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Mid-2_507(ch-15)

The money supply process involves the injection and circulation of money in an economy, primarily through central and commercial banks. Key components include currency outside banks, various types of deposits, and the monetary base, which is influenced by open market operations and discount loans. The process of multiple deposit creation allows banks to expand the money supply significantly based on reserve requirements, leading to a money multiplier effect.

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4 views

Mid-2_507(ch-15)

The money supply process involves the injection and circulation of money in an economy, primarily through central and commercial banks. Key components include currency outside banks, various types of deposits, and the monetary base, which is influenced by open market operations and discount loans. The process of multiple deposit creation allows banks to expand the money supply significantly based on reserve requirements, leading to a money multiplier effect.

Uploaded by

Md. Shahin Amir
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Chapter-15:

Q. What is money supply process?


The money supply process is the method by which money is injected and circulated within an
economy. Primarily, central banks and commercial banks play a significant role in this process.

Components of money supply:


1. Currency Outside banks
2. Deposits of Financial Institutions with Bangladesh Bank
3. Demand Deposits with Financial Institutions
4. Time Deposits with Financial Institutions
5. Money Supply (M1) (1+2+3)
6. Money Supply(M2) (4+5)

Monetary Aggregates:

The Players in the Money Supply Process:


1. Central Bank: The government agency that oversees the banking system and influences the
money supply process through monetary policy.
2. Commercial Banks: Commercial banks create money through the lending process, affecting
the money supply.
3. Depositors: individuals and institutions that hold deposits in banks.
4.Borrowers from banks: individuals and institutions that borrow from the depository
institutions and institutions that issue bonds that are purchased by the depository institutions.

Comprising of individuals and businesses, the public shapes money supply through their
demand for money, which includes loans and savings. Each time the public borrows from banks,
money is created, and when they repay loans, money is destroyed, affecting the overall money
supply.

Q. Monetary Base:
Monetary base refers to the total amount of currency that is either circulated in the hands of
the public or in the commercial bank deposits held in the central bank's reserves.
Within the economic framework, the monetary base MB can be expressed as MB = C + R
C= Currency in circulation
R= Total reserves in the banking system
 The monetary base (MB) is sometimes referred to as high-powered money as it can be
expanded through the money multiplier effect of the reserve banking system.
 The Central Bank exercises the monetary base through
o its purchases or sales of securities in the open market, called open market
operations, and through
o its extension of discount loans to banks.

CONTROL OF THE MONETARY BASE:


Monetary base is split in two components:
• non-borrowed MB(MBn): Under Fed’s control
• borrowed reserves (BR): Less tightly controlled

MBn = MB - BR
Here,
MBn = non-borrowed monetary base
MB = monetary base
BR = borrowed reserves from the central bank

Central bank exercises control over MB through:

1. Open Market Operations (OMO): Purchases or sale of government securities in the open
market.
The effect of OMO on Reserve depends on whether the bond-proceeds are kept in currency or
in deposits:
 If kept in currency, the OMO has no effect on Reserve.
 If kept as deposits, reserve increase by the amount of the OMO

2. Extension of discount loans to banks.


3. Other factors (e.g. Float or Treasury Deposits at the Central Bank) also affect the MB

Multiple Deposit Creation


Deposit creation occurs when a commercial bank retains a portion of customer's deposits
as reserves and lends out the excess to borrowers. This lending process creates new deposits
and expands the money supply in the economy.

When the Central Banks supplies the banking system with $1 of additional reserves, deposits
increase by a multiple of this amount—a process called multiple deposit creation.

Deposit creation is a vital process in the banking system. It leads to an increase in the supply of
money in circulation. Here's how:
Assume that the $100 million of deposits created by First National Bank’s loan is deposited at
Bank A and that this bank and all other banks hold no excess reserves. Bank A’s T-account
becomes:

If the required reserve ratio is 10%, the bank will find $90 million of excess reserves. Because
Bank A does not want to hold on the excess reserves, it will make loans for the entire amount.

Its loans and checkable deposits will then increase by $90 million, but when the borrowers
spend the $90 million of checkable deposits, they and the reserves at Bank A will fall back down
by this same amount. Bank A’s T-account will look like this:

If the money spent by the borrowers to whom Bank A lent the $90 million is deposited in
another bank, such as Bank B, the T-account for Bank B will be:

The checkable deposits in the banking system have risen by another $90 million, for a total
increase of $190 million ($100 million at Bank A plus $90 million at Bank B).

The T-accounts for Bank B would just apply to Bank A, and its checkable deposits would
increase by the total amount of $190 million.

Bank B will want to modify its balance sheet further. It must keep 10% of $90 million ($9
million) as required reserves and has 90% of $90 million ($81 million) in excess reserves and so
can make loans of this amount.
Bank B will make loans totaling $81 million to borrowers, who spend the proceeds from the
loans. Bank B’s T-account will be:
The $81 million spent by the borrowers from Bank B will be deposited in another bank (Bank C).
Consequently, from the initial $100 million increase of reserves in the banking system, the total
increase of checkable deposits in the system so far is $271 million (= $100m + $90m + $81m).

Following the same reasoning, if all banks make loans for the full amount of their excess
reserves, further increments in checkable deposits will continue (at Banks C, D, E, and so on), as
depicted in Table 1.

Therefore, the total increase in deposits from the initial $100 increase in reserves will be $1,000
million: The increase is tenfold, the reciprocal of the 10% (0.10) reserve requirement.

THE MONEY MULTIPLIER


The money multiplier is defined as the maximum amount of new money created by banks for
every dollar of reserves.

The relationship between the money supply M, the oney multiplier, and the monetary base is
described by the following equation:
M = m *MB
The money multiplier m tells us what multiple of the monetary base is transformed nto the
money supply.

We shall derive a money multiplier (a ratio that relates the change in the money supply to a
given change in in the MB)

Here,
r =required reserve ratio
c= currency ratio
e=Excess reserve ratio

The money multiplier of 0.73 tells us that,


– given the required reserve ratio of 10% on checkable deposits and
– the behavior of depositors, as represented by c = 0.75, and
– banks, as represented by e = 1.56,
a $1 increase in the monetary base leads to a $0.73 increase in the money supply (M1).
There are two reasons for this result:
1. First, although deposits undergo multiple expansion, currency does not.
2. Second, since e is positive, any increase in the monetary base and deposits leads to higher
excess reserves.

we can see that,


A rise in excess reserves (e), lowers the money multiplier.
When there is a rise in the currency ratio (c), the money multiplier rises.

Formula for Multiple Deposit Creation


Assuming banks do not hold on to any excess reserves means that the
total amount of required reserves in the banking system RR will equal the total reserves in the
banking system R:
Required Reserve (RR) = R Total Reserve (R)
The total amount of required reserves equals the required reserve ratio rr times the total
amount of checkable deposits D:
RR = rr X D
Substituting rr X D for RR in the first equation,
rr X D = R
and dividing both sides of the preceding equation by rr gives
D =1/rr X R
Taking the change in both sides of this equation and using delta to indicate a change gives
∆D =1/rr X ∆R

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