THE MONEY

SUPPLY
Learning Objectives:

• Discuss money supply and its types

• Develop a money supply model in which depositors
and banks assume their important roles
• Discuss that determine a money multiplier.
 Money Supply
Money is a vehicle of economic activities (i.e. in the circular flow). The stock of money serving this
function is called money supply and consists of the following:
• Coins and bills in circulation
• Demand deposits in banks (a bank account from which deposited funds can be withdrawn at any time,
without advance notice)
• Quasi Money (assets which can be easily converted to cash because they are in high demand and are
issued by entities with excellent creditworthiness.
• Saving deposits
• Time deposits
• Deposit substitutes (alternative form of obtaining funds from the public, other than deposits, through
the issuance, endorsement, or acceptance of debt instruments for the borrower's own account for the
purpose of relending or purchasing of receivables and other.)
Figure 14. Desired product flow
 Measures of Money Supply
The basic function of money is that it must The second definition of the money stock, M2
be acceptable as a medium of exchange. The is a broader definition. It includes the concept
M1 definition of money supply includes: of store of value which includes savings and
time deposits sometimes called near money or
M1 = currency circulation + demand quasi money.
deposits
M2 = M1 + time deposits + savings deposits
 Measures of Money Supply cont'd

The third measure of money is called
Total liquidator M3. This includes M2
plus papers or securities. These consist of
debt papers or securities issued by banks,
but are not deposits.
The last measure of money includes M3
plus the peso equivalent of dollar deposits
of residents called Foreign Currency deposit
units (FCDU) or offshore banking units
(OBU).

M4 = M3 + peso equivalent of dollar

M3 = M2 + deposits substitutes
deposits in FCDU and OBU.
 Effects of Money Supply in the economy
• Positive
An increase in the supply of money typically lowers interest rates.

• Negative
The opposite can occur if the money supply falls or when its growth rate declines. Banks
lend less, businesses put off new projects, and consumer demand for home mortgages and
car loans declines.
DETERMINANTS OF
MONEY SUPPLY
The Fed 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 = 𝑚 × 𝑀𝐵

where:
𝑀 = Money 𝑚 = money multiplier 𝑀𝐵= Monetary
supply base
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, as the braces in the following expressions
indicate:

𝑐 = {𝐶/𝐷} = currency ratio

𝑒 = {𝐸𝑅/𝐷} = excess reserves ratio
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 Fed affect the
multiplier m. We begin the derivation of the model of the money
supply with the equation:

𝑅 = 𝑅𝑅 + 𝐸𝑅
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 = (𝑟 × 𝐷) + 𝐸𝑅 + 𝐶
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. The currency component
of MB does not lead to multiple deposit creation as the reserves
component does.
To derive the money multiplier formula in terms of the
currency ratio c = {C/D} and the excess reserves ratio e =
{ER/D}, we rewrite the last equation, specifying C as c × D
and ER as e × D:

𝑀𝐵 = (𝑟 × 𝐷) + (𝑒 × 𝐷) + (𝑐 × 𝐷)

= (𝑟 + 𝑒 + 𝑐) × 𝐷
 Factors that Determine the Money
Multiplier

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.
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 r increases from 10% to 15% (leaving
all the other variables unchanged). The money multiplier
becomes:

𝑚=
For example, if r falls from 10% to 5%, plugging this value into
our money multiplier formula (leaving all the other variables
unchanged) yields a money multiplier of:

𝑚=
This reasoning is confirmed by our numerical example, where c
rises from 0.50 to 0.75. The money multiplier then falls from
2.5 to:

𝑚=
Two primary factors affect these costs and benefits
and hence affect the excess reserves ratio:

• Market Interest Rates

• The cost to a bank of holding excess reserves is its

opportunity cost, the interest that could have been earned
on loans or securities if they had been held instead of
excess reserves.
2. Expected Deposit Outflow

• The primary benefit to a bank of holding excess reserves is

that they provide insurance against losses due to deposit
outflows; that is, they enable the bank experiencing deposit
outflows to escape the costs of calling in loans, selling
securities, borrowing from the Fed or other corporations, or
bank failure.
 Thank you for
listening!
Reporters:
Jean Veronica Esperas
Ivan Dado
Jhon Onel Alega
Adrin Juntila Azcarraga