The Economics of Money, Banking, and Financial Markets PDF

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 15 The Money Supply Process Copyright © 2023 Pearson Canada Inc. 15 - 1 Learning Objectives (1 of 2) 1. Li...

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 15 The Money Supply Process Copyright © 2023 Pearson Canada Inc. 15 - 1 Learning Objectives (1 of 2) 1. List and describe the “three players” that influence the money supply. 2. Classify the factors affecting the Bank of Canada’s assets and liabilities. 3. Identify the factors that affect the monetary base, and discuss their effects on the Bank of Canada’s balance sheet. 4. Explain and illustrate the deposit creation process through T-accounts. Copyright © 2023 Pearson Canada Inc. 15 - 2 Learning Objectives (2 of 2) 5. List the factors that affect the money supply. 6. Summarize how the “three players” can influence the money supply. 7. Calculate and interpret changes in the money multiplier. Copyright © 2023 Pearson Canada Inc. 15 - 3 Three Players in the Money Supply Process 1. The central bank – The government agency that oversees the banking system and is responsible for the conduct of monetary policy 2. Banks (depository institutions) – The financial intermediaries that accept deposits from individuals and institutions and make loans 3. Depositors – Individuals and institutions that hold deposits in banks Copyright © 2023 Pearson Canada Inc. 15 - 4 The Bank of Canada’s Balance Sheet (1 of 4) Bank of Canada Assets Liabilities Securities Currency in circulation Loans to financial institutions Reserves Liabilities – Currency in circulation  Really: “Notes in Circulation”, i.e. bank notes in the hands of the public – Notes in the hands of depository institutions do not count  Currency = Notes and coins in circulation – Coins are issued by the Canadian Mint Copyright © 2023 Pearson Canada Inc. 15 - 5 The Bank of Canada’s Balance Sheet (2 of 4) Reserves (a.k.a. settlement balances) – Deposits of the LVTS-associated banks held at the Bank of Canada (and also their vault cash) – Banks hold reserves in order to manage liquidity Monetary base (a.k.a. “high-powered money”) – Monetary base = Reserves + currency in circulation = – Reserves + notes in circulation + coins in circulation Copyright © 2023 Pearson Canada Inc. 15 - 6 The Bank of Canada’s Balance Sheet (3 of 4) More about Reserves of banks – Reserves = desired reserves + excess reserves – Desired reserves  Reserves that banks desire to maintain to manage possible deposit outflows – Desired reserve ratio  For any individual bank, desired reserves expressed as a fraction of the deposits entrusted to the bank – Excess reserves  Reserves in excess of desired reserves Copyright © 2023 Pearson Canada Inc. 15 - 7 The Bank of Canada’s Balance Sheet (4 of 4) Assets – Securities  Primarily securities issued by the Government of Canada  Other securities in exceptional circumstances (see Chapter 16) – Loans to financial institutions: loans (advances) made to banks  Rate charged by BoC is called the bank rate Copyright © 2023 Pearson Canada Inc. 15 - 8 Control of the Monetary Base MB = C + R MB: monetary base C: currency in circulation (notes and coins held by the public) R: total reserves in the banking system The Bank of Canada controls the monetary base through open market operations and advances to banks Copyright © 2023 Pearson Canada Inc. 15 - 9 Open Market Purchase from a Bank Banking System Bank of Canada Assets Liabilities Assets Liabilities Securities −$100m Securities +$100m Reserves +$100m Reserves +$100m BoC purchases $100M of bonds from a bank Immediate effect is that reserves increase by $100M. If there is no change in currency in circulation, then MB: +$100m – Open market sale: opposite effect – Technically works through “primary dealers” Copyright © 2023 Pearson Canada Inc. 15 - 10 Loans to Financial Institutions Banking System Bank of Canada Assets Liabilities Assets Liabilities Reserves +$100m Loan from +$100m Loan to a +$100m Reserves +$100m Bank of Canadian Canada bank Immediate effect when BoC and a bank agree on a $100M loan to the bank: – Loans: +$100M (Asset for BoC and Liability for Banks) – Reserves: +$100M (Asset for Banks and Liability for BoC) From here the story is similar to open market purchase Loan of BoC to Banks has a similar effect to effect of open market purchase of securities Copyright © 2023 Pearson Canada Inc. 15 - 11 Shifts from Deposits into Currency (1 of 2) Nonbank Public Assets Liabilities Chequable −$100m Blank Blank Deposits Currency +$100m Blank Blank What is the ultimate effect of the open-market purchase on Reserves? It depends on depositor behaviour For example, if depositors would like to keep an extra $100M of their money in the form of currency. Copyright © 2023 Pearson Canada Inc. 15 - 12 Shifts from Deposits into Currency (2 of 2) Banking System Bank of Canada Assets Liabilities Assets Liabilities Reserves −$100m Chequable −$100m Blank Bla Currency in +$100m Deposits nk circulation Blank Blank Blank Blank Blank Bla Reserves −$100m nk The public’s action implies: – $100M increase in currency in circulation – Reserves in the banking system fall by $100M, undoing the initial increase in Reserves – Yet, the action of the public has not affected the monetary base, which ultimately increased by $100M Copyright © 2023 Pearson Canada Inc. 15 - 13 Open Market Policies and Advances from the Bank of Canada: Summary Immediate effect of an open market purchase or an advance to a bank is an increase in reserves in the banking system Ultimate effect on reserves depends on how the injected liquidity from the bond sale is held However, the ultimate effect on the MB is quite clear: – the MB increases by $100M in this example, independently of the public’s preference for cash and deposits. Copyright © 2023 Pearson Canada Inc. 15 - 14 Other Factors Affecting the Monetary Base As we see later, money supply is positively related to monetary base It appears the BoC has full control of the MB – BoC in full control of open-market operations Yet, full control is not 100% accurate: – Loans to banks: it take two parties to agree to these, not just the BoC – BoC does not control the float – BoC does not control government deposits at BoC – Interventions in the foreign exchange market also affect the monetary base Copyright © 2023 Pearson Canada Inc. 15 - 15 Overview of the Bank of Canada’s Ability to Control the Monetary Base Degree of control by BoC suggests another useful way to break down the monetary base: MB = MBn + BR MBn  non-borrowed monetary base: easy to control BR  borrowed reserves: not very easy to control Grand conclusion: Technical and external factors complicate control of the monetary base, yet BoC essentially still adequately controls the monetary base Copyright © 2023 Pearson Canada Inc. 15 - 16 Multiple Deposit Creation: A Simple Model (1 of 2) Deposit Creation: Single Bank First National Bank First National Bank Assets Liabilities Assets Liabilities Securities −$100m Blank Blan Securities −$100m Chequable +$100m k deposits Reserves +$100m Blank Blan Reserves +$100m Blank Blank k Loans +$100m Blank Blank Due to an open market purchase, the bank’s reserves increase and it loans out the excess Lending creates a chequable deposit, that is … lending increases the money supply (M1+) Copyright © 2023 Pearson Canada Inc. 15 - 17 Multiple Deposit Creation: A Simple Model (2 of 2) After the $100M has been extended in loans, the reserves presumably disappear before long – Borrowers didn’t take a loan just to increase their deposits – They will purchase goods and services As $100M in deposits are taken out by the borrower the final T-account of the bank will be: First National Bank Assets Liabilities Securities −$100m Blank Blank Loans +$100m Blank Blank Copyright © 2023 Pearson Canada Inc. 15 - 18 Deposit Creation: The Banking System (1 of 2) Let’s assume the $100 million of deposits created by First National Bank’s loan is deposited at “Bank A” Bank A Assets Liabilities Reserves +$100m Chequable Deposits +$100m If Bank A’s desired reserve ratio is 10%, then Bank A will extend $90M in new loans. After these are withdrawn Bank A Assets Liabilities Reserves +$10m Chequable Deposits +$100m Loans +$90m Blank Blank Copyright © 2023 Pearson Canada Inc. 15 - 19 Deposit Creation: The Banking System (2 of 2) If the $90 million loaned out is deposited at “Bank B”, then this Bank B’s T-account is Bank B Assets Liabilities Reserves +$90m Chequable Deposits +$90m If Bank B’s desired reserve ratio is also 10%, then Bank B will make $81million in new loans Bank B Assets Liabilities Reserves +$9m Chequable Deposits +$90m Loans +$81m Blank Blank Copyright © 2023 Pearson Canada Inc. 15 - 20 Creation of Deposits Table 15-1 Creation of Deposits (assuming a 10% desired reserve ratio and a $100 million increase in reserves) Increase in Increase in Increase in Deposits ($ Loans ($ Reserves ($ Bank millions) millions) millions) First National 0.00 100.00 0.00 A 100.00 90.00 10.00 B 90.00 81.00 9.00 C 81.00 72.90 8.10 D 72.90 65.61 7.29 E 65.61 59.05 6.56 F 59.05 53.14 5.91 ⁞ ⁞ ⁞ ⁞ Total 1000.00 1000.00 100.00 Copyright © 2023 Pearson Canada Inc. 15 - 21 The Formula for Multiple Deposit Creation If: Desired Reserves (DR) = Total Reserves (R) Then: DR = rd x D = R, where rd = Desired Reserve Ratio; and D = amount of chequable deposits This shows that (under sufficient loan demand): D = And therefore also (under sufficient loan demand) that changes in the reserves engineered by the BoC have the following ultimate effect: 1 D  R rd Copyright © 2023 Pearson Canada Inc. 15 - 22 Multiple Deposit Creation: The Banking System In our example, the desired reserve ratio is 10% If reserves increase by $100 million, chequable deposits must rise by $1 billion T-account for the banking system as a whole: The Banking System Assets Liabilities Securities −$100m Chequable Deposits +$1000m Reserves +$100m Blank Blank Loans +$1000m Blank Blank Copyright © 2023 Pearson Canada Inc. 15 - 23 Critique of the Simple Model Simple model: D = and therefore: 1 D  R rd However, we need to account for other factors – A desire of the public to hold additional cash affects the process  Currency has no multiple deposit expansion – A desire of banks to not use all of their additional reserves to buy securities or make loans also affects the process  Banks may not find they have sufficiently interesting lending opportunities or securities to invest in Copyright © 2023 Pearson Canada Inc. 15 - 24 Factors That Determine the Money Supply (1 of 2) Changes in the nonborrowed monetary base MBn – The money supply is positively related to the non- borrowed monetary base MBn Changes in borrowed reserves from the Bank of Canada – The money supply is positively related to the level of borrowed reserves, BR, from the Bank of Canada Copyright © 2023 Pearson Canada Inc. 15 - 25 Factors That Determine the Money Supply (2 of 2) Changes in the desired reserves ratio – The money supply is negatively related to the required reserve ratio Changes in currency holdings – The money supply is negatively related to currency holdings Changes in excess reserves – The money supply is negatively related to the amount of excess reserves Copyright © 2023 Pearson Canada Inc. 15 - 26 Money Supply Response Summary Table 15-1 Money Supply Response Money Change in Supply Player Variable Variable Response Reason Bank of Nonborrowed monetary ↑ ↑ More MB for deposit Canada base, MBn creation Banks Desired reserve ratio, rd ↑ ↓ Less multiple deposit expansion Borrowed reserves, BR ↑ ↑ More MB for deposit creation Excess reserves ↑ ↓ Less loans and deposit creation Depositors Currency holdings ↑ ↓ Less multiple deposit expansion Note: Only increases (↑) in the variables are shown. The effects of decreases on the money supply would be the opposite of those indicated in the “Money Supply Response” column. Copyright © 2023 Pearson Canada Inc. 15 - 27 The Money Multiplier Define money as currency plus chequable deposits, that is: Money = M1+ Link the money supply (M) to the monetary base (MB) and let m be the money multiplier The relationship is described by the following equation: M = m×MB Copyright © 2023 Pearson Canada Inc. 15 - 28 Deriving the Money Multiplier (1 of 5) Assumptions: – Desired holdings of currency (C) grow proportionally with chequable deposits (D).  Let c = {C/D} be the currency ratio – Excess reserves (ER) grow proportionally with chequable deposits (D).  Let e = {ER/D} be the excess reserves ratio – There is sufficient demand for loans Copyright © 2023 Pearson Canada Inc. 15 - 29 Deriving the Money Multiplier (2 of 5) The total amount of reserves (R) equals the sum of desired reserves (DR) and excess reserves (ER) R = DR + ER The total amount of desired reserves equals the desired reserve ratio, rd, times the amount of chequable deposits DR = rd × D Substituting for DR R = (rd × D) + ER Copyright © 2023 Pearson Canada Inc. 15 - 30 Deriving the Money Multiplier (3 of 5) The monetary base MB equals currency (C) plus reserves (R) by definition: MB = R + C = (rd × D) + ER + C Equation gives the size of the monetary base needed to support the amounts of chequable deposits, currency and excess reserves in the banking system Copyright © 2023 Pearson Canada Inc. 15 - 31 Deriving the Money Multiplier (4 of 5) c {C /D}  C c  D and e {ER /D}  ER e  D Substituting in the previous equation MB (r D )  (e D )  (c D ) (r  e  c) D Divide both sides by the term in parentheses 1 D MB r ec M D  C and C c D M D  (c D) (1  c) D Copyright © 2023 Pearson Canada Inc. 15 - 32 Deriving the Money Multiplier (5 of 5) Substituting again 1 c M MB r ec The maney multiplier is then 1 c m r ec Copyright © 2023 Pearson Canada Inc. 15 - 33 Intuition Behind the Money Multiplier (1 of 2) Support the following – The reserve ratio is 10% – Currency in circulation totals $400 billion – Chequable deposits total $800 billion – Excess reserves are $0.8 billion – And the money supply (M1+) is $1200 billion From these, the currency ratio is 0.5 And the excess reserve ratio is 0.001 Copyright © 2023 Pearson Canada Inc. 15 - 34 Intuition Behind the Money Multiplier (2 of 2) The resulting value of the money multiplier is 1  0.5 1.5 m  2.5 0.1  0.001  0.5 0.601 This says, a $1 increase in the monetary base leads to a $2.50 increase in the money supply (M1+) This is far less than the simple deposit multiplier – Deposits undergo multiple expansion, currency does not – Any increase in the monetary base and deposits leads to higher excess reserves Copyright © 2023 Pearson Canada Inc. 15 - 35 Application: Quantitative Easing and the Money Supply, 2007–2020 (1 of 2) Between September 2008 and December 2014 the monetary base grew by more than 350% in the US as the Fed massively purchased assets and offered new lending facilities to banks. The currency ratio fell during this period Yet, the money supply only rose by 100% How can these three things be true given what we learned about the money multiplier!? What do you observe happened to the monetary base and the money supply between February and June of 2020 (start of the coronavirus pandemic)? Copyright © 2023 Pearson Canada Inc. 15 - 36 FIGURE 15-1 M1 and the Monetary Base in the United States, 2007–2020 In percentage terms the money supply rose by substantially less than the monetary base during the two quantitative easing episodes, the global financial crisis and the coronavirus pandemic. Source: Federal Reserve Bank of St. Louis FRED database: fred.stlouisfed.org/series/BOGMBASE; https://fred.stlouisfed.org/series/M1SL. Copyright © 2020 Pearson Canada Inc. 15 - 37 Application: Quantitative Easing and the Money Supply, 2007–2020 (2 of 2) The money multiplier suggests that the decrease in c would actually raise the money multiplier, and hence would increase the money supply by much more than we observed However, remember the assumptions we made As it turns out, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e This happened both during and following the global financial crisis as well as the pandemic. Copyright © 2023 Pearson Canada Inc. 15 - 38 FIGURE 15-2 Excess Reserves and Currency Ratio in the United States, 2007–2020 The currency ratio c was relatively steady during this period, whereas the excess reserves ratio e rose sharply after quantitative easing during the global financial and coronavirus crises. Source: Federal Reserve Bank of St. Louis FRED database: fred.stlouisfed.org/series/EXCSRESNS; https://fred.stlouisfed.org/series/CURRCIR; https://fred.stlouisfed.org/series/TCDNS. Copyright © 2020 Pearson Canada Inc. 15 - 39