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Lecture 12 - Outline (Ch. 14) The Money Supply Process •The Central Bank’s Balance Sheet Control of the Monetary Base Open Market Operations Discount Loans to Banks A Simple Model of Multiple Deposit Creation The Money Multiplier The Role of Banks and Depositors in the Money Supply Process Empirical Evidence 1-2
The Money Supply Process In the 1970s, central banks in industrialized countries began to target the money supply : Changes in the money supply can: affect aggregate economic activity and the price level (see e.g. Quantity Theory of Money (Lecture #4)) We now want to understand the mechanism that determines the level of money supply, and what role central banks play in it. 1-3 3 Tools Intermediate Targets Goals Operating Instruments •Banks’ reserves Monetary base Open market operations Standing facilities Reserve requirements Money supply
Players in the Money Supply Process There are 3 main players whose behaviour we need to examine: 1. The central bank 2. Commercial banks 3. Depositors (individuals and businesses) 1-4
The Central Bank’s Balance Sheet Central Bank Government securities Discount loans to banks Currency in circulation (C) Banks’ reserves (R) Assets Liabilities Monetary Base, MB = C + R The central bank’s balance sheet is a macroeconomic tool: The central bank affects the money supply by taking actions that affect its balance sheet (assets & liabilities). Here’s a simplified balance sheet: 1-5
The Central Bank’s Balance Sheet Liabilities : (1) Currency in circulation : Currency issued by the CB that is currently in the hands of the public. Currency held by banks (vault cash) is counted as part of the reserves. – CB’s notes are a liability for the CB as they’re IOUs from the CB to the holder since they’re widely accepted as a means of payment, they function as money. (2) Reserves : Required reserves + excess reserves held by banks either in their accounts at the central bank or as vault cash. Banks can demand payment at any time, and the CB will have to meet its obligations by paying notes. 1-6
Assets : (1) Government securities : Securities issued by the government (e.g. bonds). The CB can provide reserves to the banking system by purchasing government bonds from banks. (2) Discount loans to banks : When commercial banks need liquidity, the CB can provide reserves to them by making discount loans. The CB charges a positive interest rate on these loans. Note: the CB’s assets earn interest while its liabilities cost essentially nothing central banks make billions of $ every year this way ( Seignorage ). Most of their earnings are returned to their countries’ Treasuries. The Central Bank’s Balance Sheet 1-7
Control of the Monetary Base The monetary base equals currency in circulation, C, plus the total reserves in the banking system, R: MB = C + R The CB controls the monetary base through: 1. Open market operations (purchases and sales of government securities).

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