Chapter 15 The Money Supply Process PDF

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Chapter 15: The Money Supply Process ●

There are three players in the money supply process ○

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The central bank ■

The government agency that oversees the banking system

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Conducts monetary policy

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Of the three players, this the most important.

Banks(banking system, depository institutions) ■

Accepts deposits from non banks individuals

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They make loans

Depositors or non bank individuals ■

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Hold deposits in banks

The bank of Canada’s Balance Sheet ○

Assets

Liabilities Currency in circulation Reserves

Securities Loans to financial institutions

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Liabilities? ■

Is just notes in circulation and reserves.

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Important: ↑liabilities →↑ money supply .

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Why? monetary base=currency ∈ circulation+ reserves

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Here is more information on each: ●

(1) Notes in circulation ○

Is the amount of notes in the hands of the public and depository institutions.

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(2) Reserves ○

As we know, from last chapter, all the banks that participate in the Large Value Transfer System have an account in the Bank of Canada,

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Reserves consist of all the money in these accounts

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Reserves also include currency that is physically held by banks

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↑reserves →↑ deposits →↑ money supply

Assets? ■

Why are assets of the BoC important? ●

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(1) Δ assets → Δ reserves → Δmoney supply ○

For example when you increase assets aka purchasing more bonds

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The banking system reserves increase

(2) Assets generate interests. Generating money is important OK.

More information on each: ●

(1) Government securities

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Government securities are by far the Bank’s largest category of assets, accounting for over 80% of the balance sheet.

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One way the bank can provide reserves to the banking system is by purchasing government securities.

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(2) Advances(aka loans to financial institutions) ○

The second way the Bank of Canada can provide reserves to the Banking System is by advancing loans to banks.

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There are normal advances and extraordinary advances

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The interest rate(for normal advances) charged for these loans is called bank rate(or discount rate in the U.S.)

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Control of the monetary base ○ ○ ○

Remember the monetary base OR high-powered money is just the sum of the BoC liabilities

MB =C+ R The Bank of Canada can exercise control over the monetary base through: ■

Open market operations ●

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Either purchases or sale of government securities in the open market

Extension of loans to banks

Open market purchase from a bank ○

Open market purchase ■

A purchase of bonds by the Bank of Canada

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Example: Bank of Canada purchases $100 of bonds from a bank and pays them with a $100 cheque. What happens? ●

The banks can either deposit the cheque in its account with BoC or cash it in for currency

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Deposit in the account would increase the reserves of the BoC, liabilities

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Cashin it would increase vault cash which are also reserve of the BoC

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In short, either actions means that the bank(private) will find itself with $100 more reserves AND a reduction in its holdings of securities of $100. ○

The banking system reserves are their assets but BoC liabilities

Banking system Liabiliti

Assets Securiti es $100 Reserv es + $100

es

← The y ← hav The e yless hav sec e uriti mor es e bec res aus erv e es the bec

aus sol e d they the obt Bank of Canada m Liabiliti ain to Assets es a the Securiti Reserv che Bo es + es + que C $100 $100 for thei r sec ○ Open market sale uriti ■ The Bank of Canada sells some of their bonds es ■

Example: Banks of Canada sells $100 to a primary dealer. What happens? ●

The BoC deducts $100 from the dealer’s deposit account → the BoC reserves fall by $100

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The BoC accepts currency as payment → reduces the amount of currency in circulation by $100

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BoC securities decrease by the same amount

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In short, MB decreases without affecting reserves. In the purchase example, Monetary Base changes but changing the reserves. Nonbank public Liabiliti

Assets Securiti es + $100 Curren cy -

es

← He just ← bou He ght bou sec ght Bank of Canada uriti Liabiliti thos Assets es e es ← so Securiti Curren sec The he uriti cy in es Bo ← has es circulati $100 C The mor with on gav re’s e curr e $100 less enci aw C es ay ● Shifts from deposits into currency bec so part aus now without open market operations. ○ There can be a change in reserves in the Banking System of e he HOWEVER, this change will not affect the monetary thebase. has sec deal ■ Que tipo de cambio es este? A shift from deposits less to currency, this will affect the reserves in uriti er curr the banking system. es paid enci ○ That said, the Bank of Canada has more control in over the monetary base than over reserves. es ■ It’s a more “stable variable” than reservescurr enc ○ Example: the banking system loses $100 of deposits y → loses $100 of reserves ■

What does this mean of the BoC? ●

$100 additional currency is circulating

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HOWEVER banking system reserves decrease by THE SAME AMOUNT, $100

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Thus Δ MB=0

Here is how it looks:

Nonbank system

Assets

Liabilities

Checkable deposits -$100 Currency +$100

Assets

Banking system

Reserves -$100

Liabilities

Checkable deposits -$100

Assets

Bank of Canada

Liabilities

Currency in circulation +$100 Reserves -$100

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Loans to Financial Institutions ○

So what else affects Monetary Base aside from open market purchases? LOANS TO FINANCIAL INSTITUTIONS!

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Example: The BoC makes a $100 loan to the First National Bank. What happens next? ■

The First National Banks is credited with $100 of reserves

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Because reserves increased liabilities of the BoC increase by the same amount

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Also assets of the BoC increase by the same amount

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The first national bank increases its reserves and liabilities by the same amount

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But what happens if the First National Bank pays the loan? ●

Liabilities of the BoC decrease by the amount paid

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Also the assets of the BoC decrease by the same amount

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The First National Bank reserves decrease by the same amount

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Thus the monetary base decrease by the same amount paid too, because

MB =C+ R ■

This is how it looks 1. The first national bank gets a loan AssetsBank of Canada Liabilities AssetsBanking system Liabilities Reserves +$100

Loans (borrowings from the Bank of Canada) +$100

Loans +$100

Reserves +$100

2. The first national bank pays the loan AssetsBanking system Liabilities Reserves -$100

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Loans (borrowings from the Bank of Canada) -$100

Other factors that affect the monetary base

AssetsBank of Canada Liabilities Loans -$100

Reserves -$100

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There are TWO items that affect the MB but are NOT controlled by the BoC: float and government deposits at the Bank of Canada.

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WTF is a “float”? ■

Remember the BoC is the “clearing house” of the banking system

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When X bank pays to Y bank, the BoC, sometimes deposits to Y bank BEFORE it debits the amount to X bank.

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The resulting temporary net increase in the total amount of reserves in the banking system occurring from the BOC’s cheque clearing process is called FLOAT.

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“When the government moves deposits from commercial banks to its account at the BOC, leading to an increase in government deposits at the Bank of Canada, it causes a deposit outflow at these banks and thus cause reserves I the banking system and the monetary base to decrease. “ no entiendo esto todavia ■

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Are government deposits in the BoC represented as assets instead of liabilities?

Overview of the Bank’s ability to control the monetary base ○

As we have discussed the are two primary that determine the monetary base ■

Open market operations ●

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This is completely controlled by the Bank deciding to buy or sell securities

Bank of Canada lending(to the banking system) ●

This depends on whether the banking system wants to loan from the bank. The BoC can’t predict this.

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For that reason, we divide the monetary base into two components: ■

Borrowed reserves BR ●

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Nonborrowed monetary base M Bn ●

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BoC can control completely

BoC cannot control completely

Multiple deposit creation: a simple model ○

Deposit creation: the single bank ■

Example: Suppose a $100 open market purchase was conducted with the First National Bank. What happens? ●

The First National Bank now has an excess $100 dollars in reserves NOT MAKING INTERESTS!!!

First National Bank Liabilities

Assets

less securities, because they sold to the BoC ← They have more reserves in their BoC account because that’s how theywill got probably paid for loan the But does the First National Bank do with this excess? They selling their bonds $100 to someone.

Securities -$100 Reserves +$100

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← They have $100

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So they increase their assets by $100 because of the loan, is the nonbank liability but the bank’s asset.

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However, their liabilities increase by $100 because they the consumer opens a chequable deposits account to store his money!

First National Bank

Assets

Liabilities

← Again, this loan Chequable deposits +$100

is an asset for the FNB. ← The chequable account is a liability because the consumer could want to retire it any But there is more, right? day ○ Yes, you are right!! As the consumer uses his cheques(chequable deposits

Securities -$100 Reserves +$100 Loans +$100

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are been used) → the excess reserve will be depleted. Thus at the end, it will look like this:

First Assets

National Bank Liabilities

Securities -$100 Reserves +$100

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← Just like the beginning

Deposit creation: the banking system ■

Now let’s assume there’s more than one bank and now the excess reserves in First National Bank is deposited into Bank A, all other banks, including this one do not have excess reserves; we assume.

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Let’s also assume the desired ratio reserve ratio is 10% ●

Somehow this does not affect the first bank. The first bank will throw away all of his excess. The other banks will loan only (1−reserve ratio)⋅ new deposit

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I THINK IT MAKES SENSE excess reserve is what you DO NOT want. We are said it could either be all of the purchase or the formula above.

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What will happen is that bank will loan their excess reserves until there’s no more

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This how the balance sheets of Bank A looks like, the following will look the same

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The bank A receives $100 from the consumer(or anyone who received this money) who got a loan from the First National Bank.

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Now, Bank A has $100 new reserves. However, he also has $100 new in chequable deposits; the new consumer created an account to put his money there.

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The Bank A is willing to loans up to 90% of his new deposits, what the desired reserve ratio can mean.

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So now Bank A loans $90, reserves go down by $90 because the bank no longer holds that money.

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The following banks will do the same and that is how money multiplies AMIGO!

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Important: A single bank cannot itself generate multiple deposit expansion

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Now let’s derive the formula for multiple deposit creation ●

DR ← desired reserves

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R ←total amount of reserves∈the banking system

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D ← chequable deposits

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r ←desired reserve ratio

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DR= R , here we are assuming it’s on equilibrium, that excess reserves = 0.

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DR=r ⋅ D

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1 Δ D=( )⋅ Δ R r

Critique of the simple model ■

(1) The nonbank individual might decide to stay with the loan of the first bank in currency. This would stop the multiplier effect. The model assumes the BoC can exercise complete control on the amount of deposits just by setting the level of reserves.

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(2) The banks might decide not do loans. This would stop the multiplier effect too.

Factors that determine the money supply ○

(1) Changes in the M Bn ■

The Bank of Canada open market purchases increase the non-borrowed monetary base, and its sales decrease it!

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Remember the non-borrowed monetary base are those the BoC CAN control!

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When there’s a BoC purchase, holding all variables constant, we can say it increases reserves and deposits → increases monetary base. We saw it above with the multiplier effect.

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→ decrease amount of reserves and monetary base

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A sale shrink the M Bn

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All that said, we can say that the money supply is positively related to the M Bn

(2) Changes in the borrowed reserves from the BoC ■

These are the loans the banking system takes from the Boc

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REMEMBER THESE CANNOT BE FULLY CONTROLLED BY THE BOC BECAUSE THEY DON’T DECIDE FOR THE REGULAR BANKS IF THEY WANT TO TAKE A LOAN OR NOT (caps only is a power move, power moves only).

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Money supply is positively related to the level of borrowed reserves, BR, from the Bank of Canada. ●

More advances → more reserves → increase in monetary base (reserves + currency)

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(3) Changes in the desired reserve ratio, r d ■

Money supply is negatively related to the desired reserve ratio ●

An increase in the reserve ratio → banks hold more money → less deposit expansion → money supply falls

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(4) Changes in excess reserves ■

Money supply is negatively related to the amount of excess reserves ●

If for some reasons banks are having trouble/don’t want to use the excess reserves that is less deposit expansion thus money supply falls

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(5) Changes in currency holdings ■

Money supply is negatively related to currency holdings ●

If we people want to hold more currency rather than depositing the deposit expansion will fall and thus the money supply will also fall

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Overview of the money supply process

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The money multiplier ○

M =m⋅ MB ■

This is why monetary base is called high-powered money

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e ← excess reserve ratio ,

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m=

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MB =C+ D

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C=c × D

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D=

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ER D

1+ c c+r +e

1 × MB c +r +e

We define money supply, M , as currency plus chequable deposits....