INTRODUCTION TO

MONETARY
ECONOMICS (ECN 208)

LECTURER : RASHIDAT AKANDE

 Lecture 2
The Central Bank and the
Money Supply Process.
 Money supply
• The term money supply is the total amount of money
in the economy at a particular point of time. It is
synonymous to money stock or quantity of money.
• There are two definitions of money recognized by the
monetary authority in Nigeria. They are the M1 and
M2.
• The narrow money, M1 includes currency in
circulation with non bank public and demand
deposits with current accounts in the bank
• The broad money, M2 includes narrow money plus
savings and time deposits as well as foreign dominated
deposits
Four Players in Money Supply Process

• The central bank—the government agency that oversees the banking

system and is responsible for the conduct of monetary policy.
• 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

• Depositors—individuals and institutions that hold deposits in banks

• Borrowers from banks—individuals and institutions that borrow

from the depository institutions and institutions that issue bonds
that are purchased by the depository institutions
Central bank’s Balance Sheet

ASSETS LIABILITIES

Foreign assets Monetary base or high powered money

Domestic assets • Bank reserves
• Government securities • Currency in circulation
• Discounted loans Other liabilities
Other assets
 Liabilities

• Reserves; All banks have an account with in which they

hold deposits. Reserves consist of deposits with the CB
plus currency that is physically held by banks.
• Reserves are assets for the banks but liabilities for the CB,
because the banks can demand payment on them at any
time and the CB is required to satisfy its obligation by
paying the notes.
• An increase in reserves leads to an increase in the level of
deposits and hence in the money supply.
• Currency in circulation is the amount of currency in the
hands of the public.
 Assets

• Government Securities; The CB provides reserves to the

banking system by purchasing securities, thereby
increasing its holdings of these assets. An increase in
government securities held by the CB leads to an increase
in the money supply.

• Discount Loans; The CB can provide reserves to the

banking system by making discount loans to banks. An
increase in discount loans can also be the source of an
increase in the money supply. The interest rate charged
banks for these loans is called the discount rate.
 Multiple Deposit Creation;
Single Bank
• This is a process whereby, when the CB supplies the
banking system with an additional reserves, deposits
increase by a multiple of the amount.
• Suppose there is N1000 open market purchase, the
commercial bank account would be as follows

• First Bank
ASSETS LIABILITIES

Securities -N1000
Reserves +N1000
 Multiple Deposit Creation;
Single Bank
• After the CB has bought the N1000 bond from the bank, the bank finds that
it has a reduction in its securities of N1000 and an increase in reserves of
N1000.

• Assuming the bank does not want to hold excess reserve and he makes a
loan amount of N1000

• First Bank
ASSETS LIABILITIES

Securities -N1000 Checkable deposit +N1000

Reserves +N1000
Loans +N1000
The bank has created checkable deposits by its act of lending. Because
checkable deposits are part of the money supply, the bank’s act of lending has
in fact created money.
 Multiple Deposit Creation;
Single Bank
• The loan will not stay for a long period since the
borrower would use it for some sort of transactions.

• When the borrower makes these purchases by

writing checks, they will be deposited at other banks,
and the N1000 of reserves will leave the originating
Bank. The account will therefore be as it was before.
• First Bank
ASSETS LIABILITIES

Securities -N1000
Loan +N1000
 Multiple Deposit Creation;
Other banks
• The increase in reserves of N1000 has been
converted into additional loans of N1000 at the
commercial Bank, plus an additional N1000 of
deposits that have made their way to other banks.
(All the checks written on accounts at the First Bank
are deposited in banks rather than converted into
cash, because we are assuming that the public does
not want to hold any additional currency.)
 Multiple Deposit Creation;
Other banks
• To simplify the analysis, let us assume that the
N1000 of deposits created by First Bank’s loan is
deposited at Bank A and that this bank and all other
banks hold no excess reserves. Bank A’s T-account
becomes:

• Bank A
ASSETS LIABILITIES

Reserves +N1000 Checkable deposit +N1000

 Multiple Deposit Creation;
Other banks
• If the required reserve ratio is 10%, this bank will now
find itself with a N100 increase in required reserves,
leaving it N900 of excess reserves. Because Bank A (like
the First Bank) does not want to hold on to excess
reserves, it will make loans for the entire amount.

• Its loans and checkable deposits will then increase by

N900, but when the borrower spends the N900 of
checkable deposits, they and the reserves at Bank A will
fall back down by this same amount. The net result is that
Bank A’s T-account will look like this:
 Multiple Deposit Creation;
Other banks
• Bank A
ASSETS LIABILITIES

Reserves +N100 Checkable deposit +N900

Loans +N900

• If the money spent by the borrower to whom Bank

A lent the N900 is deposited in other banks say bank
B, Bank B’s T-account would be;
 Multiple Deposit Creation;
Other banks
• Bank B
ASSETS LIABILITIES

Reserves +N900 Checkable deposit +N900

• Bank B will want to modify its balance sheet further. It

must keep 10% of N900 (N90) as required reserves and
has 90% of N900 (N810) in excess reserves and so can
make loans of this amount. Bank B will make an N810
loan to a borrower, who spends the proceeds from the
loan. Bank B’s T-account will be:
 Multiple Deposit Creation;
Other banks

ASSETS LIABILITIES

Reserves +N90 Checkable deposit +N810

Loan +N810

• The N810 spent by the borrower from Bank B will be

deposited in another bank (Bank C). Consequently, from
the initial N1000 increase of reserves in the banking
system, the total increase of checkable deposits in the
system so far is N2710 (= N1000 + N900 + N810).
 Multiple Deposit Creation

• If the banks choose to invest their excess reserves in

securities, the result is the same. If Bank A had taken
its excess reserves and purchased securities instead
of making loans, its T-account would have looked
like this:
ASSETS LIABILITIES

Reserves +N100 Checkable deposit +N1000

Security +N900
 Multiple Deposit Creation

• Following the same reasoning, if all banks make

loans for the full amount of their excess reserves,
further increments in checkable deposits will
continue (at Banks C, D, E, and so on). Therefore,
the total increase in deposits from the initial N1000
increase in reserves will be N10,000
• The multiple increase 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
r = required reserve ratio (0.10 in the example)

∆R = change in reserves for the banking system (N1000 in

the example)
 Criticism

• Not all loans are deposited, some would be held as

cash. This will stop the multiple deposit creation
process.
• Banks do not make loans or buy security of the full
amount of their excess reserves.
 Money multiplier and money
supply
• The monetary base also known as high powered money is
the sum of commercial bank reserves and currency held by
the public and it is the basis for expansion of bank deposits
and creation of money supply.

• The Money supply or stock of money (Narrow money)

consist of currency held by the non-bank public or currency
in circulation (Cp) and non-bank public deposits or
checkable deposit (Dp)

M
• = Cp + Dp eq 1
• The monetary base consists of currency held by the non-bank
public (Cp) plus currency held by banks/excess reserves (Cb)
and bank’s deposits with central bank or required reserves
(Db). B = Cp + Cb + Db

The relationship between the M and B can be express as a ratio

between the twoM Cp + Dp
=
B Cp + Cb + Db

Divide the RHS by Dp

Cp + Dp
M Dp Dp
=
B Cp + Cb + Db
Dp Dp Dp
• For convenience let Cp/Dp be c, let Cb/Dp be e and Db/Dp
be r, then the equation becomes
M c +1
=
B c+r+e
• The equation above implies that the volume of money stock or
money supply in relation to the base depends upon the ratio c,
which is the public cash ratio and r which is the required reserve
ratio and e, which is the excess reserve ratio.
• If we assume these ratios are stable then we can predict that:
c +1 c +1
M = B. ΔM = ΔB.
c+r+e c+r+e
The multiplier is therefore =
c +1
m=
c+r+e