Topic 5 factors that determine the money multiplier

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Topic 5: Factors that Determine the Money Multiplier Based on the above expression for the money multiplier, we note that the money multiplier is affected by the following two factors: the currency ratio c = ( C / D ), and the desired reserves ratio r = R/D. As we saw in topic four, the currency ratio, c, represents the amount of cash individuals hold relative to the amount of chequable deposits they have with the banking system. It can be shown that, r remaining constant, the more currency and the less deposits individuals hold (i.e., the currency ratio c increases), the lower will be the value of the money multiplier. To see this, let‘s look at example no. 2: Assume that c = 0.8 (that is, depositors hold 80% of their funds as currency, instead of 50% as in example no.1), then the money multiplier becomes m = (1 + 0.8) / (0.8 + 0.1) = 2, lower than 2.5 in example no.1 where c = 0.5. Thus, for a given r, we can say that c and m are always negatively (inversely) related. It can also be seen that as the desired reserve ratio, r, increases, the amount of loans a bank can make decreases. As a result, the money multiplier, m, will be reduced. To illustrate this point, let‘s look at example no. 3: As in example no.1, we assume that c = 0.5, but now r increases from 10% to 15%. Then the money multiplier is m = (1 + 0.5) / (0.5 + 0.15) = 2.3, which is less than m = 2.5 in example no.1. That is, for a given c, we can say that r and m are also inversely related.[1] Other Factors Determining the Money Supply We have assumed above that the Bank of Canada has complete control over the MB. But it may not have perfect control over the monetary base because it cannot determine the amount of borrowing by members of the Canadian Payments Association. To account for the possibility that borrowing by depository institutions is their decision over which the Bank of Canada has no control, we split the MB into two parts: (i) the monetary base created by advances from the Bank of Canada, which may be termed borrowed reserves (BR) over which the Bank of Canada has little control, and (ii) the non-borrowed component of the monetary base (MB n ) which the Bank of Canada can control completely (for example by making open market purchases and sales). We may, thus, write the money supply as equation (6), which is reproduced here for convenience: The following results follow from equation, (please see page 424 of the text): (a) the money supply is positively (directly) related to the non-borrowed monetary base (MB n ), and (b) the money supply is positively related to the level of BR, reserves borrowed from the Bank of Canada. We can summarize the role and behaviour of the four players in the money supply process as follows: (a) the Bank of Canada‘s role through setting the bank rate (that would influence BR above) and open market operations (that would control MB n ); (b) individuals‘ preferences for holding cash and deposits, the c -ratio; (c) the desire of depository institutions to hold excess reserves, the r-ratio, and their preferences for borrowing from the Bank of Canada; (d) borrowers from depository institutions. (Please see the text for details).

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