Description
the different ways to create money. It explains Money Supply Model & the Money Multiplier. It gives an overview of money supply process.
MONEY MULTIPLIER
THREE WAYS TO CREATE MONEY
Manufacturing a new monetary unit, such as paper currency or metal coins (money creation) Loaning out a physical monetary unit multiple times through fractional-reserve lending (credit creation) Buying of government securities or other financial instruments by central bank through Open market operations (electronic creation)
FRACTIONAL-RESERVE LENDING
The banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all deposits immediately upon demand
Stimulate the economy through government spending.
Bank-run
A Simple Money Creation Model (Assumptions)
Recipients of funds always deposit them rather than cash them
Required reserve ratio is 20%
Banks will keep no excess reserves
EXAMPLE
RELATIONSHIP BETWEEN HIGH-POWERED MONEY AND THE MONEY STOCK
FRACTIONAL LENDING
All banks must create money at the same rate, and that rate must be much more moderate.
E.g. WHICH OPTION TO CHOOSE?
1) loaning $80 of the original $100 without creating any more money,
or 2) creating an additional $400 out of thin air and loaning out that newly created $400
OPEN MARKET OPERATIONS
• REPO/REVERSE-REPO • GOVERNMENT BONDS • FOREIGN CURRENCY/GOLD
ASSETS GOVT SECURITIES ALL OTHER ASSETS MONETARY BASES (SOURCES) +1 0 LIABILITIES CURRENCY BANK DEPOSITS MONETARY BASE (USES) 0 +1
+1
+1
MONEY MULTIPLIER AND BANK LOANS
Bank lends money till optimum reserve-ratio is maintained
Money Supply Model & the Money Multiplier
M = mm * MB M=money supply
MB=monetary base
mm is the money multiplier that tells how much the money supply changes for a given change in MB The money multiplier reflects the effects on the money supply of other factors besides monetary base
Deriving the Money Multiplier
Considering the effects on deposit creation of changes in public holdings of currency and bank?s holdings of reserves
Assumptions: 1. Desired level of currency, C grows proportionately with chequable deposits, D cu = C/D (currency ratio)
re = reserves/D (desired reserve ratio) 2. Total amount of reserves in the banking system R equals desired reserves, DR R = DR (excess reserves are assumed to be zero)
Money Multiplier
M = m ? MB
Deriving Money Multiplier We have M = C + D and MB = C + reserves Substituting cu = C/D and re = reserves/D we get, M = (cu + 1) D MB = (cu + re) D
Dividing the 2 equations:
1? c M ? ? MB c?r
hence
1? c m? c?r
So,
mm is inversely related to re
An Example
r = 5% C = $40 billion D = $160 billion M = C + D = $200 billion 1 ? 0.25 m? ? 4.2 0.25 ? 0.05 The money multiplier tells us that with the given conditions, a $1 increase in MB will lead to a $4.2 increase in M
If c = 0 (no currency drains), then m = 20
An Example (Continued)
Also,
1 ? 3.3 0.25 ? 0.05
This is the deposit multiplier when
c = 25% and r = 5%.
Hence, given the behavior of the public as represented by c = 25% and that of banks as represented by r = 5%, a $1 increase in MB will lead to a $3.3 increase in D
The Full Model
• Bank does not have complete control over MB. Here we split MB into two components: • Non borrowed monetary base (MBn). This component of the MB is directly under the Bank?s control because it results from open market operations
• Borrowed monetary base (or advances A). This is the less tightly controlled component of the base, because it is influenced by banks? decisions
The Full Model (Continued)
Hence, MB = MBn + A To complete the money supply model, we rewrite it as M = m ? MB = m ? (MBn + A) where m is defined as before – money multiplier
Overview of the Money Supply Process
1? c M ? ? ( MBn ? A) c?r
M is positively related to MBn • Open market purchases increase MBn and for given c, r , and A lead to an increase in M. • Open market sales ? MBn and for given c, r , and A lead to a ? in M M is positively related to A • For given MBn , c, and r , an increase in A will MB and lead to a multiple increase in M. • For given MBn , c, and r , an ? in A will ? MB and lead to a multiple ? in M.
Ceteris paribus, how money multiplier changes in response to changes in the variables in our model
Changes in r
Changes in c
Changes in interest rate
Expected outflow of deposits
What Affects C/D?
‘m’ response to changes in ‘c’
r = 5% 1 ? 0.25 ? 4.2 C = $40 billion m ? 0.25 ? 0.05 D = $160 billion M (= M1+) = C + D = $200 billion Now C rises to $50 billion m = (1+0.3)/(0.3+0.05) = 3.7 < 4.2 On the other hand if C falls to $20 billion m = (1+0.2)/(0.2+0.05) = 4.8 > 4.2 Conclusion: Money multiplier and the money supply are negatively related to the currency ratio c
WHAT AFFECTS R/D?
‘m’ response to change in ‘r’
When banks decide to change their holdings of reserves relative to cheqable deposits Increase in r will in effect cause reduction in banks ability to make loans at a given level of MB This will cause a decline in the level of chequable deposits and a decline in the money supply The money multiplier will also fall as a result
‘m’ response to changes in ‘r’
r = 5% 1 ? 0.25 C = $40 billion m? ? 4.2 0.25 ? 0.05 D = $160 billion M (= M1+) = C + D = $200 billion Now r rises to 10% m = (1+0.25)/(0.25+0.10) = 3.6 < 4.2 Here the desired reserve ratio has doubled but fall in the value of money multiplier is small Conclusion: Money multiplier and the money supply are negatively related to the desired reserve ratio r
‘m’ response to change in interest rate
What will be the effect of holding more than the required reserves? – a higher ‘r’ It will have an opportunity cost in terms of interest income foregone on loans/securities Assume that the loans and securities earn same interest rate Now if „i? increases the cost of holding higher reserves would rise & consequently, r will fall The desired reserve ratio is negatively related to the market interest rate As r goes down both MM and Ms will increase
‘m’ response to expected deposit outflow
Holding reserves provide insurance against losses due to deposit outflows – bank failure If banks fear that deposit outflow is likely to increase they will want more insurance and increase the desired reserve ratio In other words, expected returns for holding reserves will increase Conversely, a decline in expected outflow will reduce the insurance benefits of reserves The desired reserve ratio will fall Thus r is positively related to expected deposit outflow
m falls on CRR hikes
GREAT DEPRESSION
The money stock had already declined nearly 4% from 1929 to 1930, and then it fell rapidly in 1931 and 1932 and continued falling through april 1933 Large scale bank failures(lack of reserves hence destoyed deposits)
ECONOMIC POLICY
Loss of confidence(increase in currency-deposit ratio)
Rise in reserve-deposit ratio
GOVERNMENT INITIATIVES
• Open market purchases • Drop in interest rate on 1-day loans(Great crash(black monday-19th oct?87)) • 7.56% on 19th october • 6.87% on 20th october • 6.50% on 21st october
The Myth of the Money Multiplier
Assumption:
“money multiplier asserts that the lending of banks automatically expands the credit money supply to a multiple of their aggregate reserves”
The Myth of the Money Multiplier
The money multiplier concept represents a misunderstanding about how the credit money supply grows.. •Banks with adequate capital can and do lend without adequate reserves on hand. • If a bank has a creditworthy borrower and a profitable lending opportunity, it will issue the loan and • if necessary borrow reserves in the money market to meet the reserve ratio requirement.
doc_850905987.pptx
the different ways to create money. It explains Money Supply Model & the Money Multiplier. It gives an overview of money supply process.
MONEY MULTIPLIER
THREE WAYS TO CREATE MONEY
Manufacturing a new monetary unit, such as paper currency or metal coins (money creation) Loaning out a physical monetary unit multiple times through fractional-reserve lending (credit creation) Buying of government securities or other financial instruments by central bank through Open market operations (electronic creation)
FRACTIONAL-RESERVE LENDING
The banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all deposits immediately upon demand
Stimulate the economy through government spending.
Bank-run
A Simple Money Creation Model (Assumptions)
Recipients of funds always deposit them rather than cash them
Required reserve ratio is 20%
Banks will keep no excess reserves
EXAMPLE
RELATIONSHIP BETWEEN HIGH-POWERED MONEY AND THE MONEY STOCK
FRACTIONAL LENDING
All banks must create money at the same rate, and that rate must be much more moderate.
E.g. WHICH OPTION TO CHOOSE?
1) loaning $80 of the original $100 without creating any more money,
or 2) creating an additional $400 out of thin air and loaning out that newly created $400
OPEN MARKET OPERATIONS
• REPO/REVERSE-REPO • GOVERNMENT BONDS • FOREIGN CURRENCY/GOLD
ASSETS GOVT SECURITIES ALL OTHER ASSETS MONETARY BASES (SOURCES) +1 0 LIABILITIES CURRENCY BANK DEPOSITS MONETARY BASE (USES) 0 +1
+1
+1
MONEY MULTIPLIER AND BANK LOANS
Bank lends money till optimum reserve-ratio is maintained
Money Supply Model & the Money Multiplier
M = mm * MB M=money supply
MB=monetary base
mm is the money multiplier that tells how much the money supply changes for a given change in MB The money multiplier reflects the effects on the money supply of other factors besides monetary base
Deriving the Money Multiplier
Considering the effects on deposit creation of changes in public holdings of currency and bank?s holdings of reserves
Assumptions: 1. Desired level of currency, C grows proportionately with chequable deposits, D cu = C/D (currency ratio)
re = reserves/D (desired reserve ratio) 2. Total amount of reserves in the banking system R equals desired reserves, DR R = DR (excess reserves are assumed to be zero)
Money Multiplier
M = m ? MB
Deriving Money Multiplier We have M = C + D and MB = C + reserves Substituting cu = C/D and re = reserves/D we get, M = (cu + 1) D MB = (cu + re) D
Dividing the 2 equations:
1? c M ? ? MB c?r
hence
1? c m? c?r
So,
mm is inversely related to re
An Example
r = 5% C = $40 billion D = $160 billion M = C + D = $200 billion 1 ? 0.25 m? ? 4.2 0.25 ? 0.05 The money multiplier tells us that with the given conditions, a $1 increase in MB will lead to a $4.2 increase in M
If c = 0 (no currency drains), then m = 20
An Example (Continued)
Also,
1 ? 3.3 0.25 ? 0.05
This is the deposit multiplier when
c = 25% and r = 5%.
Hence, given the behavior of the public as represented by c = 25% and that of banks as represented by r = 5%, a $1 increase in MB will lead to a $3.3 increase in D
The Full Model
• Bank does not have complete control over MB. Here we split MB into two components: • Non borrowed monetary base (MBn). This component of the MB is directly under the Bank?s control because it results from open market operations
• Borrowed monetary base (or advances A). This is the less tightly controlled component of the base, because it is influenced by banks? decisions
The Full Model (Continued)
Hence, MB = MBn + A To complete the money supply model, we rewrite it as M = m ? MB = m ? (MBn + A) where m is defined as before – money multiplier
Overview of the Money Supply Process
1? c M ? ? ( MBn ? A) c?r
M is positively related to MBn • Open market purchases increase MBn and for given c, r , and A lead to an increase in M. • Open market sales ? MBn and for given c, r , and A lead to a ? in M M is positively related to A • For given MBn , c, and r , an increase in A will MB and lead to a multiple increase in M. • For given MBn , c, and r , an ? in A will ? MB and lead to a multiple ? in M.
Ceteris paribus, how money multiplier changes in response to changes in the variables in our model
Changes in r
Changes in c
Changes in interest rate
Expected outflow of deposits
What Affects C/D?
‘m’ response to changes in ‘c’
r = 5% 1 ? 0.25 ? 4.2 C = $40 billion m ? 0.25 ? 0.05 D = $160 billion M (= M1+) = C + D = $200 billion Now C rises to $50 billion m = (1+0.3)/(0.3+0.05) = 3.7 < 4.2 On the other hand if C falls to $20 billion m = (1+0.2)/(0.2+0.05) = 4.8 > 4.2 Conclusion: Money multiplier and the money supply are negatively related to the currency ratio c
WHAT AFFECTS R/D?
‘m’ response to change in ‘r’
When banks decide to change their holdings of reserves relative to cheqable deposits Increase in r will in effect cause reduction in banks ability to make loans at a given level of MB This will cause a decline in the level of chequable deposits and a decline in the money supply The money multiplier will also fall as a result
‘m’ response to changes in ‘r’
r = 5% 1 ? 0.25 C = $40 billion m? ? 4.2 0.25 ? 0.05 D = $160 billion M (= M1+) = C + D = $200 billion Now r rises to 10% m = (1+0.25)/(0.25+0.10) = 3.6 < 4.2 Here the desired reserve ratio has doubled but fall in the value of money multiplier is small Conclusion: Money multiplier and the money supply are negatively related to the desired reserve ratio r
‘m’ response to change in interest rate
What will be the effect of holding more than the required reserves? – a higher ‘r’ It will have an opportunity cost in terms of interest income foregone on loans/securities Assume that the loans and securities earn same interest rate Now if „i? increases the cost of holding higher reserves would rise & consequently, r will fall The desired reserve ratio is negatively related to the market interest rate As r goes down both MM and Ms will increase
‘m’ response to expected deposit outflow
Holding reserves provide insurance against losses due to deposit outflows – bank failure If banks fear that deposit outflow is likely to increase they will want more insurance and increase the desired reserve ratio In other words, expected returns for holding reserves will increase Conversely, a decline in expected outflow will reduce the insurance benefits of reserves The desired reserve ratio will fall Thus r is positively related to expected deposit outflow
m falls on CRR hikes
GREAT DEPRESSION
The money stock had already declined nearly 4% from 1929 to 1930, and then it fell rapidly in 1931 and 1932 and continued falling through april 1933 Large scale bank failures(lack of reserves hence destoyed deposits)
ECONOMIC POLICY
Loss of confidence(increase in currency-deposit ratio)
Rise in reserve-deposit ratio
GOVERNMENT INITIATIVES
• Open market purchases • Drop in interest rate on 1-day loans(Great crash(black monday-19th oct?87)) • 7.56% on 19th october • 6.87% on 20th october • 6.50% on 21st october
The Myth of the Money Multiplier
Assumption:
“money multiplier asserts that the lending of banks automatically expands the credit money supply to a multiple of their aggregate reserves”
The Myth of the Money Multiplier
The money multiplier concept represents a misunderstanding about how the credit money supply grows.. •Banks with adequate capital can and do lend without adequate reserves on hand. • If a bank has a creditworthy borrower and a profitable lending opportunity, it will issue the loan and • if necessary borrow reserves in the money market to meet the reserve ratio requirement.
doc_850905987.pptx