ECO 362 MODULE 2

THEORY OF SUPPLY OF
MONEY
Definition of Money Supply
• Supply of money at any point in time is the amount of money
available in the economy in sufficiently liquid and spendable form
• What constitutes the components of money supply vary depending
on official definitions
• 2 broad definitions of money supply are identified:
a) Narrow definition of money: attributed to Keynes
• this is referred to as M1 and money supply is defined as currency
(with public) and demand deposits (with commercial banks)
• !1 = $%&&'($) + +',-(+ +'./0120
• !1 = 3 + 44
Definition of Money Supply
• This definition recognizes money’s function as a medium of exchange
• This is because cash (currency in circulation) can be spent for
transactions and demand deposits can also be used for transactions
by the issuing of cheques or transfer of money from one account to
another account to settle any business transaction
Definition of Money Supply
• b) Broad definition of money: attributed to Friedman
• This is referred to as M2 and money supply is defined as currency in
circulation plus demand deposits plus time deposits
• !2 = $%&&'($) + +',-(+ +'./0120 + 21,' +'./0120
• !2 = 3 + 44 + 54
Factors that Determine Money
Supply
• The previously widely held belief was that the supply of money in the economy
was determined solely by the central bank
• In this case money supply is exogenously determined and it is vertical
• Thus, other factors cannot affect it
• However, this view has changed and it is now accepted that other factors apart
from the central bank determine money supply
• In this case, money supply is endogenously determined and the money supply
curve has a positive slope
• It is useful to separate the discussion of the determinants of money supply into 2
based on the significant effect of the central bank on the monetary base:
1. Money multiplier
2. Other determinants of money supply
A. Money Multiplier
• The monetary base or high powered money is the total of bank reserves
plus currency held by the public
• The monetary base is important because it is possible for the central bank
to exert more precise control over the monetary base than it can over total
reserves alone
• This is achieved through the money multiplier
• Money supply is a product of money multiplier & monetary base:
• ! = # $ !% … . . (1)
• Where M = money supply
• m = money multiplier
• MB = monetary base
A. Money Multiplier
• The money multiplier signifies the extent to which money supply
changes as the monetary base changes and it is always greater than 1
• Thus, money supply changes by a greater proportion than the change
in monetary base
A. Money Multiplier: Deriving the Money
Multiplier
• Deriving the Money Multiplier
• Money multiplier is affected by the actions of 3 agents
• 1. public who DESIRE currency

• 2. banks who DESIRE excess reserves

• 3. central bank who DESIRE required reserves

A. Money Multiplier: Deriving the Money
Multiplier
• Let C = currency in circulation
• ER = excess reserves
• D = demand deposits
• RR = required reserves
• R = total amount of reserves in banking system
• r = required reserve ratio
A. Money Multiplier: Deriving the Money
Multiplier
#
•!= = !%&&'(!) &*+,- … … 1*
$
01
• e= $
= '2!'33 &'3'&4'3 &*+,- … … . 16
• 7 = 77 + 97 ……. 2
• Equation (2) implies that the total amount of reserves in the banking
system = required reserves plus excess reserves
• The total amount of required reserves = required reserve ratio (r)
times demand deposits (D)
• 77 = & 2 ; … … (3)
A. Money Multiplier: Deriving the Money
Multiplier
• !"#!$%$"$& 3 %($) 2
• + = -. + 0+ …… 4
• Equation (4) links reserves in the banking system to the amount of
demand deposits and excess reserves they can support
• ®multiple expansion of deposits can take place because required
reserve ratio (r) is less than 1, and so N1 of reserves can support more
than N1 of deposits
A. Money Multiplier: Deriving the Money
Multiplier
• Monetary base is total reserves plus currency
• !" = $ + & …. 5
• *+,*- 4 /0-1 5
• !" = 23 + 4$ + & ….. 6
• what equation (6) reveals is that if the monetary base increases and
all this increase is channelled into currency, such increase will not be
multiplied
• an increase in MB will only be multiplied if such increase is channelled
into deposits®an addition to MB that goes into excess reserves does
not support any additional deposits or currency
A. Money Multiplier: Deriving the Money
Multiplier
• From (1a) and (1b), C = cD and ER = eD
• subst C and ER into (6)
• MB = rD + eD + cD = (r + e +c)D …….(7)
• Divide (7) by (r+e+c)
#
• ! = $%&%' () …… 8
• (8)®links demand deposits (D) to monetary base (MB)
A. Money Multiplier: Deriving the Money
Multiplier
• Using narrow definition of money
• ! = # + % = # + &#
• ! = 1+& #
(
•#= …… 9
)*+
• ./012 (9) 5627 (8)
( )
• )*+ = 9*:*+ !;
A. Money Multiplier: Deriving the Money
Multiplier
#$%
• ! = &$'$% ( !) … … . 10
• ./0 (10) is similar to eqn (1) and shows the factors that affect money
multiplier
• ! = 3 ( !)
#$%
• \3 =
&$'$%
• Money multiplier is a function of
i. currency ratio (c)®set by depositors
ii. excess reserves ratio (e)® banks
iii. required reserves ratio (r)® central bank
A. Money Multiplier: Deriving the Money
Multiplier
• Currency Ratio (c) – an increase in the currency ratio means that
depositors are holding more cash
• Because as shown previously, currency is not multiplied, so increases
in the currency ratio which takes place by the conversion of demand
deposits to currency leads to a reduction in the overall level of
multiple expansion and so multiplier falls.
• ®The money multiplier and money supply have an inverse
relationship with the currency ratio (c).
A. Money Multiplier: Deriving the Money
Multiplier
• Excess reserves ratio (e) – an increase in excess reserves relative to
demand deposits by banks means that there are fewer reserves to
support demand deposits
• Thus, with the same level of monetary base, banks will reduce loans
which will lead to a reduction in level of demand deposits and a fall in
money supply ® money multiplier will fall.
• ®the money multiplier and money supply have an inverse
relationship with the excess reserves ratio (e).
A. Money Multiplier: Deriving the Money
Multiplier
• Required reserve ratio (r) – an increase in required reserve ratio on
demand deposits means that the same level of reserves cannot support as
large an amount of demand deposits ® more reserves are needed because
required reserves for these demand deposits have increased
• The resulting fall in reserves means that bank loans will fall, leading to a fall
in deposits and fall in money supply
• The reduced money supply relative to level of MB, which has remained
unchanged indicates that the money multiplier has declined as well.
• ®as r increases, less multiple expansion of demand deposits occurs, and
money multiplier falls.
• ®The money multiplier and money supply are negatively related to the
required reserve ratio (r).
(B) Other determinants of money
supply
• The previous discussion assumed that the central bank has complete
control over the monetary base and money supply is determined
exclusively by the central bank.
• In reality however, the central bank is unable to control the amount of
borrowing by banks.
(B) Other determinants of money supply
• Thus, the monetary base comprises of 2 components:
1. Borrowed reserves ®
• this is the amount of the monetary base created by discount loans from the
central bank.
• This component of the monetary base is not completely controlled by the
central bank but is determined by banks’ decisions to borrow
(B) Other determinants of money supply
2. Nonborrowed monetary base ® this component of the monetary
base results from OMOs and so is completely under the control of the
central bank
• !"# = !" − "&
• MBn = nonborrowed monetary base
• MB = monetary base
• BR = borrowed reserves from central bank
• Rewrite eqn (1)
• M = m x (MBn + BR)
• \Money supply is determined by money multiplier, non-borrowed
monetary base and borrowed reserves
(B) Other determinants of money supply
a) Changes in non-borrowed monetary base (MBn) –
• Buying of securities through OMOs by central bank increase the non-
borrowed monetary base while sales of securities decreases it.
• The nonborrowed monetary base increases as a result of buying securities
through OMO, and this increases the monetary base and so money supply will
increase.
• ® The money supply is positively related to the nonborrowed
monetary base
(B) Other determinants of money supply
• b) Changes in Borrowed Reserves (BR) from Central Bank –
• if banks increase the amount of discount loans from the central bank, the
borrowed reserves in the banking system increases and this will lead to an
increase in money supply
• ® the money supply is positively related to the level of borrowed
reserves from the central bank
Player Variable Change in Variable Money Supply
Response

Central Bank Required reserve increase decrease

ratio (r)

Central Bank Nonborrowed increase increase

monetary base
(MBn)
Central Bank Borrowed reserves increase increase
(BR)

Depositors Currency ratio (c) increase decrease

Banks Excess reserves increase decrease

ratio (e)
Example

• Calculate the money multiplier using the following information

• r = 0.10, C = N600 billion, D = N900 billion, ER = N0.6 billion,
• where r = required reserve ratio
• C = currency in circulation
• D = demand deposits
• ER = excess reserves
Example
• ! = #$%&' ()**+' = , + . = /600 23++3$% + /900 23++3$% =
/1,500 23++3$%
< >?@@ ABCCBDE
• 8 = 8)99&%8' 9:;3$ = = >F@@ ABCCBDE = 0.667
=
KL >@.? ABCCBDE
• & = &I8&(( 9&(&9J&( 9:;3$ = = = 0.0007
= >F@@ ABCCBDE
MNO MN@.??R
• !$%&' #)+;3*+3&9 = # = =
PNQNO @.M N@.@@@R N @.??R
M.??R
• = @.R?RR = 2.17
• Money multiplier = 2.17 meaning that a N1 increase in monetary base
leads to a N2.17 increase in money supply (M)