Economics Chapter 15: Money Supply Process

Chapter 15: The Money Supply Process

• Three Players:
  • Central bank: Oversees the banking system, responsible for monetary policy.
  • Banks (depository institutions): Financial intermediaries, accept deposits, make loans.
  • Depositors: Individuals/institutions holding bank deposits.

Bank of Canada's Balance Sheet

• Assets:

  • Securities (primarily government securities).
  • Loans to financial institutions (loans/advances to banks; bank rate is the interest charged).

• Liabilities:

  • Currency in circulation (bank notes held by public).
  • Reserves (deposits of banks with the Bank of Canada).

• Reserves (settlement balances): Deposits of banks with the Bank of Canada, their vault cash. Banks hold reserves to manage liquidity.

• Monetary base (high-powered money): Reserves + currency in circulation = reserves + notes in circulation + coins in circulation

• Desired reserves: Reserves banks maintain to handle potential deposit outflows. Expressed as a fraction (desired reserve ratio) of entrusted deposits.

• Excess reserves: Reserves in excess of desired reserves.

Control of the Monetary Base

• MB: Monetary base = C + R (currency circulation + total reserves)
• The Bank of Canada controls the monetary base through open market operations and advances to banks.

Open Market Purchase from a Bank

• Bank of Canada purchasing bonds from a bank increases the bank's reserves.
• If there's no change in currency circulation, the Monetary Base increases by the amount purchased.
• Open market sale has the opposite effect.

Loans to Financial Institutions

• Immediate effect of bank loans to financial institutions is an increase in reserves for both the borrowing bank and the lending (Bank of Canada).
• From here, the process is similar to open market purchases.

Shifts From Deposits into Currency

• The ultimate effect of open market purchases on reserves depends on depositor behavior.
• If depositors prefer to hold more cash, bank reserves fall, cancelling the initial increase. Yet the overall monetary base remains unchanged.

Open Market Policies and Advances

• The immediate effect of an open market purchase or advance is an increase in banking system reserves.
• The ultimate effect on reserves depends on how the injected liquidity is held.
• The ultimate effect on the monetary base is clear: It increases by the amount of the purchase or advance, irrespective of preferences for cash.

Other Factors Affecting the Monetary Base

• Money supply is positively related to the monetary base
• The Bank of Canada doesn't fully control all monetary base elements (e.g. deposits at the bank, "float")

Overview of the Bank of Canada's Ability to Control the Monetary Base

• Monetary base can be divided into non-borrowed and borrowed reserves.
• Non-borrowed reserves are easier to control.
• External factors complicate monetary base control.

Multiple Deposit Creation: A Simple Model

• Due to open market purchases, a bank's reserves increase, and it's able to loan out the excess. New loans become deposits in other banks, creating new money and further expansion in the money supply.
• The ultimate effect of the $100 million injection is an increase in the money supply by more than $100 million.
• It is determined by the desired reserve ratio.

Deposit Creation: The Banking System

• New deposits are created when banks loan out excess reserves.
• The size of the deposit increase depends on the desired reserve ratio.

Critique of the Simple Model

• Several factors may disrupt simple deposit expansion.
• A desire of the public to hold extra cash and banks unwillingness to loan out all excess reserves can dampen the total multiple increase.

Factors That Determine the Money Supply

• Changes in the non-borrowed monetary base positively relate to money supply.
• Changes in borrowed reserves from the Bank of Canada positively relate to the money supply.
• Changes in the desired reserves ratio negatively relate to the money supply.
• Changes in currency holdings negatively relate to the money supply.
• Changes in excess reserves negatively relate to the money supply.

Money Supply Response

• Summary Table of Money Supply Responses shows how various factors affect the Money Supply.

The Money Multiplier

• Money is defined as currency plus chequable deposits (M1+).
• The money supply (Money = M1+) is linked to the monetary base (MB) through a money multiplier.
• The relationship is expressed as M = m x MB

Deriving The Money Multiplier

• Assumptions on currency, excess reserves etc, lead to a formula for the money multiplier.
• The money multiplier (m) is determined by the desired reserve ratio (rd), the currency ratio (c), and the excess reserves ratio (e). An equation is given that summarizes this.

Intuition Behind the Money Multiplier

• For a reserve ratio of 10%, a $1 increase in the monetary base leads to a $2.50 increase in the money supply. This is less than the "simple" deposit multiplier

Application: Quantitative Easing and the Money Supply, 2007-2020

• During quantitative easing, the monetary base increased dramatically but the money supply didn’t rise proportionally
• This is because, the factors such as currency and excess reserves ratios held back the rise.