Lecture 9: The money supply process
Lecture 5.1
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The money supply process (part 1)
Source: Mishkin ch 15
Learning objectives
Primary objective: Understand the traditional view of how money is created
Within this framework:
List and describe the factors affecting a central bank’s assets and liabilities
Understand the role of the monetary base
money created by the central bank
Explain and illustrate the process of deposit creation by banks
Explain the concept of the money multiplier
the money used by the public is a multiple of the money created by the central bank, because it includes bank deposits
The balance sheet: review of basic concepts
A balance sheet measures the financial position of a company at a point in time
Sometimes referred to as a Statement of Financial Position
Assets (A) are things owned by the company
or equivalently, uses of funds
Liabilities (L) are claims on the company
or equivalently, sources of funds
This consists of debt (or non-capital liabilities, NKL) and capital (K)
Capital (K) represents the claims of shareholders on the net value of the company
Assets, liabilities and capital
The balance sheet always balances, so A = L
Equivalently, we can say that
A = NKL + K, or
K = A – NKL
So capital (K) represents the net value of shareholder claims (assets minus debt)
This is why the balance sheet always balances
any change in A – NKL means there is a corresponding change in K
Example of a simple balance sheet
Before asset loss
Assets Liabilities
Land 100 Bank loan 90
Capital 10
Total 100 Total 100
Land value falls by $9m
Assets Liabilities
Land 91 Bank loan 90
Total 91 Total 91
If K falls below zero, the company is insolvent
It has insufficient assets to repay its debts
Financial assets and liabilities
A financial asset is a claim on another person or entity
example: a government security
A non-financial asset is any other item of value that can be owned
example: land, buildings, equipment
Whenever a financial asset is created, a corresponding liability if also created
example: the government issues a bond. This is a liability of the government and an asset to the holder
example: a bank loan. This is an asset of the bank and a liability of the borrower
Deposits, loans and reserves
These are all examples of financial claims, so they are an asset to the claimholder and a liability to the other party
Deposits at a commercial bank are an asset of the depositor and a liability of the bank
Loans of a commercial bank are assets of the bank and liabilities of the borrower
Bank reserves are deposits of the commercial banks with the CB
Hence they are an asset of the commercial bank and a liability of the central bank
The central bank balance sheet
Securities
Loans to banks
[FX reserves]
Liabilities
Currency in circulation (C)
Bank reserves (R)
Deposits of Government (G)
Capital of the central bank (K)
Main items of the simplified CB balance sheet
Securities: mainly government securities held by the central bank
Loans to commercial banks: the central bank can lend to commercial banks, usually on a secured basis, using government or other securities as collateral
Currency in circulation: this is a liability, or source of funds, of the central bank (and, correspondingly an asset in the hands of the holder)
Bank reserves: deposits by commercial banks with the central bank, used for settling interbank payments. A liability of the central bank, and correspondingly an asset to the account holder.
The monetary base and the central bank balance sheet
Also known as high powered money
This is the money that is directly created by the central bank
Concept: any liability of the central bank that can be used as a means of payment
Definition: MB = C + R [currency on issue, plus bank reserves at the central bank]
In principle, in a simplified model, the central bank can control the size of the monetary base through open market operations (the sale or purchase of securities)
Central bank market operations and the monetary base
Assets Liabilities
Securities Currency (C)
Loans to banks Bank reserves (R)
Other assets (assumed unchanged) Capital and other liabilities (assumed unchanged)
Any decision by the CB to:
buy or sell securities, or
to change the amount of loans to commercial banks
… must result in an equal change to (C+R)
Open market operations: simple examples
(1) purchase of bonds by the central bank
Banking system
The banking system sells securities to CB and receives an increase in reserves
Central bank
In this example, the monetary base has increased by $100m
Assets Liabilities
Securities -$100m
Reserves +$100m
Assets Liabilities
Securities +$100m Reserves +$100m
Open market operations: simple examples
(2) sale of bonds by the central bank
Banking system
The banking system receives bonds, paid for by a reduction in reserves held at the central bank
Central bank
The monetary base falls by $100m
Assets Liabilities
Securities +$100m
Reserves -$100m
Assets Liabilities
Securities -$100m Reserves -$100m
Open market operations of the central bank: summary
The central bank can change the monetary base by direct sale or purchase of assets
Normally this would be done through the sale or purchase of government securities
A purchase of securities increases the monetary base (expansionary)
A sale of government securities reduces the monetary base (contractionary)
Shifts from deposits into currency
Nonbank public
Banking system
Central bank
CB balance sheet can be affected by private decisions
Assets Liabilities
Deposits -$100m
Currency +$100m
Assets Liabilities
Vault cash -$100m + $100m
Reserves -$100m Deposits -$100m
Assets Liabilities
Currency +$100m
Reserves -$100m
Central bank lending to banks
Banking system
The central bank can expand the monetary base by lending to banks
General principle: loans create deposits
Central bank
Assets Liabilities
Reserves +$100m Loans from CB +$100m
Assets Liabilities
Loans to banks +$100m Reserves +$100m
The process of money creation
We have seen an example of the principle that loans create deposits
Central bank loans create bank reserves
But, this mechanism also applies at the level of commercial banks:
commercial bank loans create bank deposits
A central bank action to expand the monetary base will induce commercial banks to increase their lending (they have more funds available to lend)
Hence, the initial impact of an expansion in the monetary base leads to flow-on effects which increase commercial bank lending and deposits
As a result, the increase in the broad money supply will be a multiple of the increase in the monetary base by the central bank
Deposit creation by a single bank (‘First National’)
The central bank buys securities from a bank. Initial impact on FN balance sheet …
FN lends out the additional reserves …
Effect on FN balance sheet after outflow of deposits to other banks …
Assets Liabilities
Securities -$100m
Reserves +$100m
Assets Liabilities
Securities -$100m Deposits +$100m
Reserves +$100m
Loans +$100m
Assets Liabilities
Securities -$100m
Loans +$100m
Describing the process of money creation
For illustration, the following slides assume:
First National Bank (FN) is small compared to the the size of the system
FN loses all its additional deposits through natural outflow
Outflows are received initially by Bank A, which then loses outflows to Bank B, etc
At each stage, the receiving bank increases lending in response to the initial inflow of deposits
Because of reserve requirements, the increase in lending is less than the initial inflow
Hence, the system converges to a new equilibrium with higher deposits
The increase in system deposits will be a multiple of the initial expansion initiated by the central bank action
Deposit creation: the banking system as a whole
Initial impact of deposit inflow
After lending out excess reserves which flow to Bank B depositors
Initial impact of deposit inflow
After lending out excess reserves which flow to Bank C depositors
Assets Liabilities
Reserves +$100m Deposits +$100m
Assets Liabilities
Reserves +$10m Deposits +$100m
Loans +$90m
Assets Liabilities
Reserves +$90m Deposits +$90m
Assets Liabilities
Reserves +$9m Deposits +$90m
Loans +$81m
Deposit creation after complete adjustment
Bank Increase in deposits ($m) Increase in loans ($m) Increase in reserves ($m)
First National 0.0 100.0 0.0
A 100.0 90.0 10.0
B 90.0 81.0 9.0
C 81.0 72.9 8.1
D 72.9 65.6 7.3
E 65.6 59.1 6.6
F 59.1 53.1 5.9
Total for all banks 1000 1000 100
The simple deposit multiplier
Deposits are created because banks lend out their excess reserves
The initial increase in reserves never disappears – it just gets passed around through the banking system
However, as the stock of deposits grows, reserve requirements grow proportionately, so excess reserves are reduced
The process continues until there are no excess reserves
The new equilibrium must satisfy the condition:
∆R = ∆D.r (where r is the reserve ratio)
We can rearrange this to give the simple deposit multiplier:
In the previous example, r = .10, so the deposit multiplier is 10
Balance sheet of the total banking system after adjustment
Assets Liabilities
Securities -$100m Deposits of non bank public +$1000m
Reserves +$100m
Loans to non bank public +$1000m
Criticisms of the simple model
The model implies precise control by the central bank over the deposit creation process by controlling the quantity of reserves (R)
In practice the links in the chain of causation are not mechanistic:
bank holdings of excess reserves may vary unpredictably
holdings of currency by the non bank public may also vary unpredictably. This will affect the deposit creation process when reserves are increased
for example, if the public chooses to hold more currency, the amount of bank deposits will be reduced for a given level of reserves
alternatively, if the money base is fixed, the amount of reserves available for banks to hold will be reduced
In both the above cases, the size of the deposit multiplier is reduced
Determination of the money supply in the simple model
Taking into account the key parameters, how is the money supply determined assuming the CB determines the money base?
In this lecture I present a slightly simplified version of Mishkin’s presentation:
I ignore the distinction between borrowed and non-borrowed reserves. This is a specifically US distinction
I also ignore the distinction between reserves required by regulation and desired excess reserves. These are just combined into the single concept of required reserves (labelled r in the following slides)
The money supply process: summary of concept
The central bank can use its market operations to determine the monetary base
Assuming some key behavioural parameters can be taken as given, this will determine the amount of available bank reserves and currency
This, in turn, determines the amount of lending by commercial banks
This then determines total bank deposits
The broad money supply is equal to currency plus bank deposits
We are now in a position to quantify the relationship between the monetary base and the supply of broad money
Determination of the money supply in the simple model
In a simple model, the money supply is equal to currency plus bank deposits of the non-bank public
The central bank is presumed to control the monetary base (currency plus reserves):
MB = C + R
Reserves are related to deposits by the equation
We can use these relationships to derive the money multiplier
The money multiplier
The process of multiple deposit creation will normally mean that the stock of money is a large multiple of the monetary base
We can write this as
The parameter m is known as the money multiplier
We can determine its value from the earlier analysis
Two key ratios
Currency ratio (ratio of desired currency holdings to deposits)
Reserve ratio (ratio of reserves to deposits)
An increase in c reduces the volume of deposit creation for a given increase in reserves
An increase in r also reduces the volume of deposit creation for a given increase in reserves
Determination of the money multiplier
We want to find the relationship between M and MB
We do this by expressing both as a function of R
M = C + D = D + c.D = (1 + c).D = (1 + c).R/r
MB = C + R = c.D + r.D = (c + r).D = (c + r).R/r
The money multiplier is defined by M = m.MB, so we just take the ratio of the two expressions above (M/MB)
m = M/MB = (1 + c)/(c + r)
Quantitative implications of the money multiplier formula
Normally the money multiplier will be a number much larger than 1, because both c and r are fractions much lower than 1
An increase in r always lowers the money multiplier
An increase in c also lowers the multiplier, unless r exceeds 1 (which should be rare) – Mishkin gives an example
If the money multiplier is constant, then the rate of growth of broad money will be the same as the rate of growth of the monetary base
Numerical example for Australia (Jan 2020)
D = 2.1 trn
C = $79 bn
M = $2.2trn (Broad money definition)
R = $38 bn
Hence MB = $117 bn
m = M/MB = 18.6
Historically the money multiplier has been quite variable because of variability in the parameters c and r
Key ratios
c = C/D = .038
r = R/D = .018
Equivalently:
m = (1 + c)/(c + r)
= 1.038/.056
Lecture 5.2
The money supply process (part 2)
Money creation in the modern economy, Bank of England 2014
Learning objectives
Review the process by which bank lending creates deposits
Understand key features of the modern central banking view of this process:
the chain of causation runs from loans to deposits to reserves
this is the opposite of the traditional view
the money supply is endogenous (determined by the economic system)
central banks adjust the quantity of reserves to meet demand for reserves
the interest rate is the monetary policy instrument of control
Contrast this with the traditional view of causation presented by Mishkin
Relationship between the two approaches
Note: All of the balance sheet identities and algebraic expressions set out in Part 1 remain valid
However, the modern central banking view asserts that causation works in the opposite direction
Two misconceptions about money creation
First misconception: household saving creates bank deposits
Reality: household saving and spending decisions only redistribute deposits between banks
Second misconception: central banks control the amount of money on deposit in banks by constraining the supply of reserves (the money multiplier approach)
Reality: modern central banks work by managing the price of reserves (the policy interest rate) not the quantity of reserves
Why study the money multiplier approach
Useful for introducing basic concepts in money and banking
Explains why the stock of broad money is so much larger than the monetary base
Useful for analysis of less developed, or highly regulated, banking systems
But, no longer used in monetary analysis in modern central banks
Money creation in reality
Most money in circulation now is in the form of bank deposits, not currency
Those deposits are created by the commercial banks themselves
They do this by making loans
This process can happen without any initial increase in bank reserves
After the event, the central bank may supply some more reserves if needed (not shown) if bank actions generate a shortage in availability of reserves
Some additional points
It is not correct to say that banks can only lend out pre-existing money
The availability of reserves at the central bank is not a constraint on bank lending in practice: there is enough ‘slippage’ at the margin
The central bank will typically supply the amount of reserves that the system needs
This means that the volume of deposits is determined by the supply and demand for bank loans
By the same argument, money can be destroyed by the opposite behaviours: thus repayment of loans reduces the amount of deposits in the system
Limits to broad money creation
Market forces acting on banks stop them from expanding credit without limit
At the margin, new loans become riskier
Limited appetite for debt by households and businesses
Monetary policy decisions of the central bank: A higher interest rate will tend to reduce bank lending and hence deposit creation
The central bank responds systematically to excessive expansion of money and credit
Market forces facing individual banks
While the availability of reserves is not a constraint on the system as a whole, each individual bank has to compete for its share of deposit and loan markets
Aggressive pricing to increase market share can reduce a bank’s profitability:
a bank that lends “too much” will have to compete more aggressively to expand its share of deposits
it may also have to compete aggressively on the loan interest rate
it also has to lend to customers who are increasingly risky
new customers with uncertain prospects
existing customers with too much debt already
Competition for market share in attracting deposits
Credit risk as a constraint on lending
A bank seeking to expand its share of the lending market may face an increase in credit risk
To compete in this way, they may need to accept a less favourable risk/return combination
In other words, they are lending to less creditworthy borrowers
Regulatory requirements as well as market forces will limit the extent to which banks can expand in this way
Hence, both credit risk and cost of attracting deposits represent practical constraints on expansion by an individual bank
These constraints are less onerous if the system as a whole is expanding
Constraints arising from behaviour of households and businesses
A generalised desire by banks to expand can generate higher loans and deposits, which the central bank would accommodate with higher reserves
In aggregate this is constrained the demand for credit by households and businesses, which will be limited by factors such as
household income (current and expected)
business investment opportunities
variable risk appetite
the interest rate (controlled by Central Bank)
Banks can’t create loans to the non-bank sectors if households and businesses don’t want to borrow, if they already have too much debt, or if they are seeking to repay debts
Monetary policy is the ultimate restraint on money creation
Central bank objectives are typically defined in terms of output and inflation
The policy instrument for achieving the objectives is the short term interest rate (the rate setting approach to monetary policy)
The policy rate of the central bank is very closely related to the interest rate on bank reserves
Central banks supply reserves to the banks as much as demanded at that rate
They do this by being willing to either lend to banks or accept deposits from banks at that rate (plus or minus a small margin)
Other things equal, a higher policy rate will tend to discourage lending and money creation. A lower rate will encourage these.
Summary: The chain of causation – two views
Classical view
Quantity setting
MB → R,M → P,Y
The money base is the instrument of CB monetary policy
The interest rate and broad money are part of the chain of causation that ultimately affects prices and output (P and Y)
Modern view
Rate setting
R → P,Y → M,MB
The interest rate is the instrument of CB monetary policy
The money supply and money base are, at best, sources of information that CBs can use in making their decisions
Implications of the Zero Lower Bound (ZLB)
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