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Lecture 28: Money supply

Mishkin Ch14 – part B

page 351- 369

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Introduction

What affect money supply? Money supply

= monetary multiplier *money base Monetary multiplier Money base

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Open market operations are controlled by the Fed.

The Fed cannot determine the amount of borrowing by banks from the Fed (discount loans).

Split the monetary base into two components Discount loans: borrowed reserves, BRRemainder: non-borrowed monetary base,

MBn, (MBn= MB - BR )

M = m*(MBn + BR)

What affect monetary base?

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Factors that determine the money supply Previously we knew that required reserve ratio

(r), currency ratio (c), and excess reserves ratio (e) negatively affect monetary multiplier (m) and thus negatively affect money supply.

The money supply is positively related to nonborrowed monetary base (MBn).

The money supply is positively related to borrowed reserve from the Fed (MR).

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Changes in the nonborrowed monetary base (MBn )

M = m*(MBn + BR) The Fed’s open market purchase increase in

nonborrowed monetary base (MBn) increase in monetary base (MB) support more currency and deposits increase money supply (M).

The money supply (M) is positively related to the nonborrowed monetary base (MBn).

How about open market sale?

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Changes in the borrowed reserves (MR) from the Fed M = m*(MBn + BR)

If discount loans increase borrowed reserves (BR) increase monetary base (MB) increase support more currency and deposits and thus a higher money supply.

The money supply is positively related to the level of borrowed reserves, BR, from the Fed.

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Overview of the money supply process

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Application I: explain money supply movements

• change in MB (mainly MBn) is important for long-term movements.

• change in m (currency ratio c) is important for short-term movements.

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Explain money supply movements – cont’d

Over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base, which is controlled by the Fed’s open market operations.

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Application II: bank panics and reduction in money supply

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Application: bank panics and money supply – cont’d Bank panics relative risks of deposits

increase, relative expected return of deposits decrease demand for deposits decrease people shift to holding cash currency ratio c increase money multiplier m decrease money supply decrease.

In times of uncertainty expected deposit outflow increases banks would increase excess reserves ratio e money multiplier m decrease money supply decrease.

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Application: bank panics and money supply – cont’d

Although the Fed tried its best to increase monetary base, it can not fully offset the negative effect of money multiplier on money supply.

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Recap

The relationship between money supply and:excess reserve ratio interest rate, expected

deposit outflowcurrency ratio (short-term effects)Nonborrowed monetary base open market

operation (long-term effects)