The Money Supply Process

Players in the money supply process
- Central Bank
- Commercial Bank
- Depositors: individuals and institutions

Monetary Base = Currency + Reserves
(MB: aka High powered money)

Reserves = RR + excess reserves

Reserves are bank's deposit with CB, plus currency in bank's vault

Monetary Base Changes
To change MB, CB uses OMO, or lending to banks
- to increase MB, buy gov bond
- to decrease MB, sell gov bond

Example: Open market purchase from a bank
CB
Asset                         Liabilities
Securities +100m     Reserves +100m
Commercial Bank
Asset                          L
Securities -100m       no change
Reserves  +100m

Example: Open market sales to a bank
CB
Asset                         L
Securities -100m     Reserves  -100m
Commercial Bank
Asset                          L
Securities +100m       no change
Reserves  -100m

Example: CB lends to bank
CB
Asset                         L
Loans +100m           Reserves  +100m
Commercial Bank
Asset                         L
Reserves +100m       Loans + 100m

MB = MBn + BR
BR: borrowed reserves by banks, cannot controlled by CB
MBn: non borrowed monetary base

Money Creation
CB control MB, but not the overall money supply
commercial banks are creators of deposit money

Bank A
Asset                   L
Reserves +100   checkable deposit +100
(after bank A makes a loan to bank B)
Bank A
Asset                  L
Reserves +100   checkable deposit +100
newloan  +90     newdeposit   +90
(after borrower withdraws cash)
Bank A
Asset                 L
Reserves +10    checkable deposit +100
newloan  +90  
Bank B
Asset                 L
Reserves +90    checkable deposit +90

R = rr x D     ; rr : required reserve ratio, D : deposit, R : reserve
M = m x MB   ; m : money multiplier
M = C + D
MB = C + R = C + rrD + ER
m = (C + D) / (C + rrD + ER)

Definition of Money
narrow money
M0: notes and coins in circulation
MB: M0 + reserves
M1: M0 + checkable deposits + traveler cheques
broad money
M2: M1 + savings deposit, time deposits,