Monetary Economics

Money Supply Process

Recaps• We have learnt the concepts and measurement of

money.• While there are several monetary aggregates, we

will focus on the narrowest definition of money, i.e. M1, consisting of Currency + Deposits.

• Money is held (Money demand) to facilitate transactions and as a part of asset portfolio.

• Thus, the holding of money depends crucially on the volume of transactions (normally measured by GDP) and the cost of holding money relative to other assets (normally represented by an interest rate).

• Other variables might affect monetary holding as well.

Recaps

M/P = L(Y, r, X)

• Ly = income elasticity of money demand

• Lr = interest rate elasticity of money demand

[X is other variables that can affect monetary holding]

Next…Money Supply• To complete the money market model, we need to

understand the money supply process.• Simplifications - Money = Currency + Deposits - Bank holds no EXCESS reserve (will modify this later) - Economic agents hold money only in the form of deposits (will modify this later) - There is only one bank in the economy. (can be viewed as consolidation of all banks).

Simple Money Supply Process• We first use the simple T-account to illustrate the money

supply process and how monetary instruments can affect the stock of money supply.

• Monetary Instruments: - Open market operations - Discount Rate - Required Reserve Ratio (assumed to be 10%)• Definition: Monetary Base = Reserve + Currency Money Supply = Deposit + Currency (For the moment: we assume currency = 0)• Question: How is money supply related to monetary base.

Banking System Balance Sheet

Initial Balance Sheet

Money Supply = 2,000

Open Market Purchases

• Suppose that the government purchases the government securities from the banking system worth a total of RM200 million.

• Reserves in banking system increase.

• Money supply remains at 2,000

Simple Money Supply Process• At this point, the banking system fi nds itself having an

excess reserve• of RM200 million. • Since the banking system does not keep the excess

reserve, it is lent out to say Mr or Corporation A, who deposits the loans obtained in the banking system. This will increase total deposits to RM2,200, the initial deposits of RM2 billion and the new deposits of RM200 million.

• With the extension of loans, the loans in the banking system increases to RM1.5 billion.

• Since money is deposited back in the bank, reserves in the banking system remains at RM400 million.

• Bank Balance sheet would be……

Simple Money Supply Process

• A simple fact from Figure 3.3 is that, through the lending of RM200, money supply increases to RM2,200.

• Simply stated, money supply is created through lending. It should be noted that the creation of money does not stop here since the banking system still have the excess reserve at hand.

• Money Supply = 2,200

Final Bank Balance Sheet

• At this point, no further lending can be made.• Money Supply = 4,000• Note: with the initial increase of reserve by 200,

money supply increases by 2,000.• Question restated: how is money supply related to

reserve (monetary base)?

Simple Money Multiplier• M = m × B M is Money Supply m is money multiplier B is monetary base• Given our assumption of no currency, we can

restate the above as: D = m × R• The simple money multiplier can be show to be

equal 1/rr, where rr is the required reserve ratio. Thus, we have:

D = (1/rr) × R

Modified Money Supply Process• Let relax the assumptions of no excess reserve

and no currency.• Denote ER/D the excess reserve to deposit ratio

and C/D is currency to deposit ratio.• Total Reserve = Excess Reserve + Required

Reserve• From M = m × B, we have: m = M/B• This can be expanded to: m = (D + C)/(ER + RR + C)• Divide the numerator and denominator by D, we

have m = (1 + cd)/(er + rr + cd)

Modified Money Supply Process

M = (1 + cd)/(er + rr + cd) B

• What does this money supply process tell us?• The Central Bank does not have complete control over

the stock of money supply.• Three economic agents determine the level of money

supply in the economy. They are: Central Bank (through rr and B), Bank (through er) and the public (through cd).

• Still, it is safe to state that the Central Bank can control the level of money supply through its monetary instruments to a certain degree.

Money Supply – Money Demand Framework