Review of the Previous
Lecture
• Residential Investment
• Inventory Investment
– Seasonal Fluctuations and Production
Smoothing
– Accelerator Model of Inventories
– Inventories and Real interest Rate
Topics under Discussion
• Money Supply
– 100% Reserve Banking
– Fractional Reserve banking
– A closer Look at Money Creation
– A Model of Money Supply
– Instruments of Money Supply
• Money Demand
– Theories of Money Demand
Money Supply
• Earlier, we introduced the concept of money
supply in a highly simplified way.
• We defined quantity of money as the number of
rupees held by public, and assumed that
central bank controls the supply of money by
increasing or decreasing the number of rupees
in circulation through open-market operations.
• Although a good approximation, this definition
omits the role of banking system in determining
the money supply.
Money Supply
• Here, we’ll see that the money supply is
determined not only by the Central Bank, but
also by the behavior of households (which hold
money) and banks (where money is held).
• Recall, the Money supply includes both
currency in the hand of public and deposits at
banks that households use on demand for
transactions.
M=C+D
Money Supply Currency
Demand Deposits
100% Reserve Banking
• Imagine a world without banks, where all the
money takes the form of currency, and the
quantity of money is simply the amount of
currency that public holds (assume $1,000).
• Now a new bank comes in and accepts
deposits but does not make loans. Its only
purpose is to provide a safe place for
depositors to keep money
100% Reserve Banking
• The deposits that banks have received but have
not lent out are called reserves.
• Some Reserves are held in the vaults of local
banks but most are held at the central bank.
• Consider the case where all deposits are held
as reserves: banks accept deposits, place the
money in reserve, and leave the money there
until the depositor makes a withdrawal or writes
a check against the balance.
• In a 100% reserve banking system, all deposits
are held in reserve and thus the banking system
does not affect the supply of money.
100% Reserve Banking
• Suppose that households deposit the economy’s
entire $1,000 in Firstbank. This bank’s balance
sheet will look like:
Assets Liabilities
Reserves $1,000 Deposits $1,000
• The bank is not making loans so it is not earning
profit rather a small fee to cover its cost.
• The money supply in the economy before and
after the creation of bank remains the same, i.e.
$1,000. So 100% reserve deposit does not affect
money supply in economy
Fractional Reserve Banking
• Now, if the banks start to use some of their
deposits to make loans (e.g. to households for
house finance and to firms for capital finance),
they can charge interest on the loans.
• The banks must keep some reserve on hand so
that reserves are available whenever
depositors want to make withdrawals.
Fractional Reserve Banking
• As long as the amount of new deposits
approximately equals the amount of
withdrawals, a bank need not keep all its
deposits in reserves.
• Note: a reserve-deposit ratio is the fraction of
deposits kept in reserve. Excess reserves are
reserves above the reserve requirement.
• Fractional-reserve banking, a system under
which banks keep only a fraction of their
deposits in reserve. In a system of fractional
reserve banking, banks create money.
A Closer Look at Money Creation
Assume each bank maintains a reserve-deposit ratio (rr)
of 20% and that the initial deposit is $1000.
Firstbank Balance Sheet
Assets Liabilities
Reserve $200 Deposits $1,000
Loans $800
Secondbank Balance Sheet
Assets Liabilities
Reserve $160 Deposits $800
Loans $640
Thirdbank Balance Sheet
Assets Liabilities
Reserve $128 Deposits $640
Loans $512
A Closer Look at Money Creation
Mathematically, the amount of money the original $1000 deposit
creates is:
Original Deposit = $1000
Firstbank Lending = (1-rr) $1000
Secondbank Lending = (1-rr)2 $1000
Thirdbank Lending = (1-rr)3 $1000
Fourthbank Lending = (1-rr)4 $1000
..
.
Total Money Supply = [1 +(1-rr)+(1-rr)2+(1-rr)3+…] $1000
= (1/rr) $1000
= (1/.2) $1000
= $5000
A Closer Look at Money Creation
• The banking system’s ability to create money is
the primary difference between banks and other
financial institutions.
• Financial markets have the important function
of transferring the economy’s resources from
households (who wish to save some of their
income for the future) to those households and
firms that wish to borrow to buy investment
goods to be used in future production
• The process of transferring funds from savers
to borrowers is called financial intermediation.
A model of Money supply
• Three exogenous variables:
• The monetary base B is the total number of
dollars held by the public as currency C and
by the banks as reserves R.
• The reserve-deposit ratio rr is the fraction
of deposits D that banks hold in reserve R.
• The currency-deposit ratio cr is the amount
of currency C people hold as a fraction of
their holdings of demand deposits D.
A model of Money supply
Definitions of money supply and monetary base:
M = C+D
B = C+R
Solving for M as a function of 3 exogenous
variables:
M/B = C/D + 1
C/D + R/D
Making substitutions for the fractions above, we
obtain:
M = cr + 1 B Let’s call this the
cr + rr money multiplier, m
A model of Money supply
Continuing:
M=mB
Money Supply Money multiplier Monetary Base
Because the monetary base has a multiplied
effect on the money supply, the monetary base is
sometimes called high-powered money.
A model of Money supply
• An Example
– Suppose, monetary base B is $500 billion, the
reserve deposit ratio rr is 0.1 and currency deposit
ratio cr is 0.6
– The money multiplier is:
m = 0.6 + 1 = 2.3
0.6 + 0.1
– And the money supply is:
M = 2.3 x $ 500 billion = $1,150 billion
A model of Money supply
Let’s go back to our three exogenous variables
to see how their changes cause the money
supply to change:
1. The money supply M is proportional to the
monetary base B. So, an increase in the
monetary base increases the money supply by
the same percentage.
2. The lower the reserve-deposit ratio rr (R/D),
the more loans banks make, and the more
money banks create from every dollar of
reserves.
A model of Money supply
3. The lower the currency-deposit ratio cr (C/D) ,
the fewer dollars of the monetary base the
public holds as currency, the more base dollars
banks hold in reserves, and the more money
banks can create. Thus a decrease in the
currency-deposit ratio raises the money
multiplier and the money supply.
Summary
• Money Supply
– 100% Reserve Banking
– Fractional Reserve banking
– A closer Look at Money Creation
– A Model of Money Supply
Upcoming Topics
• Theories of Money Demand
– Baumol-Tobin Model of Cash Management
• Financial Innovation and the Rise of Near
Money
