Balance Sheet of Bank of Canada. - Reserves (Settlement balances. - Government of Canada deposits. - SRAs (Sale and Repurchase. - Other liabilities

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1 LECTURE 7 Chapter # 5: Money Supply Process Hamza Ali Malik Econ 325: Money and Banking Winter 2007 There are four players in the money supply process: ) Central Bank: Bank of Canada 2) Banks 3) epositors 4) Borrowers from banks Balance Sheet of Bank of Canada - Government of Canada securities - Other investments - Advances to the members of CPA - Foreign currency assets - SPRAs (Special Purchase and Resale Agreements) - Other assets - Bank of Canada notes outstanding - Reserves (Settlement balances deposits of banks and vault cash) - Government of Canada deposits - SRAs (Sale and Repurchase Agreements) - Other liabilities The Monetary Base (High-Powered Money) MB = Bank of Canada s notes (and coins) outstanding + settlement balances. or MB = C + R From the balance sheet of the Bank of Canada we learned that:

2 BoC s notes outstanding + settlement balances = securities + investments + advances + foreign assets + SPRAs government deposits SRAs + other assets (net) Thus: MB = securities + investments + advances + foreign assets + SPRAs + other assets (net) government deposits SRAs + coins outstanding. Control of Monetary Base Open Market Purchase (of securities) from a Bank Securities - $000 Reserves + $000 The Banking System Securities +$000 The Bank of Canada Reserves (Settlement balances) +$000 Open Market Purchase (paid by cheque) from Public Securities - $000 Reserves + $000 Non-bank Public Banking System Securities +$000 Chequeable deposits +$000 2

3 Bank of Canada Securities +$000 Reserves +$000 Result: R $000, MB $000 If Person Cashes Cheque Securities - $000 Currency + $000 Non-bank Public Bank of Canada Securities +$000 Currency +$000 Result: R unchanged, MB $000 Bottom line: Effect on MB certain, on reserves uncertain. Multiple eposit Creation Role of Banks in the Creation of Money Suppose, as a result of an open market purchase (of $000 as described above) with the non-bank public, the balance sheet of the st Bank look like this: st Bank Reserves $000 eposits $000 Now, assume that, banks hold only a fraction of their deposits as reserves and loan out the rest. Suppose the desired reserve-deposit ratio is 20%. 3

4 Reserves $200 Loans $800 st Bank eposits $000 The total deposits in the economy will now increase, since there is still $000 worth of deposits and now there is an additional $800 back in the hands of the public, which in turn is deposited back in the banking system with 2 nd Bank. The total deposits now equal $,800. The 2 nd Bank will hold 20% ($60) as reserves and loan out the remaining 80% ($640). Reserves $60 Loans $640 2 nd Bank eposits $800 Assuming that this $640 is eventually deposited in the 3 rd Bank, the total deposits in the economy increases to $2440 ($000 + $ ). The 3 rd Bank also keeps 20% ($28) in reserves and loan out $52. Reserves $28 Loans $52 3 rd Bank eposits $640 This process goes on and on. 4

5 Letting r denote the desired reserve-deposit ratio, the amount of deposits that the original $000 creates is: Original eposit = $000 st Bank lending = ( r ) $ nd 2 Bank lending = ( r )*$000( r ) = ( r ) *$ rd 2 3 Bank lending = ( r ) *$000( r ) = ( r ) *$ Total eposits = $ 000+ ( r ) + ( r ) + ( r ) = $ 000 = $ [ +L] r ( r ) Since we had r = 20% total deposits = $5000. Thus, the original $000 of deposits creates $5000 of total deposits. Generalizing: = r * R or in change form: = r * R Critique of the Simple Model Our simple model seems to indicate that the Bank of Canada has complete control over. It ignores, however, the fact that deposit creation stops if: Proceeds from loans kept in cash. Banks holds more (or less) reserves. 5

6 Conclusion: The Bank of Canada is not the only player whose behavior influences deposits () and (M). and M depend on: The public s decisions regarding how much currency (C) to hold. The banks decisions regarding the amount of reserves (R) they wish to hold. Borrowers decisions on how much to borrow from banks. Chapter # 6: etermination of Money Supply A Model of the Money Supply The model has three exogenous variables: ) The monetary base (MB) total number of dollars held by the public as currency (C) and by banks as reserves (R). It is directly controlled by the Bank of Canada. 2) The Reserve-eposit Ratio (r ) fraction of deposits that banks hold in reserve, i.e., R r =. 3) The Currency-eposit Ratio (c) the amount of currency (C) people hold as a fraction of their holdings of deposit (), i.e., C c =. Note that c and r describe the behavior of the public and of bank respectively. 6

7 Our Objective: to link the money supply to the monetary base. We will define money supply as a money aggregate which is equal to currency in the hands of the public plus demand deposits and other checkable deposits, i.e., M = C + () Monetary base is equal to the sum of the reserve holdings of the banking sector and the currency held by the nonblank public, i.e., MB = R + C (2) ivide equation () by : M = C + or M = ( c + ) (3) ivide equation (2) by : MB = R + C ( ) or MB = r + c (4) ivide equation (3) by (4): or M MB M = ( c + ) ( r c) + + c MB r c + = (5) m = money multiplier 7

8 Numerical Example Suppose: r = 0.05, C = $40 billion, = $60 billion, M = C + = $200 billion C 40 Thus, c = = = c m = = = = 4. 2 r + c Thus, given the behavior of depositors as represented by c = 0.25 and banks as represented by r = 0.05, a $ increase in the monetary base leads to a $4.20 increase in the money supply. Note that m < r because there are multiple expansions of deposits, but no such expansion for currency. According to the analysis so far, there are two key factors that determine the money multiplier and thus affect the money supply c and r. c and r are negatively related to M. What determines c? People s preferences. What determines r? Market interest rates and expected deposit outflows. o r as market interest rate i. o r as expected deposit outflow. 8

9 Additional Considerations So far we have been assuming that the Bank of Canada has complete control over MB. This is not the case. The Bank lacks complete control over MB because it cannot unilaterally determine the amount of borrowing by banks from the Bank. Therefore, divide monetary base into two components: MB = non-borrowed monetary base (directly controlled by central bank) A = advances from the Bank of Canada (imperfectly controlled by the central bank) Thus, MB = MB n + A Therefore, M = m( MB n + A) The money supply is positively related to both MB n and A. What determines A? --- Market interest rate, i and the bank rate i b. The amount of advances (A) is positively related to the market interest rate, i and negatively related to the bank rate i b. 9