ECS 3701

Monetary Economics
Boston | UNISA 2015
15: The Money Supply Process

Errol Goetsch
Lorraine

078 573 5046

082 770 4569

errol@xe4.org
lg@xe4.org

www.facebook.com/groups/ecs3701

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Monetary Economics
Parts 1 - 6

Part 1 Introduction
Goals
01 Why study money, banking, financial markets
15.1 The behaviour of the 3 players in money creation
02 Overview of the financial system
03 What is Money?
15.2 A simple formula for multiple deposit creation
Part 2 Financial Markets
04 Understanding interest rates
15.3 A complex version of the money multiplier
05 The behaviour of interest rates
06 The risk and term structure of interest rates
Part 3 Financial Institutions
15.4 The money supply process in SA
08 An economic analysis of financial structure
09 Financial crises in advanced economies
10 Financial crises in emerging economies
11 Banking and management of financial institutions
Part 4 Central banking and monetary policy
14 Central banks: a global perspective
15 The money supply process
16 Tools of monetary policy
17 The conduct of monetary policy: strategy and tactics
Part 6 Monetary theory
20 Quantity theory, inflation and demand for money
21 The IS curve
24 Monetary policy theory
25 The role of expectations in Monetary Policy
26 Transmission mechanisms of Monetary Policy
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Summary

Money Supply = Currency + Deposits = M s = C + D

Monetary Policy is the management of Money and Interest Rates by the SARB
M1 / M2 / M3 supply see definitions of D, (we use M1 C + Cheque Deposits)
(M)oney Supply; (C)urrency; (D)eposits; Ms = C + D
(M)onetary (B)ase; MB = C + R; (R)eserves; R = MBn + BR; Ms = m x MB
Deposits > Currency because SA has a Fractional Reserve System
1. Banks hold accounts at the Reserve Bank
2. SARB changes reserves of Banks (the Monetary Base)
3. Borrowers apply to banks for loans
4. Banks turn new Reserves into new Deposits (the Money Supply ) via new loans
5. Borrowers deposit new loans at other banks
6. New bank receives deposit and lends it out again; chain of deposits continues
SARB Reserves (and MB) by 1 , Deposits (and MS ) by a multiple of 1
- limiting factors:
1. How much D increases for every R1 (m)
2. SARB's requirement for banks to hold back on loans (r)
3. Bank's tendency to hold more in reserve than required (e)
4. Borrower's tendency to hold some cash rather than deposit all their loan
(c)
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The Monetary Base

Monetary Base = Currency + Reserves MB = C + R

ForeignSARB
Assets
Assets
(C*) + I

CurrencyLiabilities
in circulation C

Loans to banks

Bank Reserves R
Central govt and other D

Total

MB =
SARB's
liabilities

Other liabilities

R when
SARB buys assets from banks

Total

SARB buys assets from pvt sector

Bank Assets

Liabilities

2 Deposits with the SARB R Deposits

SARB makes loans to banks

Pvt sector deposits C with banks

Bank notes & coins

Borrowings of bank

Securities

Capital

Govt transfers from T&L account with

SARB to T&L account with banks

Total

SARB makes payments to pvt sector

from account at SARB

3 Loans
Total

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The Monetary Base

Monetary Base = Currency + Reserves; MB = C + R

Monetary Base (MB) = the Central Bank liability
Part of the management of money supply goes through the MB
Different channels for changing the MB:
1. Buying treasury bonds on primary markets (Treasury Channel)
2. Running Open Market Operations (Banking Channel)
3. Providing Discount Loans (Banking Channel)
4. Buying-selling international reserves (Foreign Channel)

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The Monetary Base

1. Treasury Channel

Active when central banks are legally or implicitly committed to

buying newly issued treasury bonds
- the government can finance any fiscal decit, as the central bank will
intervene and provide money whenever necessary
- can be a serious source of excessive inflationary pressures
- in most countries this channel is formally prohibited, for the sake of
monetary policy independence: I.e separate who creates money
from those who spend it

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The Monetary Base

2. Banking Channel Open Market Operations

Suppose that the central bank (SARB) buys (sells) securities from the private sector. This
means that it will offer (withdraw) money in exchange
An expansionary (contractionary) monetary policy will expand (contract) the central bank
balance sheet, affecting the MB. Under a monetary policy expansion, SARB buys securities and
credits an equal amount on the Reserve account that the counterpart has with the SARB
A monetary policy contraction works on the other way around: SARB contracts its balance
sheet. OMOs are run by central banks on a daily basis, not just for changing the monetary
policy stance but also to meet the demand for reserves by the system.

Banking System
Assets
Securities -100

SARB
Liabilities

Assets

Liabilities

Securities +100

Reserves +100

Reserves +100
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The Monetary Base

3 Banking Channel - Discount Loans

Commercial Banks can approach the SARB directly for loans, if they
cannot or do not want to raise funds from the private sector
This facility allows the SARB to inject liquidity directly towards speci
fic institutions, instead of increasing the monetary base for the
entire System
The downside is that an institution demanding funds directly on the
discount window is a negative signal to the markets
The reserves provided to the system with this channel are called
Borrowed Reserves. The other are simply non-borrowed reserves.
MB = borrowed and non-borrowed MB

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The Monetary Base

3 Banking Channel - Discount Loans

Note, unlike OMOs, it is the private sector that decides indirectly

whether the MB will expand, as the SARB has already committed to
providing loans upon request at the discount rate

Banking System

SARB

Assets

Liabilities

Assets

Liabilities

Reserves +100

Discount loans +100

Discount loans +100

Reserves +100

(borrowing from
SARB)

(borrowing from
SARB)
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The Monetary Base

4. Buying/selling international reserves (Foreign Channel)

Under fixed exchange rates, central banks engage in buying-selling of
foreign currency in order to stabilize the exchange rate. As SARB withdraws
(offers) foreign currency it will have to pay (withdraw) domestic currency in
exchange. This will affect the MB
The accounting mechanism will be the same. The counterpart of an
in reserves will be an in the balance sheet item International
Reserves", rather than Securities"
Banking System
Assets
International
Reserves -100

SARB
Liabilities

Assets

Liabilities

International
Reserves -100

Reserves +100

Reserves +100
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Deposit Creation
M = C + D

Start from the in MB achieved through, say, OMOs

Call r = 0:10 the reserve requirement, i.e. the share of deposits that
commercial banks must deposit as reserves at the SARB for
precautionary reasons
Assume that the counterpart in the OMO is the First Bank.
It will receive 100 on its reserves. But its deposits have not , so it
can provide a loan for the entire amount (no excess reserves)
First Bank
Assets
Securities -100

Liabilities

{Total change in money supply} =

{Initial change in reserves} *
{Money multiplier}

Loans +100
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Deposit Creation
M = C + D

The firm receiving this loan from the First Bank will deposit this
cheque in its own bank account, say at Bank A.
Assume that the entire amount is deposited, no cash is held.
Bank A will experience an in deposits for 100.
10 % of this will have to go in reserves, leaving 90 for new loans

Bank A

Bank A

Assets

Liabilities

Reserves +100

Cheque deposits +100

Assets
Reserves 10

Liabilities
Cheque deposits +100

Loans 90
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Deposit Creation
M = C + D

But this new loan implies exactly the same mechanism:

some Bank B will receive an extra deposit of 90, out which 81 will be
given as new loans and the remainder held for required reserves
This mechanism multiplies the initial effect triggered by the SARB:
the deposit base will by a multiple of the initial injection of
liquidity through the OMO

Bank B

Bank B

Assets

Liabilities

Assets

Liabilities

Reserves +90

Cheque deposits +90

Reserves 9

Cheque deposits +90

Loans 81

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Deposit Creation
M = C + D

r = 10%
Bank

Deposits

Loans

Reserves

Example

0.0

100.0

0.0

100.0

90.0

10.0

90.0

81.0

9.0

81.0

72.9

8.1

72.9

65.6

7.3

65.6

59.0

6.6

59.0

53.1

5.9

53.1

47.8

5.3

1,000.0

1,000.0

100.0

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The (simple) Money Multiplier

D = 1 / r R

SARB has MB by 100

mathematically, Deposits by
100 + (1 - r)100 + (1 - r )2100 + (1 - r )3100 + .... =

Note that 1/r is bigger than one, given that r is smaller than one.
This is not the full money multiplier, since
- static
- no excess reserves (e = ER / D)
- no money kept as cash (c = C / D)

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The (complex) Money Multiplier

The multiplier for turning Reserves into Cash + Deposits into M

r = RRR / D ratio of deposits that banks must keep as Required Reserves 1
e = ER / D ratio of deposits that banks want to keep as Excess Reserves 1
c =C / D proportion of deposits that borrowers want to keep as cash 0
MB = C + R = c D + r D + e D = (c + r + e) D
MS = C + D = c D + D = (c + 1) D
Combine the two, substitute out D, get
1 + [C/D]
m = ----------------------------- RRR + [ER/D] + [C/D]
Since r + e < 1, m > 1

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The (complex) Money Multiplier

The multiplier for turning Reserves into Cash + Deposits into M

MB the in reserves after a monetary policy expansion;
Bank 1 receives this extra reserve, with no extra deposits, lends it all
Borrower 1 keeps c/(1 + c) MB in cash +
deposits 1/(1 + c) MB in Bank 2
C= cD so C + D = MB
Bank 2 will provide a new loan for the amount of 1 r e / (1 + c) MB
Borrower 2 keeps c/(1 + c) MB in cash
deposits 1/(1 + c) MB in Bank 3
and so on

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Endogeneity of Money Multiplier

The multiplier for turning reserves into deposits

The SARB can influence the size of m by changing the RRR, but it can't
control C/D or ER/D, which depend on the behavior of banks and their
borrowers and depositors. If and when m changes, the SARB needs to
make offsetting changes in the monetary base so as to keep the money
supply stable.
The SARB does not have full control of money supply,
- it partially depends on outside behaviour which depends on the economic
environment.
The SARB can control the MB and the reserve ratio r.
But e and c are under the control of agents,
so Money Supply can vary for reasons independent on the SARB
Additionally, the MB itself is not fully perfectly controlled by the SARB,
as the discount window works at the discretion of borrowers,
whenever they have funding needs
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Endogeneity of Money Multiplier

The multiplier for turning reserves into deposits
Player

Variable

Ms

Reason

The SARB

RRR

multiple-deposit expansion (m )

MB (through R)

reserves mean loans (and redeposits)

discount rate

bank reserves --> MB

Banks

supply of loans
(ER/D if banks plan
to lend more)

Depositors C/D

m
multiple-deposit expansion (m )

expected deposit
Depositors
outflows (ER/D if
and banks
banks expect more)

demand for loans

Borrowers (ER/D if demand
for loans )

banks make more (safe) loans at same or higher i, so they

loan out more of their excess reserves (ER/D falls) ==> money
multiplier . If those interest rates allow banks to attract
new depos its away from competitors like MMF's, then MB

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Sensitivity of Money Multiplier

The parameters that affect m

m in r and e: the banks keep as reserves, and provide fewer loans, the m can work
m in c: the wealth kept as cash, money is available for loans to start the m process
A banking panic can reduce money supply:
Increase in c and e can cause a sharp collapse in money supply, making MB ineffective
m is procyclical (m rises in economic upswings; m falls in recessions).
the excess reserves ratio (ER/D) tends to rise during recessions
the currency-deposit ratio (C/D) tends to rise during recessions
m is also affected by changes in interest rates.

c+1

c+r+e

0.2

0.1

0.1

3.0

1.2

0.4

0.2

0.3

0.1

2.0

1.2

0.6

0.1

0.0

4.0

1.2

0.3

0.4

1.7

1.2

0.7

Central Bank r
0.2

Banks hold no excess reserves

0.2

0.1

Banks excess reserves

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Causal Direction of Ms Process

R => D vs D => R

1. Cash Reserves comprise Money issued by SARB, kept as deposits by banks at the SARB
2. This makes banks dependent on the SARB
3. SARB must issue csh reserves as needed on day to day and lender of last resort basis
4. SARB meet demand by (a) fixing cash Q and let cash P float or (b) fixing P and let Q
float
5. Given policy 2, SARB will always meet systemic demand for cash
6. Average bank with normal cash demand will always be met
7. Knowing this, banks lend out their deposits and buy (cheap) cash to fill reserve
8. Changes in r, c and e affect D:
- if r (= R/D) , banks need R for the D they created
- if c (= C/D) , SARB must create R for the D the banks created
- if e (= ER/D) , SARB must create R for the D the banks created
Confirmation
1. Banks have low e (see no need to hold cash)
Explanation
1. P collusion means fight for market share (ie maximise Q)
2. Banks only need to have reserve on monthly average, not daily

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Monetary Economics
Parts 1 - 6

Part 1 Introduction
Goals
01 Why study money, banking, financial markets
15.1 The behaviour of the 3 players in money creation
02 Overview of the financial system
03 What is Money?
15.2 A simple formula for multiple deposit creation
Part 2 Financial Markets
04 Understanding interest rates
15.3 A complex version of the money multiplier
05 The behaviour of interest rates
06 The risk and term structure of interest rates
Part 3 Financial Institutions
15.4 The money supply process in SA
08 An economic analysis of financial structure
09 Financial crises in advanced economies
10 Financial crises in emerging economies
11 Banking and management of financial institutions
Part 4 Central banking and monetary policy
14 Central banks: a global perspective
15 The money supply process
16 Tools of monetary policy
17 The conduct of monetary policy: strategy and tactics
Part 6 Monetary theory
20 Quantity theory, inflation and demand for money
21 The IS curve
24 Monetary policy theory
25 The role of expectations in Monetary Policy
26 Transmission mechanisms of Monetary Policy
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