the money supply process

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Chapter 16
The Money Supply Process
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Players in the Money Supply Process
•
Central bank (Bank of Canada)
•
Banks (depository institutions; financial
intermediaries)
•
Depositors (individuals and institutions)
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Bank of Canada’s Balance Sheet I
•
Monetary Liabilities
–
Notes in circulation—in the hands of the public
–
Reserves - bank deposits at Bank of Canada and vault
cash
•

Assets
–
Government securities - holdings by the Bank of Canada
that affect money supply and earn interest
–
Advances to banks - provide reserves to banks and earn
the discount rate
Bank of Canada
Assets Liabilities
Government securities Notes in circulation
Advances to banks Reserves
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Bank of Canada’s Balance Sheet II
•
Monetary liabilities of the Bank = Notes in circulation
+ Settlement balances
•
Monetary base = Bank of Canada’s monetary
liabilities + Royal Canadian Mint’s monetary liabilities
(coins in circulation)
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Bank of Canada’s Balance Sheet III
•
Define:

–
Currency = Notes + Coins
–
Reserves = Vault cash + Settlement balances
•
Banks hold desired reserves to manage their short
term liquidity requirements and respond to clearing
drains and currency drains
•
Reserves above that desired are known as excess
reserves
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Monetary Base
•
MB = C + R
–
MB: monetary base (high-powered money)
–
C: currency in circulation (notes and coins held by
the public outside banks)
–
R: total reserves in the banking system (vault cash
+ settlement balances)
•
The Bank of Canada controls the monetary
base through open market operations and
advances to banks

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Open Market Purchase from a Bank
•
Net result is that reserves have increased
by $100
•
No change in currency
•
Monetary base has risen by $100
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Reserves +$100
Reserves +$100
Bank of Canada purchases $100 of bonds from a
bank and pays them with a $100 cheque
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Open Market Purchase from Nonbank Public I
•
Person selling bonds to the Bank of Canada deposits
the Bank’s cheque in the bank
•
Identical results as the purchase from a bank
Banking System Bank of Canada
Assets Liabilities Assets Liabilities

Reserves +$100 Chequable
deposits
+$100 Securities +$100 Reserves +$100
Non bank public sells $100 of bonds to the Bank of
Canada and deposits the Bank’s cheque in the local bank
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Open Market Purchase from Nonbank Public II
•
Reserves are unchanged
•
Currency in circulation increases by the amount of
the open market purchase
•
Monetary base increases by the amount of the open
market purchase
Nonbank Public Bank of Canada
Assets Liabilities Assets Liabilities
Securities -$100 Securities +$100 Currency in
circulation
+$100
Currency +$100
The person selling the bonds cashes the Bank’s cheque
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Open Market Purchase: Summary

•
The effect of an open market purchase on
reserves depends on whether the seller of the
bonds keeps the proceeds from the sale in
currency or in deposits
•
The effect of an open market purchase on the
monetary base (MB) always increases the base
by the amount of the purchase
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Open Market Sale
•
Reduces the monetary base by the amount of the sale
•
Reserves remain unchanged
•
The effect of open market operations on the monetary
base is much more certain than the effect on reserves
Nonbank Public Bank of Canada
Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in
circulation
-$100
Currency -$100
Bank of Canada sells $100 of bonds to a bank or the non-
bank public
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Shifts from Deposits
into Currency
Nonbank Public Banking System
Assets Liabilities Assets Liabilities
Chequable
deposits
+$100 Reserves +$100 Cheqeable
deposits
-$100
Currency -$100
Bank of Canada
Assets Liabilities
Currency in
circulation
+$100
Reserves -$100
•
Net effect of monetary
liabilities is zero.
•
Reserves are changed by
random fluctuations.
•
Monetary base is more
stable
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Bank of Canada Advances
•
Monetary liabilities of the Bank of Canada have
increased by $100
•
Monetary base also increases by this amount
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Reserves +$100 Advances +$100 Advances +$100 Reserves +$100
When the Bank makes a $100 loan to the First Bank, the
bank, the bank is credited with $100 of reserves (settlement
balances) from the proceeds of the loan
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Paying Off a Loan from the Bank of Canada
•
Net effect on monetary base is a reduction
•
Monetary base changes one-for-one with a change in
the borrowings from the Bank of Canada
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Reserves -$100 Advances -$100 Advances -$100 Reserves -$100
A loan is from the Bank of Canada is paid off by a bank
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Other Factors Affecting the Monetary Base
1. Float
2. Government deposits at the Bank of Canada
•
Although technical and external factors complicate
control of the monetary base, they do not prevent
the Bank of Canada from accurately controlling it
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Deposit Creation: Single Bank
First Bank First Bank
Assets Liabilities Assets Liabilities
Securities -$100 Securities -$100 Chequable
deposits
+$100
Reserves +$100 Reserves +$100
Loans +$100
First Bank
Assets Liabilities
Securities -$100
Loans +$100
Excess reserves increase
Bank loans out the excess
reserves
Creates a chequing account
Borrower make purchases

The money supply has increased
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Deposit Creation: The Banking System
Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves +$100 Chequable
deposits
+$100 Reserves +$10 Chequable
deposits
+$100
Loans +$90
Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90 Chequable
deposits
+$90 Reserves +$9 Chequable
deposits
+$90
Loans +$81
$100 of deposits created by First Bank’s loan is deposited at
Bank A. This bank and all other banks hold no excess
reserves
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Creation of Deposits

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The Formula for Multiple Deposit Creation
Dx
Rx
∆=∆
=
=
=
=

r
1
D
:yields sides both in change the Taking

r
1
D
r by sides both Dividing
R D x r ngSubstituti
(D) deposits chequableof
amount total the times (r) Ratio Reserve Required RR
(R) Reserves Total (RR) Reserves Required
reserves excess hold not do banks Asssuming
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Simple Deposit Multiplier
Rx∆=∆
r
1
D :Multiplier Deposit Simple
Rx
r
1
D
D x r RR R :Formula the Deriving
=
==
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Multiple Deposit Creation:
The Banking System
Banking System
Assets Liabilities
Securities - $100 Deposits + $1000
Reserves + $100
Loans + $1000
Desired reserve ratio = 10%. If reserves increase by
$100, chequable deposits rise to $1000 in order for total
desired reserves to also increase by $100
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Critique of the Simple Model
•
Holding cash stops the process
•
Banks may not use all of their excess reserves
to buy securities or make loans
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•
Changes in the Non-borrowed monetary base
(MB
n
)
- the money supply is positively related to the
non-borrowed monetary base (MB
n
)
•
Changes in advances from the Bank of Canada
- the money supply is positively related to the
level of borrowed reserves (BR) from the Bank
of Canada
Factors that Determine the Money Supply
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Factors that Determine the Money Supply II
•
Changes in the Desired Reserve Ratio, r
–
The money supply is negatively related to the
desired reserve ratio
•
Changes in Currency Holdings
–
The money supply is negatively related to the
currency holdings
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The Money Multiplier
•
Define money as currency plus chequable
deposits: M1
•
The Bank of Canada 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 x MB