Chapter 8 - Determinants of the Money Supply

Chapter 8 - Determinants of the Money Supply - Chapter 8...

Info icon This preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 8 Determinants of the Money Supply In deriving a model of the money supply process, we focus on a simple definition of money (currency plus checkable deposits), which corresponds to M1, because it is less complicated and yet provides a basic understanding of the money supply process. A. The money supply model and the money multiplier The following two factors are ignored in the last chapter: Depositors’ decisions about their holdings of currency and checkable deposits are one set of factors affecting the money multiplier. Banks’ decisions about excess reserves also affect the money multiplier. Now we incorporate these factors into our model of the money supply process by assuming that the desired level of currency C and excess reserves ER grow proportionally with checkable deposits D : D C c / = and it is called the currency ratio D c C × = D ER e / = and it is called the excess reserves ratio D e ER × = Deriving the money multiplier As we have known, the total amount of reserves in the banking system R equals the sum of required reserves RR and excess reserves ER : ER RR R + = ER D r R + × = (since RR = r* D , required reserves equal to the required reserve ratio r times the total amount of checkable deposits D ) If excess reserves are held at zero, the required reserve ratio is set at r =10%, and the level of checkable deposits in the banking system is $800 billion, the amount of reserves needed to support these deposits is $80 billion. Put it 8-1
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
another way, the $80 billion of reserves can support ten times this amount in checkable deposits, because multiple deposit creation will occur. Because the monetary base MB equals currency plus reserves R, we have: C ER D r C R MB + + × = + = ) ( ) ( ) ( ) ( D c D e D r MB × + × + × = (since D e ER × = and D c C × = ) MB c e r D × + + = 1 (1) Using the definition of the money supply as currency plus checkable deposits: C D M + = D c D c D M × + = × + = ) 1 ( ) ( Substituting in this equation the expression for D from Equation (1), we have: MB m MB c e r c M × = × + + + = 1 As you can see, the ratio that multiplies MB is the money multiplier that tells how much the money supply changes in response to a given change in the monetary base. The money multiplier m is thus: c e r c m + + + = 1 (2) and it is a function of the currency ratio set by depositors c , the excess reserves ratio set by banks e , and the required reserve ratio set by the Fed r . The money multiplier m tells us how much the money supply changes for a given change in the monetary base MB . Because the money multiplier is larger than 1, the alternative name for the monetary base, high-powered money , is logical. A numerical example: Intuition Behind the money multiplier r = required reserve ratio= 0.10 D = checkable deposits= $800 billion C = currency in circulation=$400 billion c = $400 billion/$800 billion= 0.5 ER= excess reserves = $0.8 billion e = $0.8 billion/$800 billion = 0.0001 8-2
Image of page 2
Thus resulting value of the money multiplier is 5 . 2 4958 . 2
Image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern