monetary base, also called high powered moeny?

Answer 9

Currency in circulation (C) plus the total reserves in the banking system (R).

Question 10

The central bank exercises control over the monetary base through its purchases or sale of government securities in the open market, called open market operations and through its extension of loans to banks. What is an open market purchase?

Answer 10

A purchase of bonds by the central bank.

Question 11

What is an open market sale?

Answer 11

A sale of bonds by the central bank.

Question 12

What does the term ‘open market’ refer to?

Answer 12

Commercial banks and the non bank public.

Question 13

The effect of an open market purchase on reserves depends on…

Answer 13

Whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits. If the proceeds are kept in currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves increase by the amount of the open market purchase.

Question 14

The effect of an open market purchase on the monetary base, however is…

Answer 14

Always the same (the monetary base increase by the amount of the purchase) whether the seller of the bonds keeps the proceeds in the deposits or currency.

Question 15

The impact of an open market purchase on reserves is much more…

Answer 15

Uncertain than its impact on the monetary base. Therefore, the central bank can control the monetary base with open market operations more effectively than it can control reserves. The central bank has full control over the size of the monetary base, but not over the size of its individual components.

Question 16

Even if the central bank does not conduct open market operations, a shift from deposit to currency will affect the reserves in the banking system. However, such a shift will have…

Answer 16

No effect on the monetary base, which is why the central bank has more control over the monetary base than over reserves.

Question 17

The monetary base changes one for one with the…

Answer 17

Change in the borrowings from the central bank.

Question 18

What are the two primary features that determine the monetary base?

Answer 18

• Open market operations.

- Lending to banks.

Question 19

Whereas the amount of open market purchases or sales is completely controlled by the central bank’s placing orders with dealers in bond markets, the central bank cannot unilaterally determine, and therefore cannot…

Answer 19

Perfectly predict, the amount of borrowing by banks from the central bank. Central banks set the interest rate on loans to banks, and then banks make decisions about whether to borrow. The amount of loans, though influenced by the central bank’s setting of the interest rate, is not completely controlled by the central bank; banks’ decision play a role too.

Question 20

The monetary base can be split into two components; one that the central bank can control completely and another that is less tightly controlled. The less tightly controlled component is the amount of the base that is created by banks’ loans from the central bank. The remainder of this base called the…

Answer 20

Non borrowed monetary base. This is under the central bank’s control, because it results primarily from open market operations.

Question 21

The non borrowed monetary base is formally defined as the monetary base minus banks’ borrowings from the central bank, which are referred to as…

Answer 21

Borrowed reserves.

Question 22

What is the process of multiple deposit creation?

Answer 22

When the central bank supplies the banking system with a certain amount of additional reserves, depostis increase by a multiple of this amount.

Question 23

A bank cannot safely make loans for an amount…

Answer 23

Greater than the excess reserves it has before it makes the loan.

Question 24

What are the assumptions of this model?

Answer 24

• Banks do not want to hold any excess reserves, since they only get very little interest on them.
• The public does not want to hold any additional amount of currency, all cheques are deposited in banks rather than converted into cash.
• There is a required reserve ratio.

Question 25

Whether a bank chooses to use its excess reserves to make loans or to purchase securities…

Answer 25

The effect on deposit expansion is the same.

Question 26

The multiple increase in deposits generated from an increase in the banking system’s reserves is called the…

Answer 26

Simple deposit multiplier.

Question 27

As a single bank can create deposits equal only to the amount of its reserves…

Answer 27

It cannot itself generate multiple deposit expansion.

Question 28

Why can a single bank not make loans greater in amount than its reserves?

Answer 28

The bank will lose these reserves as the deposits created by the loan find their way to other banks.

Question 29

Why can the banking system as a whole generate a multiple expansion of deposits?

Answer 29

When a bank loses its reserves, these reserves do not leave the banking system even though they are lost to the individual bank. So as each bank makes a loan and creates deposits, the reserves find their way to another bank, which uses them to make additional loans and create additional deposits. This process continues until the initial increases in reserves results in a multiple increase in deposits.

Question 30

For the banking system as a whole, deposit creation (or contraction) will stop only when…

Answer 30

All excess reserves in the banking system are gone; that is, the banking system will be in equilibrium when the total amount of required reserves equals the total amount of reserves.

Question 31

The model of multiple deposit creation seems to indicate that the central bank is able to exercise complete control over the level of chequeable deposits by…

Answer 31

Setting the required reserve ratio and the level of reserves.

Question 32

Currency has no multiple deposit expansion, while…

Answer 32

Deposits do. Thus, if some proceeds from loans are used to raise the holdings of currency, there is less multiple expansion overall, and the money supply will not increase by as much as our simple model of multiple deposit creation tells us.

Question 33

Banks do not make loans or buy securities in the full amount of…

Answer 33

Their excess reserves.

Question 34

If banks choose to hold (in cash) all or some of their excess reserves (not deposited), the full expansion of deposits predicted by the simple model of multiple deposit creation again…

Answer 34

Does not occur.

Question 35

If a bank decides not to invest its excess reserves…

Answer 35

The deposit creation process stops.

Question 36

The central bank is not the only player whose behaviour influences the level of deposits and therefore the…

Answer 36

Money supply.

Question 37

Depositors’ decisions regarding how much currency and banks’ decisions regarding the amount of excess reserves to hold can cause…

Answer 37

The money supply to change.

Question 38

Money supply =

Answer 38

Currency + chequeable deposits.

Question 39

How does changes in the required reserves ratio (r) affect the money supply?

Answer 39

If the required reserve ratio on chequeable deposits increases while all other variables, such as the monetary base, stay the same, there is less multiple deposit expansion (the money multiplier becomes smaller), and hence the money supply falls. All else constant, if the required reserves ratio (r) increases, banks need more reserves to meet the reserve requirement and banks will reduce their loans causing a decline in deposits and hence, in the money supply. If, on the other hand, the required reserve ratio falls, multiple deposit expansion is higher (the money multiplier increases) and the money supply rises. The money supply is negatively related to the required reserves ratio (r).

Question 40

How does changes in the currency ratio (c) affect the money supply?

Answer 40

Chequeable deposits undergo multiple expansions while currency does not. Hence, when chequeable deposits are converted into currency, holding the monetary base and other variables constant, there is a switch from a component of the money supply that undergoes multiple expansion to one that does not. The overall level of multiple expansion declines, so must the money multiplier, which leads to a fall in the money supply. On the other hand, if currency holdings fall, there would be a switch into chequeable deposits that undergo multiple deposit expansion, so the money multiplier would increase causing a rise of the money supply. The money supply is negatively related to the currency ratio (c).

Question 41

How does changes in the excess reserves ratio (e) affect the money supply?

Answer 41

When banks increase their holdings of excess reserves relative to the chequeable deposits, those reserves are no longer being used to make loans, causing multiple deposit creation to stop, thus causing a contraction of the money multiplier and the money supply. If, on the other hand, banks chose to hold less excess reserves, loans and multiple deposit creation would go up and the money supply would rise. The money supply is negatively related to the excess reserves ratio (e).

Question 42

What does the level of excess reserves depend on?

Answer 42

• Nominal interest rates. When market interest rates are high, the opportunity cost of holding reserves is high (reserves pay very little or no interest), so excess reserves will be low.
• Expected deposit outflows. A primary benefit to a bank of holding excess reserves is that they provide insurance against losses due to deposit outflows; that is, they enable the bank experiencing deposit outflows to escape the costs of calling in loans, selling securities, borrowing from the central bank or other corporations, or bank failure. If banks fear that deposit outflows are likely to increase (that is if expected deposit outflows increase), they will want more insurance against this possibility and excess reserves will increase.

Question 43

How does changes in the non borrowed monetary base, MBn affect the money supply?

Answer 43

The central bank’s open market purchases increase the non borrowed monetary base, and its open market sales decrease it. Holding all other variables constant, an increase in MBn arising from an open market purchase increases the amount of the monetary base and reserves, so that multiple creation occurs and the money supply increases. Similarly, an open market sale that decreases MBn shrinks the amount of the monetary base and reserves, thereby causing a multiple contraction of deposits and the money supply decrease. The money supply is positively related to the non borrowed monetary base MBn.

Question 44

How does changes in the borrowed reserves, BR, from the central bank, affect the money supply?

Answer 44

An increase in loans to banks from the central bank provides additional borrowed reserves, and thereby increases the amount of the monetary base and reserves, so that multiple deposit creation occurs and . the money supply increases. If banks reduce the level of their borrowing from central banks, all other variables held constant, the monetary base and amount of reserves would fall, and the money supply would decrease. The money supply is positively related to the level of borrowed reserves (BR) from the central bank.

Question 45

Depositors influence the money supply through their decisions about their holdings of…

Answer 45

Currency.

Question 46

Banks influence the money supply with their decisions about…

Answer 46

Excess reserves.

Question 47

The money multiplier is particularly unstable when…

Answer 47

A banking or financial crisis hits the economic.

Question 48

In the 1980s, central banks of industrialised countries realised that money multiplier was no longer stable and the relationship between intermediate targets and goals had become very unstable. What did they end up doing?

Answer 48

Most of them decided to abandon monetary targeting and instead choose short-term interest rates as their policy instrument. A structural weakness of the money multiplier model is that it is based on the stability of currency and reserve ratios, which, however, in reality fluctuate in response to changes in economic, financial and institutional conditions both in the short and medium - long run.