# B the arithmetic of the money multiplier 1 the amount

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B. The Arithmetic of the Money Multiplier 1. The amount of excess reserves a bank holds depends on the costs and benefits of holding them, where the cost is the interest foregone and the benefit is the safety from having the reserves in case there is an increase in withdrawals. 2. The higher the interest rate, the lower banks’ excess reserves will be; the greater the concern over possible deposit withdrawals, the higher the excess reserves will be. 3. Similarly, the decision of how much currency to hold depends on the costs and benefits, where the cost is the interest foregone and the benefit is the lower risk and greater liquidity of currency. 4. As interest rates rise cash becomes less desirable, but if the riskiness of alternative holdings rises or liquidity falls, then it becomes more desirable. 5. Deriving the money multiplier tells us that the quantity of money in the economy depends on the monetary base, the reserve requirement, the desire by banks to hold excess reserve and the desire by the public to hold currency. 6. The quantity of money changes directly with the base, and for a given amount of the base, an increase in either the reserve requirement or the holdings of excess reserves will decrease the quantity of money. 7. But currency holdings affect both the numerator and the denominator of the multiplier, so the effect is not immediately obvious. Logic tells us that an increase in currency decreases reserves and so decreases the money supply. C. The Limits of the Central Bank’s Ability to Control the Quantity of Money 1. There is no tight link between the monetary base and the quantity of money. 2. In places like the United States, Europe, and Japan, the link between the central bank’s balance sheet and the quantity of money circulating in the economy has become too weak and unpredictable to be exploited for policy purposes. 3. The problem is that the money multiplier is too variable. 4. Therefore, modern central banks keep an eye on trends in money growth since that is what ultimately determines inflation. For short-run policy, interest rates have become the monetary policy tool of choice. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 245
Chapter 17 The Central Bank Balance Sheet and the Money Supply Process Terms Introduced in Chapter 17 central bank’s balance sheet currency-to-deposit ratio deposit expansion multiplier discount loans excess reserves excess reserve-to-deposit ratio foreign exchange reserves foreign exchange intervention high-powered money monetary base multiple deposit creation open market operations (OMO) open market purchase open market sale required reserve ratio required reserves reserves T-account vault cash Lessons of Chapter 17