Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply

Chapter 16. Determinants of the Chapter 16. Determinants of the Money SupplyMoney Supply

• Money multiplier

• Factors that determine multiplier & MS

• Applications: Great Depression

• Money multiplier

• Factors that determine multiplier & MS

• Applications: Great Depression

• given problems with simple money multiplier,

• construct better multiplier• cash holdings• excess reserves holdings

• based on M1 = C + D

• given problems with simple money multiplier,

• construct better multiplier• cash holdings• excess reserves holdings

• based on M1 = C + D

I. money multiplierI. money multiplierI. money multiplierI. money multiplier

• how $1 change in MB will affect MS:

M = m x MB• how $1 change in MB will affect MS:

M = m x MB

rD = required reserve ratio

c = ratio of currency to deposits

e = ratio of excess reserves to deposits

m =

rD + e + c

1 + c

exampleexampleexampleexamplerD = .10 C = $400 billion D = $800 billion

ER = $.8 billion or $800 million

= 2.5

$1 increase in MB, $2.5 increase in M

m =.10 + .001 + .5

1 + .5

II. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MSII. Factors affecting m & MS

• changes in rD

• changes in c

• changes in e

• changes in MB

• changes in rD

• changes in c

• changes in e

• changes in MB

changes in rchanges in rDDchanges in rchanges in rDD

• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation

• higher reserve requirement• fewer excess reserves to lend• smaller amount of deposit creation

higherrD

smallermultiplier

exampleexampleexampleexample

• rD was .10

• suppose it rises to .20

• rD was .10

• suppose it rises to .20

m = 2.14

m =.20 + .001 + .5

1 + .5

changes in cchanges in cchanges in cchanges in c

• higher c• currency does not expand like deposits• smaller amount of deposit creation

• higher c• currency does not expand like deposits• smaller amount of deposit creation

higherc

smallermultiplier

exampleexampleexampleexample

• original example: c = .5

• suppose c = .8• original example: c = .5

• suppose c = .8

m =.10 + .001 + .8

= 2.001 + .8

changes in ER/Dchanges in ER/Dchanges in ER/Dchanges in ER/D

• higher e• banks hold more ER, lend less• smaller amount of deposit creation

• higher e• banks hold more ER, lend less• smaller amount of deposit creation

highere

smallermultiplier

exampleexampleexampleexample

• original example: e = .001

• suppose e = .005• original example: e = .001

• suppose e = .005

m =.10 + .005 + .5

= 2.481 + .5

what affects e?what affects e?what affects e?what affects e?

• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)

• as interest rates rise• opportunity cost of holding ER rise• (money could be lent out)

higheri

ERfall

• expected deposit outflows• must hold more ER

• expected deposit outflows• must hold more ER

Factors affecting MBFactors affecting MBFactors affecting MBFactors affecting MB

• MB = MBn + DL• MBn is nonborrowed MB

-- open market purchase will

increase MBn

-- open market sale will

decrease MBn• increase MBn will increase M

• MB = MBn + DL• MBn is nonborrowed MB

-- open market purchase will

increase MBn

-- open market sale will

decrease MBn• increase MBn will increase M

• DL is discount loans

-- increase as banks borrow from

the Fed

-- increase as spread between

market interest rate and discount

rate increases

• DL is discount loans

-- increase as banks borrow from

the Fed

-- increase as spread between

market interest rate and discount

rate increases

Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33Great Depression 1930-33

• big contraction in M1

• big increases in c, e• depositors withdrew cash• banks increase ER due to increase

in deposit outflow

• big contraction in M1

• big increases in c, e• depositors withdrew cash• banks increase ER due to increase

in deposit outflow

• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33

• as c and e rise,• money multiplier declines• M1 declines by 25% from 1930-33