the money supply process

Central bank (Bank of Canada) Banks (depository institutions; financial intermediaries) Depositors (individuals and institutions) Monetary Liabilities Notes in circulation—in the hands of the public Reserves - bank deposits at Bank of Canada and vault cash Assets Government securities - holdings by the Bank of Canada that affect money supply and earn interest Advances to banks - provide reserves to banks and earn the discount rate

Chapter 16

The Money Supply Process

Players in the Money Supply Process

¢ Central bank (Bank of Canada)

¢ Banks (depository institutions; financial

intermediaries)

¢ Depositors (individuals and institutions)

16-Bank of Canada’s Balance Sheet |

¢ Monetary Liabilities

— Notes in circulation—in the hands of the public

— Reserves - bank deposits at Bank of Canada and vault

Bank of Canada’s Balance Sheet II

¢ Monetary liabilities of the Bank = Notes in circulation + Settlement balances

e Monetary base = Bank of Canada’s monetary

liabilities + Royal Canadian Mint’s monetary liabilities (coins in circulation)

16-Bank of Canada’s Balance Sheet III

° Define:

— Currency = Notes + Coins

— Reserves = Vault cash + Settlement balances

¢ Banks hold desired reserves to manage their short

term liquidity requirements and respond to clearing drains and currency drains

e Reserves above that desired are known as excess

reserves

Monetary Base

® MB=C+R

— MB: monetary base (high-powered money)

— C: currency in circulation (notes and coins held by the public outside banks)

— R: total reserves in the banking system (vault cash + settlement balances)

® The Bank of Canada controls the monetary

base through open market operations and

advances to banks

16-Open Market Purchase from a Bank

Bank of Canada purchases $100 of bonds from a

bank and pays them with a $100 cheque

Open Market Purchase from Nonbank Public |

Non bank public sells $100 of bonds to the Bank of

Canada and deposits the Bank’s cheque in the local bank

16-Open Market Purchase from Nonbank Public II

+S100

® Reserves are unchanged

e Currency in circulation increases by the amount of

the open market purchase

e Monetary base increases by the amount of the open

market purchase

Open Market Purchase: Summary

® The effect of an open market purchase on

reserves depends on whether the seller of the bonds keeps the proceeds from the sale in

16-Open Market Sale

Bank of Canada sells $100 of bonds to a bank or the non-

bank public

Securities +S100 Securities -$100 | Currency in -$100

circulation

® Reduces the monetary base by the amount of the sale

e Reserves remain unchanged

e The effect of open market operations on the monetary

base is much more certain than the effect on reserves

Shifts from Deposits

Chequable +5100 Reserves +S100 | Cheqeable -5100

Currency -S100

Bank of Canada

Bank of Canada Advances

When the Bank makes a $100 loan to the First Bank, the

bank, the bank is credited with $100 of reserves (settlement balances) from the proceeds of the loan

Paying Off a Loan from the Bank of Canada

A loan is from the Bank of Canada is paid off by a bank

Assets Liabilities Assets Liabilities

e Net effect on monetary base is a reduction

e Monetary base changes one-for-one with a change in the borrowings from the Bank of Canada

Other Factors Affecting the Monetary Base

1 Float

2 Government deposits at the Bank of Canada

e Although technical and external factors complicate

control of the monetary base, they do not prevent the Bank of Canada from accurately controlling it

Deposit Creation: Single Bank

First Bank Excess reserves Increase

Assets Liabilities Bank loans out the excess

Deposit Creation: The Banking System

S100 of deposits created by First Bank’s loan is deposited at Bank A This bank and all other banks hold no excess

Creation of Deposits

TABLE 16-1 Creation of Deposits (assuming a 10% desired reserve ratio

and a $100 increase in reserves)

Increase in Increase in Increase in

Bank Deposits ($) Loans ($) Reserves ($)

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The Formula for Multiple Deposit Creation

Asssuming banks do not hold excess reserves

Required Reserves (RR)= Total Reserves (R)

RR =Required Reserve Ratio(r) times the total amount

Simple Deposit Multiplier

1 Simple Deposit Multiplier : AD= mxAR

16-Multiple Deposit Creation:

The Banking System

Desired reserve ratio = 10% If reserves increase by

$100, chequable deposits rise to $1000 in order for total

desired reserves to also increase by $100

Critique of the Simple Model

® Holding cash stops the process

® Banks may not use all of their excess reserves

to buy securities or make loans

16-Factors that Determine the Money Supply

e Changes in the Non-borrowed monetary base

(MB,)

- the money supply is positively related to the

non-borrowed monetary base (MB,)

e Changes in advances from the Bank of Canada

- the money supply is positively related to the

level of borrowed reserves (BR) from the Bank

of Canada

Factors that Determine the Money Supply II

e Changes in the Desired Reserve Ratio, r

— The money supply is negatively related to the

desired reserve ratio

¢ Changes in Currency Holdings

— The money supply is negatively related to the

currency holdings

16-The Money Multiplier

e Define money as currency plus chequable

deposits: M1

® The Bank of Canada can control the monetary

base better than it can control reserves

e Link the money supply (M/) to the monetary

base (MB) and let m be the money multiplier

Deriving the Money Multiplier |

e Assume the desired level of currency (C)

and excess reserves (ER) grows

proportionately with chequable deposits

16-Deriving the Money Multiplier II

e The total amount of reserves (R) equals the sum of

desired reserves (DR) and excess reserves (ER)

Deriving the Money Multiplier III

e An increase in MB going into C is not multiplied, but

an increase in MB going into D is multiplied

16-The Money Multiplier in Terms of the Currency Ratio

Money Supply Response to Changes in the

to the level of borrowed reserves, BR, from

the Bank of Canada

16-Desired Reserve Ratio and Currency Ratio 1929-

Crisis 0.05 | ¬ 0.01

0.0 = | 0.0

1929 1930 1931 1932 1933

Source: Federal Reserve Bulletin, Milton Friedman and Anna Jacobson Schwartz, A Monetary History Copyright © 2011 Pearson Canada Inc

M1 and the Monetary Base, 1929-1933

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960 (Princeton, N.J.: Princeton University Press, 1963), p 333

Copyright © 2011 Pearson Canada Inc

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