Chapter 14 Determinants of the Money Supply The

Chapter 14 Determinants of the Money Supply The Money Supply Model Define money as currency plus checkable deposits: M1 The Fed can control the monetary base better than it can control reserves Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

M =m MB Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-2 Deriving the Money Multiplier I Assume the desired level of currency C and excess reserves ER grows proportionally with checkable deposits D Then c = {C / D} = currency ratio e = {ER / D} = excess reserves ratio

Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-3 Deriving the Money Multiplier II The total amount of reserves (R) equals the sum of required reserves (RR) and excess reserves (ER). R = RR + ER The total amount of required reserves equals the required reserve ratio times the amount of checkable deposits RR = r ? D

Subsituting for RR in the first equation R = (r ? D) + ER The Fed sets r to less than 1 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-4 Deriving the Money Multiplier III The monetary base MB equals currency (C) plus reserves ( R) MB = R + C = (r D)+ ER + C R evealsthe am ount of the m onetary base needed to support

the existing am ountsof checkable deposits, currency, and excessreserves. An increase in the m onetary base that goesinto currency is not m ultiplied, whereasan increase that goesinto supporting depositsism ultiplied. An additionaldollarof MB that goesinto excessreservesER doesnot support any additionaldepositsorcurrency Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-5 Deriving the Money Multiplier IV

c = {C / D} C = c D and e ={ ER / D } ER =e D Substituting in the previousequation MB =(r D )+ (e D )+ (c D ) =(r + e + c) D Divide both sidesby the term in parentheses 1 D= MB r+ e + c M = D + C and C =c D M = D + (c D ) =(1+ c) D Substituting again

1+ c M= MB r+ e + c The m oney m ultiplieristhen 1+ c m= r+ e + c Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-6

Intuition Behind the Money Multiplier r =required reserve ratio =0.10 C =currency in circulation =$400B D =checkable deposits=$800B ER =excessreserves=$0.8B M =m oney supply (M1) =C + D =$1,200B $400 B =0.5 $800 B $0.8 B e= =0.001

$800 B 1+ 0.5 1.5 m= = =2.5 0.1+ 0.001+ 0.5 0.601 Thisislessthan the sim ple deposit m ultiplier Although there ism ultiple expansion of deposits, there isno such expansion forcurrency c=

Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-7 Factors that Determine the Money Multiplier Changes in the required reserve ratio r The money multiplier and the money supply are negatively related to r

Changes in the currency ratio c The money multiplier and the money supply are negatively related to c Changes in the excess reserves ratio e The money multiplier and the money supply are negatively related to the excess reserves ratio e

Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-8 Factors that Determine the Money Multiplier (contd) The excess reserves ratio e is negatively related to the market interest rate The excess reserves ratio e is positively related to expected deposit outflows

Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-9 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-10 Additional Factors Open market operations are controlled by the Fed The Fed cannot determine the amount of

borrowing by banks from the Fed Split the monetary base into two components MBn= MB - BR M = m(MBn + BR) The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Fed Copyright 2007 Pearson Addison-Wesley. All rights reserved.

14-11 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-12 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-13 Explaining Movements in the Money Supply

Over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base, which is controlled by the Feds open market operations Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-15 Copyright 2007 Pearson Addison-Wesley. All rights reserved.

14-16 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-17 Copyright 2007 Pearson Addison-Wesley. All rights reserved. 14-18