Money Supply and Its

Determinants
(Mishkin: Ch.15-16; Miller Ch.14)

It is important to understand how the

money supply is determined; Who
controls it; what causes it changes,
etc. Money Supply Process
The first step in understanding the
money supply process is
understanding how the deposit of the
bank are created
 FOUR PLAYERS IN THE
MONEY SUPPLY PROCESS

1. THE CENTRAL BANK

2. BANKS
3. DEPOSITORS
4. BORROWERS FROM BANKS
 Bank &
Supply Money Process

Under legal
requirement, a single
bank must hold required
reserves, which are equal
to a specified percentage
of total deposits
 The relationship between
reserves & total deposits in
banks
How single bank reacts to an
increase in reserves?
Assumption:
The required reserve ratio is 10%
for all transaction deposits
Bank desire to keep their excess
reserve at a zero level. (why?)
 Example:

Bank 1
Assets Liabilities
Total reserve $ Transact. deposits $
100,000 1,000,000
Required reserves
$ 100,000
Excess reserve
( $0 )
Loans $
900,000
Total $ Total $
1,000,000 1,000,000
 If the new depositors write a $
100,000 check drawn on another
bank and deposits it in bank 1:.

Assets Liabilities
Total reserve $ Transact. deps. $
200,000 1,100,000
required reserves
$110,000
Excess reserve
$ 90,000
Loans $
900,000
Total $ Total $
1,100,000 1,100,000
 Bank 1 will now lend out the $
90,000 in excess reserves in order
to obtain
interest income
Bank 1
Assets Liabilities
Total reserve $ Transact. deposits $
110,000 1,100,000
required reserves $
110,000
Excess reserve
$0
Loans $
990,000
Total $ Total $
1,100,000 1,100,000
 What happened to the
Quantities of Deposits and
Money..?

the total amount of money

and credit in the economy is
unaffected by the transfer of
funds from one bank to
another
The Feds effect on the total
reserves in the banking
system

Open Market Operations:

the buying and selling of
government securities in the
open market (by central
bank) in order to change the
quantity of money
Central bank purchase a $
100,000 government
security
Central banks Bank
Liabiliti Liabiliti
Asset Asset
es es
+$ +$ +$ 100,000 +$
100,.000 100,000 reserve 100,000
Gov. sec Bank Transacti
reserve on
deposits
 The Sale of a $ 100,000
Government Security by the
Central Bank

Central banks Bank

Asset Liabiliti Asset Liabilitie

es s
-$ -$ -$ -$
100,000 100,000 100,000 100,000
Gov. sec Bank Reserve Transc.
reserve dep
Deposits Expansion by
Banking System

How money is created?

how bank respond to Fed

action that increase reserves
in the entire system
 The Fed Purchases a $ 100,000
Government security from a bond
broker
Bank 1st
Assets Liabilities
Total reserve $ Transact. deps. $
200,000 1,100,000
Required reserves $
110,000
Excess reserve
$ 90,000
Loans $
900,000
Total $ Total $
1,100,000 1,100,000
 Continuing process(1)

Bank 1st
Assets Liabilities
Total reserve $ Transact. deposits $
110,000 1,100,000
required reserves $
110,000
Excess reserve
$0
Loans $
990,000

Total $ Total $
Continuing process(#2)
Bank 2nd
Assets Liabilities
Total reserve $ Transact. deposits $
90,000 90,000
required reserves
$ 9,000
Excess reserve
$ 81,000

Total +$ Total +$
90,000 90,000
 Continuing process(3)

Bank 2nd
Assets Liabilities
Total reserve + Transact. deposits +
$ 9,000 $ 90,000
required reserves
$ 9,000
Excess reserve
$0
Loan +$
81,000
Total + $ Total +$
90,000 90,000
 Continuation of the
Deposit Expansion
Process(1)

Bank 3rd
Assets Liabilities
Total reserve + Transact. deposits +
$ 81,000 $ 81,000
required reserves
$ 8,100
Excess reserves +
$ 72,900

Total + Total +$
$ 81,000 81,000
 A continuation.(2)

Bank 3rd
Assets Liabilities
Total reserve + Transact. deposits +
$ 8,100 $ 81,000
required reserves
($ 8,100)
Excess reserves
($ 0)
Loans
$ 72,900
Total + Total +$
$ 81,000 81,000
 What has happened to the
total amounts of deposits
and money?
This process will continue
The levels of deposits and money will
increase by
a total approaching
$ 1,000,000 (see: Miller ; p. 337)
The mechanism would work, if bank used

their excess reserves to acquire interest-

earning securities instead of to make loans
The Max. Potential Effect on the Money Supply
of an Increase in Reserves of $ 100,000 with a
10% RR

Bank New Possb.loan RR

Deps &Inv
1 100,000 90,000 10,000
2 90,000 81,000 9,300
3 81,000 72,900 8,100
4 72,900 65,610 7,290
5 65,610 59,049 6,561
6 59,049 53,144 5,905
7 53,144 47,830 5,314
8 47,830 43,047 4,783
All other 430,467 387,420 43,047
banks
 The simplest deposit
(money) expansion
multiplier
TR = d x D

TR/d = (d x D)/d

1/d x TR = D
Where; 1/d : deposit expansion multiplier
d : required reserve ratio for
transaction deposits
TR : total reserve
D : transaction deposits