Chapter 8 - Determinants of the Money Supply

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

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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

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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
Thus resulting value of the money multiplier is 5 . 2 4958 . 2

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