Chapter 4

The Money supply Process

• 4.1. Players in the Money Supply Process
• 1. The central bank – the government agency that oversees the
banking system and is responsible for the conduct of monetary
policy. This bank takes different names in different countries; the
Federal reserve system in the United States and National Bank in
Ethiopia, for instance.
• 2. Banks (depository institutions) – the financial intermediaries that
accept deposits from individuals and institutions and make loans:
commercial banks, savings and loan associations, mutual savings
banks, and credit unions.
• 3. Depositors – individuals and institutions that hold deposits in
banks.
• 4. Borrowers from banks – individuals and institutions that borrow
from the depository institutions and institutions that issue bonds that
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are purchased by the depository institutions.
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 4.2. Central Bank Balance Sheet and Control of the
monetary base
• 4.2.1. The central bank Balance sheet
• Just as any other bank has a balance sheet that lists its assets and
liabilities, so does the central bank.
• Assets:
• 1. Securities – these are the central banks holdings of securities,
which consist primarily of treasury securities. The total amount of
securities is controlled by open market operations (the central bank’s
purchase and sale of these securities). Securities are by far the largest
category of assets in the central banks’ balance sheet.
• 2. Discount loans- these are loans the Central Bank (Fed) makes to
banks, and the amount is affected by the Central bank's setting the
discount rate, the interest rate the Central bank charges banks for these
loans.
• 3. Gold and SDR certificate accounts. Special drawing rights (SDRS) are issued
to governments by the International Monetary Fund (IMF) to settle international
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debts and have replaced gold in international financial transactions.
 • 4. Coin- this is the smallest item in the balance sheet, and it
consists of Treasury currency (mostly coins) held by the
Central bank.
• 5. Cash items in process of collection- these arise from the
Central bank’s check-clearing process. When a check is
given to the Central bank for clearing, the Central bank will
present it to the bank on which it is written and will collect
funds by deducting the amount of the check from the bank’s
deposits (reserves) with the Central bank. Before these
funds are collected, the check is a cash item in process of
collection and is a Central bank asset.
• 6. Other Federal Reserve assets. These include deposits
and bonds denominated in foreign currencies as well as
physical goods such as computers, office equipment, and
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buildings owned by the Central bank.
 • Liabilities:-
• 1. Central bank notes (currency) outstanding. The Central bank
issues currency
• The Central bank notes outstanding are the amount of this currency
that is in the hands of the public.
• 2. Reserves. All banks have an account at the Central bank in which
they hold deposits.
• Reserves are assets for the banks but liabilities for the Central bank
because the banks can demand payment on them at any time and the
Central bank is required to satisfy its obligation by paying Central
bank notes.
• Total reserves can be divided in to two categories: reserves that the
Central bank requires banks to hold (required reserves) and any
additional reserves the banks choose to hold (excess reserves).
• 3. Treasury deposits. The Treasury keeps deposits at the Central
5/17/2024 bank, against which it writes all its checks
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 • 4. Foreign and other deposits, these include the deposits
with the Central bank owned by foreign governments,
foreign central banks, and international agencies (such as
the World Bank and the United Nations)
• 5. Deferred-availability cash items. Like cash items in
process of collection, these also arise from the Central
bank’s check–clearing process.
• 6. Other liabilities and capital accounts: this item
includes all the remaining liabilities not included
elsewhere on the balance sheet.
• For example, stock in the Central bank purchased by
member banks is included here.

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 Table 4.1. Central Bank Balance Sheet
Assets Liabilities

Securities Currency in circulation (notes

Discount loans and coins)
 Government Deposits (Reserves)
 Banks Banks reserve
Government reserve
 Non bank public
Foreign liabilities
Fixed assets Other liabilities
International Reserve Capital
 Foreign exchange
 Gold
Other assets
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Total assets Total Liabilities & Capital
 • 4.2.2 Monetary Base
• The first two liabilities on the balance sheet of the Central bank,
Central bank notes (currency) outstanding and reserves are often
referred to as the monetary liabilities of the Central bank.
• When we add to these liabilities the Treasury's monetary liabilities
(Treasury currency in circulation, primarily coins), we get a construct
called the monetary base.
• The monetary base is an important part of the money supply
because increases in it will lead to a multiple increase in the money
supply (everything else being constant).
• This is why the monetary base is also called high-powered money.
• Recognizing that Treasury currency and & Central bank currency can
be lumped together in to the category currency in circulation, denoted
by C, the monetary base equals the sum of currency in circulation C
plus reserves R. The monetary base MB is expressed as
• MB = (Central bank notes + Treasury currency - Coin) + reserves
5/17/2024 = C + R…….(1) By:Mesay.G.(Msc) 7
 • Because the " Central bank notes (currency)" and "reserves"
items in the uses of the base are Central bank liabilities, the
"assets equals liabilities" property of the Central bank
balance sheet enables us to solve for these items in terms of
the Central bank balance sheet items that are included in the
sources of the base:
• Specifically, Central bank notes (Currency) and reserves
equal the sum of all the Central bank assets minus all the
other Central bank liabilities:
• MB = Securities + discount loans + gold and SDRs +
f1oat + other Federal Reserve assets + Treasury
currency - Treasury deposits - foreign and other deposits
- other Federal Reserve liabilities and capital.
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 • 4.2.3 CONTROL OF THE MONETARY BASE
• The Central bank exercises control over the monetary base
via the first two factors listed in Table 4.2 below: through
its purchases or sales of government securities in the open
market, called open market operations, and through its
extension of discount loans to banks.
• i. Open Market Operations (OMO)
• As Table 4.2 suggests, the primary way in which the
Central bank causes changes in the monetary base is
through its open market operations.
• A purchase of bonds by the Central bank is called an open
market purchase, and a sale of bonds by the Central bank
is called an open market sale.
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 N Factors Value ($ Change Change in
o billions, end in factor Monetary
Base
of 1996)
Factors that Increase the Monetary Base

1 Securities: U.S. government and agency securities and 414.7

bankers acceptances

2 Discount loans 0.1

3 Gold and SDR certificate accounts 20.8

4 Float 4.3

5 Other Federal Reserve assets 32.2

6 Treasury currency 25.0

Subtotal 1 497.1

Factors that Decrease the Monetary Base

7 Treasury deposits with the Fed 7.7

8 Foreign and other deposits with the Fed 7.9

9 Other Federal Reserve liabilities and capital accounts 13.8

5/17/2024 Subtotal 2 29.4

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 • 4.2.4 Overview of the Central Bank's Ability to Control
the Monetary Base
• The factor that most affects the monetary base is the
Central bank's holdings of securities, which are
completely controlled by the Central bank through its open
market operation.
• Factors not controlled by the Central bank (for example,
float and Treasury deposits with the Central bank) undergo
substantial short-run variations and can be important
sources of fluctuation in the monetary base over time
periods as short as a week.
• Although float and Treasury deposits with the Fed undergo
substantial short-run fluctuations, which complicate control
of the monetary base, they do not prevent the Central bank
5/17/2024 from accurately controlling it.
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 • 4.3 MULTIPLE DEPOSIT CREATION: A
SIMPLE MODEL
• With our understanding of how the Central bank
controls the monetary base and the banking system,
we now have the tools necessary to explain how
deposits are created.

• When the Central bank supplies the banking

system with $1 of additional reserves, deposits
increase by a multiple of this amount - a process
called multiple deposit creation.
•
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 • 4.3.2 Deposit Creation: The Banking System
• The multiple increases in deposits generated from an
increase in the banking system's reserves is called the
simple deposit multiplier.

Where: D = change in total checkable deposits in the banking

system
• rD = required reserve ratio (0.10 in the example)
• R =change in reserves for the banking system
• The multiple deposit creation process should also work in
reverse; that is, when the Central Bank withdraws reserves
from the banking system, there should be a multiple
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contraction of deposits.
 • Deriving the Formula for Multiple Deposit Creation
• The formula for the multiple creations of deposits can also be derived directly using
algebra. We obtain the same answer for the relationship between a change in
deposits and a change in reserves, but more quickly.
• Our assumption that banks do not hold on to any excess reserves means that the total
amount of required reserves for the banking system RR will equal the total reserves
in the banking system R:
• RR= R...................................................................................................... (3)
• The total amount of required reserves equals the required reserve ratio rD times the
total amount of checkable deposits D:
• RR = rD X D............................................................................................ (4)
• Substituting rD X D for RR in the first equation,
• rD X D = R................................................................................................(5)
• and dividing both sides of the preceding equation by rD gives us
• ................................................................................... (6)
Taking the change in both sides of this equation and using delta to indicate a change,
• ................................................................................ ………..(7)

5/17/2024 which is the same formula for deposit creation found in Equation 2.
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 • This derivation provides us with another way of looking at the
multiple creations of deposits because it forces us to look directly
at the banking system as a whole rather than one bank at a time.
• For the banking system as a whole, deposit creation (or
contraction) will stop only when all excess reserves in the
banking system are gone; that is, the banking system will be in
equilibrium when the total amount of required reserves equals the
total amount of reserves, as seen in the equation RR = R. When rD
x D is substituted for RR, the resulting equation R = rD x D tells us
how high checkable deposits will have to be in order for required
reserves to equal total reserves.
• Accordingly, a given level of reserves in the banking system
determines the level of checkable deposits when the banking
system is in equilibrium (when ER = 0); put another way, the given
level of reserves supports a given level of checkable deposits.
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 • Critique of the Simple Model
• Our model of multiple deposit creation seems to indicate that the
Central Bank is able to exercise complete control over the level
of checkable deposits by setting the required reserve ratio and
the level reserve.
• 4.3.3 DETERMINANTS OF THE MONEY SUPPLY
• To simplify the analysis, we separate the development of our
model into several steps.
• First, because the Fed can exert more precise control over the
monetary base (currency in circulation plus total reserves in
the banking system) than it can over total reserves alone, our
model links changes in the money supply to changes in the
monetary base. This link is achieved by deriving a money
multiplier (a ratio that relates the change in the money supply to
a given change in the monetary base).
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• Finally, we examine the determinants
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of the money multiplier. 16
 • 4.3.4 THE MONEY SUPPLY MODEL AND THE
MONEY MULTIPLIER
• The Central Bank can control the monetary base better
than it can control reserves, it makes sense to link the
money supply M to the monetary base MB through a
relationship such as the following:
• M=mxMB...................................................................... (8)
• The variable “m” is the money multiplier, which tells us
how much the money supply changes for a given change
in the monetary base MB.
• This multiplier tells us what multiple of the monetary base
is transformed into the money supply. Because the money
multiplier is larger that 1, the alternative name for the
monetary base, high-powered money, is logical; a $1
change in the monetary base leads to more than a $1
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change in the money supply.
 The money multiplier reflects the effect on the money supply of
other factors besides the monetary base.
• Deriving the Money Multiplier
• In our model of multiple deposit creation above, we ignored the
effects on deposit creation of changes in the public's holdings
of currency and banks' holdings of excess reserves. Now we
incorporate these changes into our model of the money supply
process by assuming that the desired level of currency C and
excess reserves ER grows proportionally with checkable
deposits D; in other words, we assume that the ratios of these
items to checkable deposits are constants in equilibrium:
• {C/D} = currency ratio
• {ER/D} = excess reserves ratio
• where the braces indicate that we are treating the ratio as a
5/17/2024 constant in equilibrium. By:Mesay.G.(Msc) 18
 • We will now derive a formula that describes how the currency ratio
desired by depositors, the excess reserves ratio desired by banks; and
the required reserve ratio set by the Central Bank affect the multiplier
m. We begin the derivation of the model of the money supply with the
equation
• R=RR+ER........................................................................................ (9)
• which states that the total amount of reserves in the banking system R
equals the sum of required reserves RR and excess reserves ER. (Note
that this equation corresponds to the equilibrium condition RR = R in
equation 3, where excess reserves were assumed to be zero.).
• The total amount of required reserves equals the required reserve ratio
rD times the amount of checkable deposits D:
• RR = rD x D.................................................................................. (10)
• Substituting rD x D for RR in the first equation yields an equation that
links reserves in the banking system to the amount of checkable
deposits and excess reserves they can support:
• R = (rD x D) + ER.......................................................................... (11)
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 • Because the' monetary base MB equals currency C plus reserves R,
we can generate an equation that links the amount of monetary base to
the levels of checkable deposits and currency by adding currency to
both sides of the equation:
• MB = R + C = (rD X D) + ER + C................................................(12)
• An important feature of this equation is that an additional dollar of
MB that arises from an additional dollar of currency does not support
any additional deposits. This occurs because such an increase leads to
an identical increase in the right-hand side of the equation with no
change occurring in D.
• Another important feature of this equation is that an additional dollar
of MB that goes in to excess reserves ER does not support any
additional deposits or currency. The reason for this is that when a bank
decides to hold excess reserves, it does not make additional loans, so
these excess reserves do not lead to the creation of deposits.
• Therefore, if the Fed injects reserves into the banking system and they
are held as excess reserves, there will be no effect on deposits or
currency and hence no effect on the money supply.
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 • To derive the money multiplier formula in terms of the currency
ratio {C/D} and the excess reserves ratio {ER/D}, we rewrite the
last equation, specifying C as {C/D} x D and ER as {ER/D} X D:
• MB = (rD x D) + ({ER/D) x D). + ({CID)} xD) = (rD + {ER/D} +
{C/D}) x D
• We next divide both sides of the equation by the term inside the
parentheses to get an expression linking checkable deposits D to the
monetary base MB:

• Using the definition of the money supply as currency plus

checkable deposits (M = D +C) and again specifying C as {C/D} x D,
• M = D + ({C/D) x D) = (1 + {C/D}) x D
• Substituting in this equation the expression for D from Equation 13,
we have
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 • we have

• Finally, we have achieved our objective of deriving an

expression in the form of our earlier Equation 8. As you
can see, the ratio that multiplies MB is the money
multiplier that tells how much the money supply changes
in response to a given change in the monetary base
(high-powered money).
• The money multiplier m is thus;

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 • Intuition behind the Money Multiplier
• To get a feel for what the money multiplier means, let us again
construct a numerical example with realistic numbers for the
following variables:
• rD = required reserve ratio = 0.10
• C = currency in circulation = $400 billion
• D = checkable deposits = $800 billion
• ER = excess reserves = $0.8 billion
• M = money supply (Ml) = C + D = $1200 billion
• From these numbers we can calculate the values for the currency ratio
{C/D} and the
• excess reserves ratio {ER/D}:

The resulting value of the money multiplier is

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 4.3.5 FACTORS THAT DETERMINE THE MONEY MULTIPLIER
• To develop our intuition of the money multiplier even further, let us
look at how this multiplier changes in response to changes in the
variables in our model: {C/D}, {ER/D}, and rD. The "game" we are
playing is a familiar one in economics: We ask what happens when
one of these variables changes, leaving all other; variables the same
(ceteris paribus).
A-Changes in the Required Reserve Ratio rD
• If the required reserve ratio on checkable deposits increases while all
the other variables stay the same, the same level of reserves cannot
support as large an amount of checkable deposits; more reserves are
needed because required reserves for these checkable deposits have
risen.
• The resulting deficiency in reserves then means that banks must
contract their loans, causing a decline in deposits and hence in the
5/17/2024 money supply. By:Mesay.G.(Msc) 24
 • With less multiple deposit expansion, the money multiplier must fall.
We can verify that the foregoing analysis is correct by seeing what
happens to the value of the money multiplier in our numerical
example when rD increases from 10 percent to 15 percent (leaving all
the other variables unchanged).
• The money multiplier becomes
which, as we would expect, is less than 2.5.
• In this case, there will be more multiple expansions for checkable
deposits because the same level of reserves can now support more
checkable deposits, and the money multiplier will rise. For example, if
rD falls from 10 percent to 5 percent, plugging this value into our
money multiplier formula (leaving all the other variables unchanged)
yields a money multiplier of
• which is above the initial value of 2.5.
• We can now state the following result: money multiplier and the
money supply are negatively related to the required reserve ratio
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 • When banks increase their holdings of excess reserves relative
to checkable deposits, the banking system in effect has fewer
reserves to support checkable deposits.
• This means that given the same level of MB banks will
contract their loans, causing a decline in the level of checkable
deposits and a decline in the money supply, and the money
multiplier will fall.
• This reasoning is supported in our numerical example when
{ER/D} rises from 0.001 to 0.005.

• The money multiplier declines from 2.5 to 2.48

• Note that although the excess reserves ratio has risen , there
has been only a small decline in the money multiplier.
• The money multiplier and the money supply are negatively
5/17/2024 related to the excess reserves ratio {ER/D}.
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