Chapter FOUR

4. The money supply process

Introduction

Changes in the size of the money supply are very important in the functioning of the economy.
Thus movements in the money supply affect interest rates and the overall health of the economy
and thus affect us all. Because of its far reaching effects on economic activity, it is important to
understand how the money supply is determined, controlling mechanism of the money supply
and factors affecting the money supply and related issues.

Since deposits at banks are by far the largest component of the money supply, understanding
how these deposits are created is the first step in understanding the money supply process. This
chapter also provides an overview of how the banking system creates deposits.

4.1. The four players in the money supply process

1. The central bank – the government agency that oversees the banking system and is responsible
for the conduct of monetary policy. This bank takes different names in different countries; the
Federal reserve system in the United states and National Bank in Ethiopia, for instance

2. Banks (depository institutions) – the financial intermediaries that accept deposits from
individuals and institutions and make loans: commercial banks, savings and loan associations,
mutual savings banks, and credit unions.

3. Depositors – individuals and institutions that hold deposits in banks.

4. Borrowers from banks – individuals and institutions that borrow from the depository
institutions and institutions that issue bonds that are purchased by the depository institutions.

4.2. The central bank balance sheet and the monetary base

The balance sheet of banks lists assets and liabilities.

4.2.1. The central bank Balance sheet

Just as any other bank has a balance sheet that lists its assets and liabilities, so does the central
bank. We examine each of the categories of assets and liabilities because changes in them have
an important impact on the money supply.

Assets:

1. Securities – these are the central banks holdings of securities, which consist primarily of
treasury securities. The total amount of securities is controlled by open market operations (the
central bank’s purchase and sale of these securities). Securities are by far the largest category of
assets in the central

banks’ balance sheet.

2. Discount loans- these are loans the Central Bank (Fed) makes to banks, and the amount is
affected by the Central bank's setting the discount rate, the interest rate the Central bank charges
banks for these loans.

These first two Central bank assets are important because they earn interest. Because the
liabilities of the Central bank do not pay interest, the Central bank makes billions of dollars
every year. Its assets earn income and its liabilities cost nothing. Although it returns most of its
earnings to the federal government, the Central bank does spend some of it on “worthy causes”,
such as supporting economic research.

3. Gold and SDR certificate accounts. Special drawing rights (SDRS) are issued to governments
by the International Monetary Fund (IMF) to settle international debts and have replaced gold in
international financial transactions. When the treasury acquires gold or SDRs, it issues
certificates to the Central bank that are claims on the gold or SDRS and is in turn credited with
deposit balances at the Central bank. The gold and SDR accounts are made up of these
certificates issued by the Treasury.

4. Coin- this is the smallest item in the balance sheet, and it consists of Treasury currency
(mostly coins) held by the Central bank.

5. Cash items in process of collection- these arise from the Central bank’s check-clearing
process. When a check is given to the Central bank for clearing, the Central bank will present it
to the bank on which it is written and will collect funds by deducting the amount of the check
from the bank’s deposits (reserves) with the Central bank. Before these funds are collected, the
check is a cash item in process of collection and is a Central bank asset.

6. Other Federal Reserve assets. These include deposits and bonds denominated in foreign
currencies as well as physical goods such as computers, office equipment, and buildings owned
by the Central bank.

Liabilities:-

1. Central bank notes (currency) outstanding. The Central bank issues currency
(those pieces of paper in your wallet). The Central bank notes outstanding are
the amount of this currency that is in the hands of the public. (Currency held by
depository institutions is also a liability of the Central bank but is counted as
part of the reserves liability.)
2. Reserves. All banks have an account at the Central bank in which they hold
deposits. Reserves consist of deposits at the Central bank plus currency that is
 physically held by banks (called vault cash because it is stored in bank vaults).
Reserves are assets for the banks but liabilities for the Central bank because the
banks can demand payment on them at any time and the Central bank is
required to satisfy its obligation by paying Central bank notes. As you will see,
an increase in reserves leads to an increase in the level of deposits and hence in
the money supply.
Total reserves can be divided in to two categories: reserves that the Central
bank requires banks to hold (required reserves) and any additional reserves the
banks choose to hold (excess reserves). For example, the Central bank might
require that for every dollar of deposits at a depository institution, a certain
fraction (say, 10 cents) must be held as reserves. This fraction (10 percent) is
called the required reserve ratio.

3. Treasury deposits. The Treasury keeps deposits at the Central bank, against
which it writes all its checks.
4. Foreign and other deposits, these include the deposits with the Central bank
owned by foreign governments, foreign central banks, international agencies
(such as the World Bank and the United Nations)
5. Deferred-availability cash items. Like cash items in process of collection,
these also arise from the Central bank’s check–clearing process.
6. Other liabilities and capital accounts: this item includes all the remaining
liabilities not included elsewhere on the balance sheet. For example, stock in
the Central bank purchased by member banks is included here.

Table 4.1 Central Bank Balance Sheet

Assets Liabilities
 Securities  Currency in circulation(notes&
 Discount loans coins)
 Government  Deposits(Reserves)
 Banks  Banks reserves
 Nonbank public  Government reserves
 Fixed assets  Foreign liabilities
 International Reserves  Other liabilities
 Foreign exchange
 Gold Capital
 Other assets
Total assets Total Liabilities & Capital

4.2.2 Monetary Base

The first two liabilities on the balance sheet of the Central bank, Central bank notes (currency)
outstanding and reserves are often referred to as the monetary liabilities of the Central bank.
When we add to these liabilities the Treasury's monetary liabilities (Treasury currency in
circulation, primarily coins), we get a construct called the monetary base. The monetary base is
an important part of the money supply because increases in it will lead to a multiple increase in
the money supply (everything else being constant). This is why the monetary base is also called
high-powered money. Recognizing that Treasury currency and & Central bank currency can be
lumped together in to the category currency in circulation, denoted by C, the monetary base
equals the sum of currency in circulation C plus reserves R. The monetary base MB is expressed
as:

MB = (Central bank notes + Treasury currency - Coin) + reserves

=C+R

The items on the right-hand side of this equation indicate how the base is used and are called the
uses of the base. Unfortunately, this equation does not tell us the factors that determine the base
(the sources of the base), but the Central bank balance sheet in Table 4.1 comes to the rescue
because like all balance sheets, it has the property that the total assets on the left-hand side must
equal the total liabilities on the right-hand side. Because the " Central bank notes (currency)" and
"reserves" items in the uses of the base are Central bank liabilities, the "assets equals liabilities"
property of the Central bank balance sheet enables us to solve for these items in terms of the
Central bank balance sheet items that are included in the sources of the base: Specifically,
Central bank notes (Currency) and reserves equal the sum of all the Central bank assets minus all
the other Central bank liabilities:

MB = Securities + discount loans + gold and SDRs + f1oat + other Federal Reserve assets +
Treasury currency - Treasury deposits - foreign and other deposits -other Federal Reserve
liabilities and capital.

4.2.3 CONTROL OF THE MONETARY BASE

The Central bank exercises control over the monetary base via the first two factors: through its
purchases or sales of government securities in the open market, called open market operations,
and through its extension of discount loans to banks.

i. Open Market Operations (OMO)

The primary way in which the Central bank causes changes in the monetary base is through its
open market operations. A purchase of bonds by the Central bank is called an open market
purchase, and a sale of bonds by the Central bank is called an open market sale.

OPEN MARKET PURCHASE FROM A BANK: Suppose that the National Bank of Ethiopia
purchases Birr 100 of bonds from a bank and pays for them with a Birr 100 check. The bank will
either deposit the check in its account with the National bank or cash it in for currency, which
will be counted as vault cash. To understand what occurs as a result of this transaction, we look
at T-accounts, which list only the changes that occur in balance sheet items starting from the
initial balance sheet position. Either action means that the bank will find itself with Birr 100
more reserves and a reduction in its holdings of securities of Birr 100. The T-account for the
banking system, then, is

BANKING SYSTEM
Asset Liabilities
Securities -$100
Reserves +$100
The National bank meanwhile finds that its liabilities have increased by the additional Birr 100
of reserves, while its assets have increased by the Birr 100 of additional securities that it now
holds. Its T-account is

National bank of Ethiopia

Asset Liabilities
Securities +$100 Reserves +$100

The net result of this open market purchase is that reserves have increased by $100, the amount
of the open market purchase. Because there has been no change of currency in circulation, the
monetary base has also risen by $100.

OPEN MARKET PURCHASE FROM THE NONBANK PUBLIC: To understand what happens
when there is an open market purchase from the nonbank public; we must look at two cases.
First, let's assume that the person or corporation that sells the $100 of bonds to the Central bank
deposits the Central bank's check in the local bank. The nonbank public's T-account after this
transaction is

Nonbank public
Asset Liabilities
Securities -$100
Checkable deposits +$100
When the bank receives the check, it credits the depositor's account with the $100 and then
deposits the check in its account with the Central bank, thereby adding to its reserves. The
banking system's T-account becomes

Banking system
Asset Liabilities
Reserves +$100 Checkable deposits +$100
The effect on the Central bank's balance sheet is that it has gained $100 of securities in its assets
column, while it has an increase of $100 of reserves in its liabilities column:

Central Bank
 Asset Liabilities
Securities +$100 Reserves +$100
As you can see in the above T-account, when the Central bank's check is deposited in a bank, the
net result of the Central bank's open market purchase from the nonbank public is identical to the
effect of its open market purchase from a bank: Reserves increase by the amount of the open
market purchase, and the monetary base increases by the same amount.

If, however, the person or corporation selling the bonds to the Central bank cashes the Central
bank's check either at a local bank or at a Central bank for currency, the effect on reserves is
different. This seller will receive currency of $100 while reducing holdings of securities by $100.
The bond seller's T-account will be

Nonbank public
Asset Liabilities
Securities -$100
Currency +$100
The Central bank now finds that it has exchanged $100 of currency for $100 of securities, so its
T-account is

Central Bank
Asset Liabilities
Securities +$100 Currency in circulation +$100
The net effect of the open market purchase in this ease is that reserves are unchanged, while
currency in circulation increases by the $100 of the open market purchase. Thus the monetary
base increases by the $100 amount of the open market purchase, while reserves do not. This
contrasts with the case in which the seller of the bonds deposits the Central bank's check in a
bank; in that case, reserves increase by $100, and so does the monetary base.

The analysis reveals that the effect of an open market purchase on reserves depends on whether
the seller of the bonds keeps the proceeds from the sale in currency or in deposits. If the proceeds
are kept in Currency, the open market purchase has no effect on reserves; if the proceeds are kept
as deposits, reserves increase by the amount of the open market purchase.

The effect of an open market purchase on the monetary base, however, is always the same (the
monetary base increases by the amount of the purchase) whether the seller of the bonds keeps the
proceeds in deposits or in currency. The impact of an open market purchase on reserves is much
more uncertain than its impact on the monetary base.

OPEN MARKET SALE: If the Central bank sells $100 of bonds to a bank or the nonbank
public; the monetary base will decline by $100. For example, if the Central bank sells the bonds
to an individual who pays for them with currency, the buyer exchanges $100 of currency for
$100 of bonds, and the resulting T-account is

Nonbank public
 Asset Liabilities
Securities +$100
Currency -$100
The Central bank, for its part, has reduced its holdings of securities by $100 and has also lowered
its monetary liability by accepting the currency as payment for its bonds, thereby reducing the
amount of currency in circulation by $100:

Central Bank
Asset Liabilities
Securities -$100 Currency in circulation -$100
The effect of the open market sale of $100 of bonds is to reduce the monetary base by an equal
amount, although reserves remain 'unchanged. Manipulations of T-accounts in cases in which the
buyer of the bonds is a bank or the buyer pays for the bonds with a check written on a checkable
deposit account at a local bank lead to the same $100 reduction in the monetary base, although
the reduction occurs because the level of reserves has fallen by $l00.

The following conclusion can be drawn from our analysis of open market purchases and sales:
The effect of OMO on the monetary base is much more certain than the effect on reserves.
Therefore, the central bank can control the monetary base with OMO more effectively than it can
control reserves.

Open market operations can also be done in other assets besides government bonds and have the
same effects on the monetary base we have described here. One example of this is a foreign
exchange intervention by the Central bank.

Shifts from Deposits into currency

Even if the Central bank does not conduct open market operations, a shift from deposits to
currency will affect the reserves in the banking system. However, such a shift will have no effect
on the monetary base, another reason why the Central bank has more control over the monetary
base than over reserves.

Let's suppose that W/ro Roman (who opened a $100 checking account at the Commercial bank
of Ethiopia) decides that tellers are so abusive in all banks that she closes her account by
withdrawing the $100 balance in cash and vows never to deposit it in a bank again. The effect on
the T-account of the nonbank public is

Nonbank public
Asset Liabilities
Checkable deposits -
$100
Currency +$100
The banking system loses $100 of deposits and hence $100 of reserves:
 Banking System
Asset Liabilities
Reserves -$100 Checkable deposits -$100
For the Central bank, W/ro Roman's action means that there is $100 of additional Currency
circulating in the hands of the public, while reserves in the banking system have fallen by $100.
The Central bank's T-account is

Central Bank
Currency in circulation +$100
Reserves -$100

The net effect on the monetary liabilities of the Central bank is a wash; the monetary base is
unaffected by W/ro Roman's disgust at the banking system. But reserves are affected. Random
fluctuations of reserves can occur as a result of random shifts into currency and out of deposits,
and vice versa. The same is not true for the monetary base, making it a more stable variable.

ii. Discount Loans

In this chapter so far we have seen changes in the monetary base solely as a result of open
market operations. However, the monetary base is also affected when the Central bank makes a
discount loan to a bank. When the Central bank made a $100 discount loan to the Commercial
Bank of Ethiopia, the bank was credited with $100 of reserves from the proceeds of the loan. The
effects on the balance sheet of the banking system and the Central bank are illustrated by the
following T-accounts:

Banking System
Asset Liabilities
Reserves + Discount loans +$100
$100

Central Bank
Asset Liabilities
Discount Reserves +$100
loans +$100
The monetary liabilities of the Central bank have now increased by $100 and the monetary base,
too, has increased by this amount. However, if a bank pays off a loan from the Central bank,
thereby reducing its borrowings from the Central bank by $100, the T accounts of the banking
system and the Central bank are as follows:

Banking System
Asset Liabilities
Reserves - Discount loans -$100
$100
 Central Bank
Asset Liabilities
Discount Reserves -$100
loans -$100
The net effect on the monetary liabilities of the Central Bank, and hence on the monetary base, is
then a reduction of $100. We see that the monetary base changes one-for-one with the change in
the borrowings from the Central bank.

4.2.4 Overview of the Central Bank's Ability to Control the Monetary Base

The factor that most affects the monetary base is the Central bank's holdings of securities, which
are completely controlled by the Central bank through its open market operation Factors not
controlled by the Central bank (for example, float and Treasury deposits with the Central bank)
undergo substantial short – run variations and can be important sources of fluctuation in the
monetary base over time periods as short as a week. However, these fluctuations are usually
quite predictable and so can be offset through open market operations. Although float and
Treasury deposits with the Fed undergo substantial short-run fluctuations, which complicate
control of the monetary base, they do not prevent the Central bank from accurately controlling it.

4.3 MULTIPLE DEPOSIT CREATION: A SIMPLE MODEL

With our understanding of how the Central bank controls the monetary base and the banking
system, we now have the tools necessary to explain how deposits are created. When the Central
bank supplies the banking system with $1 of additional reserves, deposits increase by a multiple
of this amount - a process called multiple deposit creation.

4.3.1 Deposit Creation: The Single Bank

Suppose that the $100 open market purchase described earlier was conducted with the
Commercial Bank of Ethiopia. After the Central bank has bought the $100 bond from the
Commercial Bank of Ethiopia, the bank finds that it has an increase in reserves of $100. To
analyze what the bank, will do with these additional reserves, assume that the bank does not want
to hold excess reserves because it earns no interest on them, We begin the analysis with the
following T-account:

Commercial Bank of Ethiopia

Asset Liabilities
Securities -$100
Reserves +$100
Because the bank has no increase in its checkable deposits, required reserves remain the same,
and the bank finds that its additional $100 of reserves means that its excess reserves have
increased by $100. Let's say that the bank decides to make a loan equal in amount to the $100
increase in excess reserves. When the bank makes the loan, it sets up a checking account for the
borrower and puts the proceeds of the loan into this account. In this way the bank alters its
balance sheet by increasing its liabilities with $100 of checkable deposits and at the same time
increasing its assets with the $100 loan. The resulting T-account looks like this:

Commercial Bank of Ethiopia

Asset Liabilities
Securities -$100 Checkable deposits +$100
Reserves +$100
Loans +$100

The bank has created checkable deposits by its act of lending. Because checkable deposits are
part of the money supply, the bank's act of lending has in fact created money.

In its current balance sheet position, the Commercial Bank of Ethiopia still has excess reserves
and so might want to make additional loans. However, these reserves will not stay at the bank for
very long. The borrower took out a loan not to leave $100 idle at the Commercial Bank of
Ethiopia but to purchase goods and services from other individuals and corporations. When the
borrower makes these purchases by writing checks, they will be deposited at other banks, and the
$100 of reserves will leave the Commercial Bank of Ethiopia. A bank cannot safely make loans
for an amount greater than the excess reserves it has before it makes the loan.

The final T-account of the Commercial Bank of Ethiopia is

Commercial Bank of Ethiopia

Asset Liabilities
Securities +$100
Loans -$100

The increase in reserves of $100 has been converted into additional loans of $100 at the
Commercial Bank of Ethiopia, plus an additional $100 of deposits that have made their way to
other banks. (All the checks written on accounts at the Commercial Bank of Ethiopia are
deposited in banks rather than converted into cash because we are assuming that the public does
not want to hold any additional currency.) Now let's see what happens to these deposits at the
other banks.

4.3.2 Deposit Creation: The Banking System

To simplify the analysis, let us assume that the $100 of deposits created by Commercial Bank of
Ethiopia's loan is deposited at Wegagen Bank and that this bank and all other banks hold no
excess reserves. Wegagen's T-account becomes

Wegagen Bank
Asset Liabilities
Reserves +$100 Checkable deposits +$100

If the required reserve ratio is 10 percent, this bank will now find itself with a $10 increase in
required reserves, leaving it $90 of excess reserves. Because Wegagen Bank (like the
Commercial Bank of Ethiopia) does not want to hold on to excess reserves, it will make loans for
the entire amount. Its loans and checkable deposits will then increase by $90, but when the
borrower spends the $90 of checkable deposits, they and the reserves at Bank A will fall back
down by this same amount. The net result is that Wegagen Bank 's T-account will look like this:

Wegagen Bank
Asset Liabilities
Reserves +$10 Checkable deposits +$100
Loan +$90
If the money spent by the borrower to whom Wegagen Bank lent the $90 is deposited in another
bank, such as Awash International Bank, the T-account for Awash International Bank will be

Awash International Bank

Asset Liabilities
Reserves +$90 Checkable deposits +$90

The checkable deposits in the banking system have increased by another $90, for a total increase
of $190 ($100 at Wegagen Bank plus $90 at Awash International Bank). In fact, the distinction
between Wegagen Bank and Awash International Bank is not necessary to obtain the same result
on the overall expansion of deposits. If the borrower from Wegagen Bank writes checks to
someone who deposits them at Wegagen Bank, the same change in deposits would occur. The T-
accounts for Awash International Bank would just apply to Wegagen Bank, and its checkable
deposits would increase by the total amount of $190.

Awash International Bank will want to modify its balance sheet further. It must keep 10 percent
of $90 ($9) as required reserves and has 90 percent of $90 ($81) in excess reserves and so can
make loans of this amount. Awash International Bank will make an $81 loan to a borrower, who
spends the proceeds from the loan. Awash International Bank T-account will be

Awash International Bank

Asset Liabilities
 Reserves +$9 Checkable deposits +$90
Loan +$81
The $81 spent by the borrower from Awash International Bank will be deposited in another bank
(Dashen Bank). Consequently, from the initial $100 increase of reserves in the banking system,
the total increase of checkable deposits in the system so far is $271 (= $100 + $90 + $81).

Following the same reasoning, if all banks make loans for the full amount of their excess
reserves, further increments in checkable deposits will continue (at Dashen Bank, Abyssinia
Bank, United Bank, and so on), as depicted in Table 4.3. Therefore, the total increase in deposits
from the initial $100 increase in reserves will be $1000: The increase is tenfold, the reciprocal of
the 0.10 reserve requirement.

If the banks choose to invest their excess reserves in securities, the result is the same. If
Wegagen Bank had taken its excess reserves and purchased securities instead of making loans,
its T-account would have looked like this:

Wegagen Bank
Asset Liabilities
Reserves +$10 Checkable deposits +$100
Securities +$90

When the bank buys $90 of securities, it writes a. $90 check to the seller of the securities, who in
turn deposits the $90 at a bank such as Awash International Bank.Awash International Bank's
checkable deposits rise by $90 and the deposit expansion process is the same as before. Whether
a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on
deposit expansion is the same.

TABLE 4.3 Creation of Deposits (assuming 10 percent reserve requirement and a $100 increase
in reserves)

Bank Increase in Deposits Increase in Loans ($) Increase in Reserves

($) ($)
Commercial Bank of 0.00 100.00 0.00
Ethiopia
Wegagen Bank 100.00 90.00 10.00
Awash Internationa 90.00 81.00 9.00
Bank
Dashen 81.00 72.90 8.10
Abyssinia Bank 72.90 65.61 7.29
United Bank 65.61 59.05 6.56
Nib International Ban 59.05 53.14 5.91
--- ----- --- -----
----- ------ --- -----
------- ------ ----- ------
Total for all bank 1000.00 1000.00 100.00

You can now see the difference in deposit creation for the single bank versus the banking system
as a whole. Because a single bank can create deposits, equal only to the amount of its excess
reserves, it cannot by itself generate multiple deposit expansion. A single bank cannot make
loans greater in amount than its excess reserves because the bank will lose these reserves as the
deposits created by the loan find their way to other banks. However, the banking system as a
whole can generate a multiple expansion of deposits because when a bank loses its excess
reserves, these reserves do not leave the banking System even though they are lost to the
individual bank. So as each bank makes a loan and creates deposits, the reserves find their way
to another bank, which uses them to make additional loans and create additional deposits. As you
have seen, this process continues until the initial increase in reserves results in a multiple
increase in deposits.

The multiple increases in deposits generated from an increase in the banking system's reserves is
called the simple deposit multiplier. In our example with a 10 percent required reserve ratio, the
simple deposit multiplier is 10. More generally, the simple deposit multiplier equals the
reciprocal of the required reserve ratio, expressed as a fraction (10 = 1/0.10), so the formula for
the multiple expansions of deposits can be written as:

1
∆ D= .∆ R
rD

Where: ∆D = change in total checkable deposits in the banking system

rD = required reserve ratio (0.10 in the example)

∆R =change in reserves for the banking system ($100 in the example).

The multiple deposit creation process should also work in reverse; that is, when the Central Bank
withdraws reserves from the banking system, there should be a multiple contraction of deposits.
To prove this, let us trace the effect of a reduction of reserves in the banking system when again
we assume that banks do not hold any excess reserves.

Deriving the Formula for Multiple Deposit Creation

The formula for the multiple creations of deposits can also be derived directly using algebra. We
obtain the same answer for the relationship between a change in deposits and a change in
reserves, but more quickly.

Our assumption that banks do not hold on to any excess reserves means that the total amount of
required reserves for the banking system RR will equal the total reserves in the banking system
R:
 RR=R……………………………………………………………………..
(1)

The total amount of required reserves equals the required reserve ratio rD times the total amount
of checkable deposits D:

RR = rD X D............................................................................................ (2)
Substituting rD X D for RR in the first equation,

rD X D = R..............................................................................................(3)
and dividing both sides of the preceding equation by rD gives us

1
D= . R ………………………………………………………………………………..(4)
rD

Taking the change in both sides of this equation and using delta to indicate a change,
1
∆ D= . ∆ R …………………………………………………………………………………(5)
rD

4.3.3 DETERMINANTS OF THE MONEY SUPPLY

We have already developed a simple model of multiple deposit creation that showed how the
Central Bank can control the level of checkable deposits by setting the required reserve ratio and
the level of reserves. Unfortunately for the Central Bank, life isn't that simple; control of the
money supply is far more complicated. Our critique of this model indicated that decisions by
depositors about their holdings of currency and by banks about their holdings of excess reserves
also affect the money supply. To deal with these criticisms, in this chapter we develop a money
supply model in which depositors and banks assume their important roles. The resulting
framework provides an in-depth description of the money supply process to help you understand
the complexity of the Central Bank 's role.

To simplify the analysis, we separate the development of our model into several steps.

First, because the Fed can exert more precise control over the monetary base (currency in
circulation plus total reserves in the banking system) than it can over total reserves alone, our
model links changes in the money supply to changes in the monetary base. This link is achieved
by deriving a money multiplier (a ratio that relates the change in the money supply to a given
change in the monetary base). Finally, we examine the determinants of the money multiplier.

In deriving a model of the money supply process, we focus here on a simple definition of money
(currency plus checkable deposit), which corresponds to Ml. Although other broader definitions
of money are frequently used in policymaking, particularly M2, conduct the analysis with an Ml
definition because it is less complicated and yet provides a basic understanding of the money
supply process. Furthermore, all analyses and results using the M1 definition apply equally well
to the M2 definition.

4.3.4 THE MONEY SUPPLY MODEL AND THE MONEY MULTIPLIER

Because, as we saw at the beginning of this Chapter, the Central Bank can control the monetary
base better than it can control reserves, it makes sense to link the money supply M to the
monetary base MB through a relationship such as the following:

M= m X MB........................................................................................ (6)

The variable m is the money multiplier, which tells us how much the money supply changes for a
given change in the monetary base MB. This multiplier tells us what multiple of the monetary
base is transformed into the money supply. Because the money multiplier is larger that 1, the
alternative name for the monetary base, high-powered money, is logical; a $1 change in the
monetary base leads to more than a $1 change in the money supply.

The money multiplier reflects the effect on the money supply of other factors besides the
monetary base, and the following model will explain the factors that determine the size of the
money multiplier. Depositors' decisions about their holdings of currency and checkable deposits
are one set of factors affecting the money multiplier. Another involves the reserve requirements
imposed by the Fed on the banking system. Banks' decisions about excess reserves also affect the
money multiplier.

Deriving the Money Multiplier

In our model of multiple deposit creation above, we ignored the effects on deposit creation of
changes in the public's holdings of currency and banks' holdings of excess reserves. Now we
incorporate these changes into our model of the money supply process by assuming that the
desired level of currency C and excess reserves ER grows proportionally with checkable deposits
D; in other words, we assume that the ratios of these items to checkable deposits are constants in
equilibrium:

{C/D} = currency ratio

{ER/D} = excess reserves ratio

Where the braces indicate that we are treating the ratio as a constant in equilibrium. We will now
derive a formula that describes how the currency ratio desired by depositors, the excess reserves
ratio desired by banks; and the required reserve ratio set by the Central Bank affect the multiplier
m. We begin the derivation of the model of the money supply with the equation which states that
the total amount of reserves in the banking system R equals the sum of required reserves RR and
excess reserves ER. (Note that this equation corresponds to the equilibrium condition RR = R in
equation 1, where excess reserves were assumed to be zero.).
The total amount of required reserves equals the required reserve ratio rD times the amount of
checkable deposits D:

RR = rD X D............................................................................ (7)

Substituting rD X D for RR in the first equation yields an equation that links reserves in the
banking system to the amount of checkable deposits and excess reserves they can support:

R = (rD X D) + ER............................................................................. (8)

A key point here is that the Central Bank sets the required reserve ratio rD to be less than 1. Thus
$1 of reserves can support more than $1 of deposits, and the multiple expansions of deposits can
occur.

Let's see how this works in practice. If excess reserves are held at zero (ER = 0), the required
reserve ratio is set at rD = 0.10, and the level of checkable deposits in the banking system is
$80Q billion, the amount of reserves needed to support these deposits is $80 billion (= 0.10 X
$800 billion). The $80 billion of reserves can support ten times this amount in checkable deposits
because multiple deposit creation will occur.

Because the' monetary base ME equals currency C plus reserves R, we can generate an equation
that links the amount of monetary base to the levels of checkable deposits and currency by
adding currency to both sides of the equation:

MB = R + C = (rD X D) + ER + C...................................................(9)

Another way of thinking about this equation is to recognize that it reveals the amount of the
monetary base that is needed to support the existing amounts of checkable deposits, currency,
and excess reserves.

An important feature of this equation is that an additional dollar of MB that arises from an
additional dollar of currency does not support any additional deposits. This occurs because such
an increase leads to an identical increase in the right-hand side of the equation with no change
occurring in D. The currency component of MB does not lead to multiple deposit creation as the
reserves component does. Put another way, an increase in the monetary base that goes into
currency is not multiplied, whereas an increase that goes into supporting deposits is multiplied.

Another important feature of this equation is that an additional dollar of MB that goes into excess
reserves ER does not support any additional deposits or currency. The reason for this is that
when a bank decides to hold excess reserves, it does not make additional loans, so these excess
reserves do not lead to the creation of deposits. Therefore, if the Fed injects reserves into the
banking system and they are held as excess reserves, there will be no effect on deposits or
currency and hence no effect on the money supply, In other words, you can think of excess
reserves as an idle component of reserves that are not being used to support any deposits
(although they are important for bank liquidity management). This means that for a given level
of reserves, a higher amount of excess reserves implies that the banking system in effect has
fewer reserves to support deposits.

To derive the money multiplier formula in terms of the currency ratio {C/D} and the excess
reserves ratio {ER/D}, we rewrite the last equation, specifying C as {C/D} X D and ER as
{ER/D} X D:

MB = (rD X D) + ({ER/D) X D). + ({CID)} XD) = (rD + {ER/D} + {C/D}) X D

We next divide both sides of the equation by the term inside the parentheses to get an expression
linking checkable deposits D to the monetary base MB:

1
D= ∗MB ………………………………………………(10)
rD+(ER/ D)+(C /D)

Using the definition of the money supply as currency plus checkable deposits (M = D +C) and
again specifying C as {C/D} X D,

M = D + ({C/D) X D) = (1 + {C/D}) X D

Substituting in this equation the expression for D from Equation 10, we have

C
1+()
D ………………………………………………………………(11)
M= ∗MB
rD+( ER/ D)+(C /D)

Finally, we have achieved our objective of deriving an expression in the form of our earlier
Equation 6. 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 (high-
powered money). The money multiplier m is thus

C
1+(
)
D ………………………………………………………………(12)
m=
rD+(ER/ D)+(C /D)

and it is a function of the currency ratio set by depositors {C/D}, the excess reserves ratio set by
banks {ER/D}, and the required reserve ratio set by the Central bank rD.

Although the algebraic' derivation we have just completed shows you how the money multiplier
is constructed, you need to understand the basic intuition behind it in order to be able to
understand and apply the money multiplier concept without having to memorize it.

4.3.5 FACTORS THAT DETERMINE THE MONEY MULTIPLIER

To develop our intuition of the money multiplier even further, let us look at how this multiplier
changes in response to changes in the variables in our model: {C/D},{ER/D}, and rD. The
"game" we are playing is a familiar one in economics: We ask what happens when one of these
variables changes, leaving all other; variables the same (ceteris paribus).

Changes in the Required Reserve Ratio r D

If the required reserve ratio on checkable deposits increases while all the other variables stay the
same, the same level of reserves cannot support as large an amount of checkable deposits; more
reserves are needed because required reserves for these checkable deposits have risen. The
resulting deficiency in reserves then means that banks must contract their loans, causing a
decline in deposits and hence in the money supply. The reduced money supply relative to the
level of MB, which has remained unchanged, indicates that the money multiplier has declined as
well. Another way to see this is to realize that when rD is higher, less multiple expansions of
checkable deposits occur. With less multiple deposit expansion, the money multiplier must fall.

The money multiplier and the money supply are negatively related to the required reserve ratio
rD.

Changes in the Currency Ratio {C/D}

Next, what happens to the money multiplier when depositor behavior causes {C/D} to increase
with all other variables unchanged? An increase in {C/D} means that depositors are converting
some of their checkable deposits into currency. As shown before; checkable deposits undergo
multiple expansions while currency does not. Hence when checkable deposits are being
converted into currency, there is a switch from a component of the money supply that undergoes
multiple expansions to one that does not. The overall level of multiple expansion declines, and so
must the multiplier.

The money multiplier and the money supply are negatively related to the currency ratio {C/D}.

Changes in the Excess Reserves Ration {ER/D}

When banks increase their holdings of excess reserves relative to checkable deposits, the banking
system in effect has fewer reserves to support checkable deposits. This means that given the
same level of MB banks will contract their loans, causing a decline in the level of checkable
deposits and a decline in the money supply, and the money multiplier will fall.

The money multiplier and the money supply are negatively related to the excess reserves ratio
{ER/D}.