Monetary Economics

Chapter Four
The Money Supply Process
4.1 Measure of Money Stock
• Money supply or money stock:
• The total amount of money available in an economy at a particular point in time.
• several ways to define money:
• Standard measures usually include currency in circulation and demand deposits
(depositors' easily accessed assets on the books of financial institutions).
• money only in a narrower sense.
• Why money supply:
• Policy instrument.
• recorded and published, usually by the government or the central bank of the country.
• Possible effects on the price level, inflation, and the business cycle.
• Several measures for the money supply:
• the two measures of money stock are M1, and M2.
Money Stock…
1) M1 :
• the narrowest of the money supply definitions.
• Includes:
• currency held by the non-bank private sector (or held outside the bank for circulation including
traveler’s checks (TC)).
• Checkable or demand deposits held by non-bank private (firms and households) sector (D1f+D1h=D1).
• M1 is the potential base for deposit expansion and money supply creation.
2) M2:
• The broadest measure of money supply and is larger than M1.
• It includes:
• M1
• other quasi money or deposit (D2)
• Time deposits (TD), saving deposits (SD), and money market mutual funds (MMMFs) of
individuals and firms.
• M2 is the most widely accepted measure of money supply.
 • Mathematically:
Money Stock…
4.2 Players in Money Supply Process
• In unit one, we saw that if the monetary authorities wish to conduct any sort of monetary policy, they must
decide which measure of money supply.
• Which assets they are going to monitor?
• In practice, most monetary authorities work with three measures of money.
1. The monetary base
2. the M1
3. M2 measures.

• We are going to explore how changes in the quantity of money occur.

• For this purpose, money consists:
• notes and coins in circulation outside the banking system (C)
• plus, demand deposits (D)
• Put differently, we will use the M1 definition of money.
 • In studying the money supply process, the magnitude of demand deposits is very
important for two reasons.

1. It gives us an insight into the fact that changes in the quantity of money are the
outcomes of an interaction between the preferences of banks, their customers,
and the monetary authorities.

Money • The quantity of deposits will not expand, for example, unless banks can find
a profitable return from accepting deposits and making loans at the margin,

Stock… and unless clients wish to add to loan and deposit portfolios on current
terms.

2. It calls attention to the likely difficulties that monetary authorities will face
when they try to control the quantity or growth of money and credit.

• In short, the money supply is determined not only by the actions of the central bank but
also by the behavior of households (who hold money) and banks (where money is held).
 These agents whose behaviors affect the

Money Stock… supply of money are grouped into four as

follows:
Inside Money and Outside Money
• The distinction between the two rests on whether such assets can be offset by a liability of the private sector
(inside money) or cannot (outside money).
• When agents hold money balances that they use to self-finance investments, the money used is not
borrowed (i.e., the agent has no liability to reply), and hence outside money is used.
• When agents use borrowed funds in investment, probably in addition to self-financing, such money is
considered as inside money.
• For the private sector, therefore, inside money cannot be counted as an asset or as part of the aggregate
private sector‘s net worth, since the value of the asset is equal to the value of the liability (i.e., aggregate net
worth is equal to zero).
• Of the four players, the central bank is the most important.
• The central bank‘s conduct of monetary policy involves actions that affect
• balance sheet
• its holdings of assets

•
liabilities.
Money Stock…
• To discuss how the money supply is determined, we need to be familiar with the balance sheets:
• commercial banks,
• Non-bank private agents
• the central bank.

• We shall then analyze money supply changes through the base-multiplier approach.
• Let‘s first see the balance sheet of a commercial bank.
• A balance sheet is a standard double-entry accounting representation of an economic agent‘s assets and
liabilities.
• It must "balance" in that assets and liabilities must add up to the same amount .
• The left-hand side of the balance sheet lists an agent‘s assets – things that the agent owns.
• The right-hand side of a balance sheet lists an agent‘s liabilities.
• An economic liability is anything that one economic actor owes to another.
• Banks create money when they issue loans or purchase securities.
 • The following table shows a simplified balance sheet of a
Money Stock commercial bank.
Money Stock…
• The deposits that banks have received but have not lent out are called reserves.
• Bank reserves include:
• Vault cash that the bank keeps around to meet likely short-term calls such as depositors‘ withdrawals,
• deposits that the commercial bank has in an account at the central bank.

• Government securities
• The money that commercial banks loan to the government and earn some interest.
• The government, at least in principle, borrows from the public when it needs to finance a government
deficit or refinance part of its debt.
• Depending on the duration of the loan, these securities may be called bills (short-term securities) or
bonds (long-term securities).

• Deposits:
• The funds you deposit in a bank are listed among the bank‘s liabilities because it has an obligation to
repay these funds to you.
 • Loans:
• The major asset of a commercial bank and the
major way it makes its earnings is its portfolio of
loans to other economic agents.

Money • These are funds that are owed to the bank by

businesses, households, and non-profits.

Stock… • Some of these loans may be business loans,

home mortgages, or consumer loans that won't be
repaid for years.
• These assets are generally far less liquid than
vault cash or government securities.
 Let us also have a look at the

Money Stock… consolidated balance sheet

of a non-bank private sector.
Money • Now, let us discuss a simplified balance sheet of the central bank that
includes just four items (two assets and two liabilities) that are essential to
our understanding of the money supply process.
Stock…
Money Stock…
• The two liabilities on the balance sheet, currency in circulation and reserves, are often referred to as the
monetary liabilities of the central bank.
• They are an important part of the money supply story because increases in either or both will lead to an
increase in the money supply (ceteris paribus).
• The sum of the currency in circulation and reserves is called the monetary base (the central bank‘s monetary
liabilities).
• Currency in circulation is the amount of currency in the hands of the public.
• The notes and coins the central bank (or a monetary authority) issues are IOUs – I Owe You’s from the
central bank to the bearer and are also liabilities.
• The currency component of the money supply, no matter how it is defined, includes only currency in
circulation.
• It does not include any additional currency that is not yet in the hands of the public.
Money Stock…
• Reserves consist of banks‘ 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 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 into two categories:
• reserves that the central bank requires banks to hold (required reserves)
• any additional reserves the banks choose to hold (excess reserves).

• For example, the NBE might require that for every Birr of deposits at a depository institution, a certain
fraction (say, 10 cents) must be held as reserves.
• This fraction (10%) is called the required reserve ratio.
• Currently, central banks in the world pay no interest on reserves in general.
 • The two assets on the central bank‘s balance sheet are important for two reasons.
• First, changes in the asset items lead to changes in reserves and consequently
to changes in the money supply.
• Second, because these assets (government securities and discount loans) earn
interest while the liabilities (currency in circulation and reserves) do not: the
central bank makes huge profit every year – its assets earn income, and its
liabilities cost nothing!
• Government security is a category of asset that covers the central bank‘s holdings

Money
of securities issued by the government treasury.
• As you will see, the central bank provides reserves to the banking system by
purchasing securities, thereby increasing its holdings of these assets.

Stock…
• An increase in government securities held by the central bank leads to an
increase in the money supply.
• The central bank can provide reserves to the banking system by making discount
loans to banks.
• An increase in discount loans can also be the source of an increase in the money
supply.
• The interest rate charged by the central bank for these loans is called the discount
rate or the window rate.
• The window rate is the rate at which the central bank makes emergency loans to
banks that get into a liquidity crunch.
4.3 The Creation of Money
1. The Monetary Base Approach
• The mechanics of how the central bank influences the money supply.
• Central banks have various means of changing the volume of money and credit in the economy, all of
which involve changing the level of bank reserves.
• The most used tool is Open Market Operations (OMO).
• In open market operations, the central bank changes the level of bank reserves by buying or
selling government bonds.
• when the NBE undertakes a purchase of government bonds on the open market.
• Its bond holdings increase.