Chapter 6:

Central Bank and

the money supply
process

LECTURER: MSC LE VAN CHI

EMAIL: CHILV@NEU.EDU.VN
Content
6.1 Central banks
6.1 1. Historical development of central banks
6.1.2 Central banks’ models
6.1.3 Functions and operations of central banks
Content
6.2. The Money supply process
6.2.1 The money supply process
3.2.2 Multiple deposit creation: a simple model
6.2.3 Factors that determine the money supply
6.2.4 The complete money supply model
Abbreviation in chapter
MS: Money supply (=C+D) MB: Monetary base (=C+R)
mm: Money multiplier C: Currency in circulation
D: Checkable Deposit c: C/D
RR: Required reserve rr: required reserve ratio (=RR/D)
ER: Excess reserve er: excess reserve ratio (=ER/D)
R: Total reserve in banks (=RR+ER)
Historical development of central
bank
Central banks’ models
Central Banks around the world was organized by 2 main model
base on its dependence on government:
◦ Central bank depends on government
◦ Central bank is independent with government
Central banks’ models
4 facts to illustrate the dependence of the Central Banks:
◦ Instrument independence
◦ Goal independence
◦ Institutional independence
◦ Financial independence
Functions and operations of
central banks
Functions and operations of
central banks
Traditional functions:
◦ Primary Functions (most important): issue note, conduct monetary policy and
control money supply, regulation of financial system.
◦ Secondary functions: manage public debt, manage foreign exchange, give advice
for government on policy (especially in money, banking and finance part), maintain
the relationships with the international financial institutions.

Non-traditional Functions:
◦ Develop the financial framework
◦ Provision of credit to priority sectors
Functions and operations of
central banks

Print bank note and conducting

monetary policy

The central bank of all banks

The bank of the State

Functions and operations of
central banks
Print bank note and conducting monetary policy
State bank of Vietnam is the only organization that can print bank note.
To print bank note, the state bank must follow the principle:
◦ Guarantee by gold
◦ In relationship with GDP growth rate.
◦ In relationship with credit
◦ In relationship with Government debt
◦ In relationship with net assets from international

State bank of Vietnam can control money supply in Vietnam by monetary

policy.
Functions and operations of
central banks
The central bank of all banks
Receive reserve from commercial banks
Make discount loans to banks and other financial institutions.
Clearing check for commercial Banks
Functions and operations of
central banks
The bank of the State
• Is Treasury issue agent for State
• Do cashless payment for State Treasury
• Ensure international reserve
• Manage banking system
• Government Representative in financial international relationships.
The money supply process
•Participants of money supply process
oCentral banks
oBanks
oDepositors
oBorrowers from banks
The money supply process
FED’s Balance sheet
Assets Liabilities

Government Securities Currency in circulation (C)

Discount loans Reserves (R)

Monetary base: MB=C+R

The money supply process
Control of the monetary base (MB)
o The Central bank can make a change in monetary
base by:
o + Open market operation
o + Loans to Financial Institutions
The money supply process
Open market purchase from a bank
FED purchases $100m from a bank:

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Securities -$100m Securities +$100m Reserves +$100m
Reserves +$100m

àReserve increased by $100m

àNo change in currency
àMonetary base risen by $100m
The money supply process
Open market purchase from Nonbank Public
FED purchases $100m from Public, this person deposits the money in the bank:
Public Banking System
Assets Liabilities Assets Liabilities
Securities -$100m Reserves +$100m Checkable +$100m
deposits
Deposits +$100m

àReserve increased by $100m Federal Reserve System

Assets Liabilities
àNo change in currency
Securities +$100m Reserves +$100m
àMonetary base risen by $100m
(The same as the purchase from bank)
The money supply process
Open market purchase from Nonbank Public
FED purchases $100m from Public, this person keep the money in cash
Nonbank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities -$100m Securities +$100m Currency in +$100m
circulation
Currency +$100m

àReserve are unchanged

àCurrency in circulation increased by $100m
àMonetary base increased by the same amount
The money supply process
Open market purchase: Summary
The effect of an open market purchase on reserves
The effect of an open market purchase on monetary base
The money supply process
Shifts from deposits into currency
Nonbank public withdraw $100m from their checkable deposits
Nonbank Public Banking System
Assets Liabilities Assets Liabilities
Checkable -$100m Reserves -$100m Checkable -$100m
deposits deposits
Currency +$100m
Federal Reserve System

Assets Liabilities
Currency in +$100m
circulation
Reserves -$100m
The money supply process
Shifts from deposits into currency
Reserves are changed
Monetary base is stable (unchanged)
àEven if FED does not conduct open market operations, a shift from
deposits into currency will affect R. However, such a shift will have no
effect on MB.
The money supply process
Open market sale
The money supply process
Loans to Financial Institutions
Banking system make $100m discount loan with FED
Banking System Federal Reserve System
Assets Liabilities Assets Liabilities
Reserve +$100m Discount +$100m Discount +$100m Reserves +$100m
s Loans Loans
(borrowing from Fed) (borrowing from Fed)

àReserves increased by $100m

àMonetary base increased by $100m
The money supply process
Overview of The Fed’s Ability to Control the Monetary Base
FED can control Monetary base better than reserves in banking
system
FED can control open market operations, hence, can fully control
monetary base
FED cannot determine the amount of borrowing by banks, hence,
remain passive in controlling monetary base
Multiple deposit creation: a simple
model
Deposit creation: a single bank
Deposit creation: the banking system
Multiple deposit creation: a simple
model
Deposit creation: a single bank
Case study: FED makes a $100m open market purchase with First National bank
First National bank has excess reserve à make loans with borrowers to gain
profit by open checkable deposits and put the process of loans into this account
à create money
First National Bank
First National Bank Assets Liabilities
Assets Liabilities Securities -$100m Checkable +$100m
Securities -$100m deposits
Reserves +$100m Reserves +$100m
Loans +$100m
Multiple deposit creation: a simple
model
Deposit creation: a single bank
Borrowers make purchase from their checkable deposits, this make
First National bank reserve decrease.
àA bank cannot safely make a loan for an amount greater than the
excess reserves that they have before making the loan
The Final T-account of First National Bank First National Bank
Assets Liabilities
Securities -$100m
Loans +$100m
Multiple deposit creation: a simple
model
Deposit creation: a single bank
Conclusion: The increase in reserves of $100m has been converted
into additional loans of the same amount at First National Bank,
plus an additional $100m of deposits that have made their way to
another bank
Multiple deposit creation: a simple
model
Deposit creation: Banking system (rr=10%)
Bank A Bank A
Assets Liabilities Assets Liabilities
Reserves +$100m Checkable +$100m Reserves +$10m Checkable +$100m
deposits deposits
Loans +$90m

Bank B Bank B
Assets Liabilities Assets Liabilities
Reserves +$90m Checkable +$90m Reserves +$9m Checkable +$90m
deposits deposits
Loans +$81m
Multiple deposit creation: a simple
model
Deposit creation: Banking system (rr=10%)
Multiple deposit creation: a simple
model
Deposit creation: Banking system (rr=10%)
Banking system as a whole
Banking system

Assets Liabilities
Securities -$100m Checkable +$1000m
deposits

Reserves +$100m

Loans +$1000m
Multiple deposit creation: a simple
model
Deposit creation: Banking system (rr=10%)
The same result when banks invest their excess reserves in securities
If the banks choose to invest their ER in securities, the result is the same. If
Bank A buys securities with $90 cheque
Bank A

Assets Liabilities
Securities -$10m Deposits +100m

Loans +$90m

Seller deposits $90m at bank B and the process is the same

à Whether the bank chooses to use excess reserve to make loans or buy
securities, the effect on deposit expansion is the same
Multiple deposit creation: a simple
model
Multiple Deposit Contraction
The multiple deposit creation process should also work in reverse. When
FED withdraws reserves from the banking system , there should be a
multiple contraction of deposits.
In fact, the contraction in deposits will be
DD = (1/ r ) ´ DR
Example:
If DR = -100 and (1/ r ) = 10 because r =.10, then
DD = -1000.
Multiple deposit creation: a simple
model
Multiple Deposit Contraction
The banking system Banking system
Assets Liabilities

Securities +$100m Checkable -$1000m

deposits

Reserves -$100m
Loans -$1000m
Multiple deposit creation: a simple
model
Critique of the Simple Model
Holding cash stops the process
◦ Currency has no multiple deposit expansion
Banks may not use all of their excess reserves to buy securities or
make loans.
Depositors’ decisions (how much currency to hold) and bank’s
decisions (the number of excess reserves to hold) also cause the
money supply to change.
Factors that determine the money
supply
Changes in the non-borrowed monetary base MBn(Central Bank)
◦ The money supply is positively related to the non-borrowed monetary base MBn

Changes in borrowed reserves from the Fed (Bank)

◦ The money supply is positively related to the level of borrowed reserves, BR, from the Fed

Changes in the required reserves ratio (Central Bank)

◦ The money supply is negatively related to the required reserve ratio.

Changes in currency holdings (public)

◦ The money supply is negatively related to currency holdings.

Changes in excess reserves (bank)

◦ The money supply is negatively related to the amount of excess reserves.
Factors that determine the money
supply
The complete money supply
model
Money Supply is defined as M1 (M1=C+R)
Because Central bank can exert more precise control over MB
than it can over R, we link the money supply with MB. Let’s say m
is the relation between MB and M
M = m x MB
The complete money supply
model
(*)MB = C+R = C + RR + ER RR = rr x D ER = er x D C = C/D x D
àMB = (rr + er + C/D) x D
àD = 1/(rr+er+C/D) x MB
(**)M = C + D = C/D x D + D = (1+C/D) x D
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àM= ! ×𝑀𝐵
(%%#&%# )
"
!
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àm= !
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The complete money supply
model
An example
rr=1%; er=4% C=$40 billion D=$160 billion
M=C+D=40+160=$200b
!"#/% !"()/!*)
m=&&"'&"#/% = ),)!"),)("()/!*) = 4.2

The money multiplier tells us that given the behavior of the public as
represented by C/D=0,25 and banks as represented total reserve ratio
rr+er=5%, a $1 increase in MB will lead to a $4,2 rise in M
Thank you!