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MATP Session 17a

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17 views21 pages

MATP Session 17a

Uploaded by

Deepti Bhagavatula
Copyright
© © All Rights Reserved
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Macroeconomic

Theory and Policy

Session-17
Part-1

Biswa Swarup Misra


A model of the money supply
exogenous variables

▪ Monetary base, B = C + R
controlled by the central bank

▪ Reserve-deposit ratio, rr = R/D


depends on regulations & bank policies

▪ Currency-deposit ratio, cr = C/D


depends on households’ preferences

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 31


Solving for the money supply:
C +D
M = C +D = B = m B
B
where
C +D
m =
B

=
C +D
=
(C D ) + (D D )
=
cr + 1
C +R (C D ) + (R D ) cr + rr

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 32


The money multiplier

cr + 1
M = m B, where m =
cr + rr
▪ If rr < 1, then m > 1
▪ If monetary base changes by B,
then M = m  B
▪ m is the money multiplier,
the increase in the money supply
resulting from a one-dollar increase
in the monetary base.
Session 16 Money and Money Multiplier Biswa Swarup Misra slide 33
Exercise
cr + 1
M = m B, where m =
cr + rr

Suppose households decide to hold more of


their money as currency and less in the form of
demand deposits.
1. Determine impact on money supply.
2. Explain the intuition for your result.

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 34


Solution to exercise
Impact of an increase in the currency-deposit ratio
cr > 0.
1. An increase in cr increases the denominator
of m proportionally more than the numerator. So
m falls, causing M to fall.
An increase in cr raises both the numerator and denominator of the expression
for m. But since rr < 1, the denominator is smaller than the numerator, so a
given increase in cr will increase the denominator proportionally more than the
numerator, causing a decrease in m.

2. If households deposit less of their money, then


banks can’t make as many loans, so the banking
system won’t be able to “create” as much money.

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 35


Why the RBI/Fed can’t precisely
control M
cr + 1
M = m  B , where m =
cr + rr
▪ Households can change cr,
causing m and M to change.
▪ Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves,
then rr, m, and M change.

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 36


The Monetary Base, the Money Multiplier, and the
Money Supply in the United States-2009

slide 37
CASE STUDY: Bank failures in the 1930s

▪ From 1929 to 1933,


▪ Over 9,000 banks closed.
▪ Money supply fell 28%.
▪ This drop in the money supply may have caused
the Great Depression.
It certainly contributed to the severity of the
Depression.

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 38


CASE STUDY: Bank failures in the 1930s

cr + 1
M = m B, where m =
cr + rr
▪ Loss of confidence in banks
 cr  m
▪ Banks became more cautious
 rr  m

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 39


The money multiplier during the
Great Depression
▪ The money multiplier is usually fairly stable, but
it fell sharply in the Great Depression
▪ The decline in the multiplier was due to bank
panics, which affected the multiplier in two ways
▪ People became mistrustful of banks and
increased the currency-deposit ratio
▪ Banks held more reserves, in anticipation of
bank runs, which raised the reserve-deposit
ratio

slide 40
CASE STUDY: Bank failures in the 1930s

August 1929 March 1933 % change


M 26.5 19.0 –28.3%
C 3.9 5.5 41.0
D 22.6 13.5 –40.3
B 7.1 8.4 18.3
C 3.9 5.5 41.0
R 3.2 2.9 –9.4
m 3.7 2.3 –37.8
rr 0.14 0.21 50.0
cr 0.17 0.41 141.2
Session 16 Money and Money Multiplier Biswa Swarup Misra slide 41
The currency-deposit ratio and the reserve-deposit
ratio in the Great Depression

Source: Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960: Currency—Table A-1, column (1); deposits, total
commercial banks (demand and time)—Table A-1, column (4); bank reserves—Table A-2, column (3).
slide 42
CASE STUDY: Bank failures in the 1930s

▪ Even though the monetary base grew


20% from March 1930 to March 1933,
the money supply fell 35%
▪ As a result, the price level fell sharply
(nearly one-third) and there was a
decline in output (though attributing the
drop in output to the decline in the
money supply is controversial)

slide 43
Monetary Variables in the Great Depression

Source: Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960: Currency—Table A-1, column (1); deposits, total
commercial banks (demand and time)—Table A-1, column (4); bank reserves—Table A-2, column (3); base = currency + reserves; money multiplier =
(currency + deposits)/base; money = currency + deposits. slide 44
Could this happen again?
▪ Many policies have been implemented since the
1930s to prevent such widespread bank failures.
▪ E.g., Federal Deposit Insurance,
to prevent bank runs and large swings in the
currency-deposit ratio.

Session 16 Money and Money Multiplier Biswa Swarup Misra slide 45


Money Multiplier during the Financial Crisis of 2008
▪ The money multiplier during the financial crisis of 2008
▪ The worldwide financial panic in fall 2008 caused
the money multiplier to decline sharply, especially
because of a sharp rise in the reserve-deposit ratio
▪ Banks wanted to hold more reserves because the
Fed began paying interest on reserves and because
the Fed increased the monetary base significantly
and banks had few good lending opportunities
▪ Despite the sharp decline in the money multiplier,
the money supply increased because the Fed
significantly increased the monetary base by more
than the decline in the money multiplier
slide 46
The currency-deposit ratio and the reserve-deposit
ratio, 2007–2009

Source: Authors’ calculations based on data from Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2; variables are currency—
CURRSL, deposits—M2SL – CURRSL; reserves—ADJRESSL.

slide 47
Monetary variables in the financial crisis of 2008

Source: Authors’ calculations based on data from Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2; variables are currency—
CURRSL, deposits—M2SL – CURRSL; reserves—ADJRESSL.

slide 48
GDP, M3 and Velocity of Circulation in India

Components 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 Formula


Currency in Circulation 1 429578 504099 590801 691153 799549 949660 1067890
Cash with Banks 2 17454 21244 22390 25703 32056 37820 41300
Currency with the Public 3 412124 482854 568410 665450 767492 911840 1026600 1-2
'Other' Deposits with the RBI 4 6869 7496 9054 5570 3839 3650 3060
Bankers' Deposits with the RBI 5 135511 197295 328447 291275 352299 423510 356290
Demand Deposits 6 407423 477604 578372 588688 717970 722860 700220
Time Deposits 7 1893104 2342113 2862046 3535105 4113430 4865770 5614200
Reserve Money 8 571958 708890 928302 987998 1155686 1376820 1427240 1+4+5
Narrow Money 9 826415 967955 1155837 1259707 1489301 1638350 1729870 3+4+6

Broad Money 10 2719519 3310068 4017882 4794812 5602731 6504120 7344069 3+4+6+7
Reserves with RBI 11 142380 204791 337501 296845 356138 427160 359350 4+5
M3 based Money Multiplier 12 4.8 4.7 4.3 4.9 4.8 4.7 5.1 10/8
M1based Money Multiplier 13 1.4 1.4 1.2 1.3 1.3 1.2 1.2 9/8

GDP at Market Prices 14 3693369 4294706 4987090 5630063 6457352 7674148 8855797
Velocity of Circulation wrt M3 15 1.4 1.3 1.2 1.2 1.2 1.2 1.2 14/12
Velocity of Circulation wrt M1 16 4.5 4.4 4.3 4.5 4.3 4.7 5.1 14/9
Summary

slide 50

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