KUWAIT UNIVERSITY
COLLEGE OF BUSINESS ADMINISTRATION
DEPARTMENT OF ECONOMICS
Money & Banking
Econ240
Instructor Notes
Mahmoud Arab
TEACHING ASSISTANT
Kuwait University Econ240 Mahmoud Arab
Chapter 15: The Money Supply Process
❖ Players in the Money Supply Process:
1. The Central bank: “strongest player because of the tools it has”.
2. Banks: depository institutions; financial intermediaries
3. Depositors: individuals and institutions
❖ The Fed’s Balance Sheet:
1. Liabilities:
i) Currency in circulation: in the hands of the public.
ii) Reserves: bank deposits at the Fed and vault cash.
2. Assets:
i) Government securities: holdings by the Fed that affect money supply and earn
interest (TBills, Government Bonds) (largest part in the assets).
ii) Discount loans: provide reserves to banks and earn the discount rate (Central Bank is
the lender).
Central Bank Commercial Bank
Assets Liabilities Assets Liabilities
Reserves Deposits
Securities Currency in circulation
Securities Borrowings (Discount
Discount Loans Reserves Loans)
Loans Capital
❖ Monetary Base:
𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒 (𝑀𝐵) = 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦𝑖𝑛 𝑐𝑖𝑟𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 (𝐶) + 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠(𝑅)
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 (𝑅) = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 (𝑅𝑅) + 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠(𝐸𝑅)
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 (𝑅) = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 𝑅𝑎𝑡𝑖𝑜 (𝑅𝑅𝑅) × 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠 (𝐷)
1. Monetary Base is high powered money because the Central Bank has fully control over
the monetary base.
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Kuwait University Econ240 Mahmoud Arab
2. How To control Monetary Base:
a. Open Market Operations: The purchase and sale of government severities by the
Central Bank:
(i) Open Market Purchase:
1. Central Bank purchase securities from the banks or public.
2. The effect of an open market purchase on reserves depends on
whether the seller of the bonds keeps the proceeds from the sale in
currency or in deposits.
3. The effect of an open market purchase on the monetary base always
increases the monetary base by the amount of the purchase.
4. Central Bank usually does not care who keeps the proceeds from the
sale in currency or in deposits because it will always end with increase
in monetary base.
(ii) Open Market Sale:
1. Central Bank sells securities to the banks or public.
2. Reduces the monetary base by the amount of the sale
3. The effect of open market operations on the monetary base is much
more certain than the effect on reserves.
Open
Market
Operations
Sale Purchase
"Monetary "Monetary
Base Base
Decreases" Increases"
Non Bank Non Bank
Bank Bank
(Public) (Public)
Reserves Reserves
Cash Checks Cash Deposit
Decreases Increases
Currency in Currency in
Reserves Reserves
Circuraltion Circuraltion
Decreases Increases
Decreases increases
b. The composition of the MB can change because of shifts from Deposits into
Currency:
i. Net effect on monetary liabilities (central bank) is zero
ii. Reserves are changed by random fluctuations
iii. Monetary base is a relatively stable variable
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Kuwait University Econ240 Mahmoud Arab
c. Loans to Banks: loans to banks by Fed at a lending rate:
i. Monetary liabilities of the Federal Reserve will increase.
ii. Monetary base also increases by the same amount.
d. Other factors that affect the Monetary Base:
i. Treasury deposits at the Federal Reserve.
ii. Interventions in the foreign exchange market.
❖ Overview of the Fed’s Ability to Control the Monetary Base:
1. Open market operations are controlled by the Fed
2. The Fed cannot determine the amount of borrowing by banks from the Fed
3. The money supply is positively related to both the non-borrowed monetary base and
to the level of borrowed reserves from the Fed
4. Deposit Creation: Single Bank:
Bank The
Excess loans out Creates a Borrower Money
reserves the checking makes supply
increase excess account purchases has
reserves increased
5. Deposit Creation: The Banking System
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∆𝐷 = 𝑥 ∆𝑅
𝑟
∆𝐷 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠
𝑟 = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑑 𝑅𝑎𝑡𝑖𝑜
∆𝑅 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠
1
= 𝑟𝑒𝑝𝑟𝑒𝑠𝑒𝑛𝑡𝑠 𝑡ℎ𝑒 𝑆𝑖𝑚𝑝𝑙𝑒 𝑀𝑜𝑛𝑒𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
𝑟
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Kuwait University Econ240 Mahmoud Arab
6. Critique of the Simple Model:
a) Holding cash stops the process
b) Currency has no multiple deposit expansion
c) Banks may not use all of their excess reserves to buy securities or make loans
d) Depositors’ decisions (how much currency to hold) and bank’s decisions (amount
of excess reserves to hold) also cause the money supply to change.
❖ Factors That Determine the Money Supply:
1. Changes in the nonborrowed monetary base (open market operations):
a. The money supply is positively related to the non-borrowed monetary base MBn
2. Changes in borrowed reserves from the Fed (discount loans):
a. The money supply is positively related to the level of borrowed reserves, BR,
from the Fed
3. Changes in the required reserves ratio (Central Bank):
a. The money supply is negatively related to the required reserve ratio.
4. Changes in currency holdings (Public):
a. The money supply is negatively related to currency holdings. Because the
currency holding by the public will not lead to create loans, unlike when the
currency is withing the banks as reserves.
5. Changes in excess reserves (Commercial Banks):
a. The money supply is negatively related to the number of excess reserves
holdings.
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Kuwait University Econ240 Mahmoud Arab
❖ The Money Multiplier:
1. Link the money supply (M) to the monetary base (MB) and let m be the money multiplier
𝑀𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 (𝑀1) = 𝐶𝑢𝑟𝑟𝑛𝑐𝑦 𝑖𝑛 𝐶𝑢𝑟𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 + 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠
𝑀𝑚𝑜𝑛𝑒𝑦 𝑠𝑢𝑝𝑝𝑙𝑦 (𝑀1) = 𝑚𝑜𝑛𝑒𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑚) 𝑥 𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒(𝑀𝐵)
1+𝑐
𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑙𝑙𝑦 (𝑀1) = 𝑥 𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒 (𝑀𝐵)
𝑟+𝑒+𝑐
1+𝑐
𝑚𝑜𝑛𝑒𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑚) =
𝑟+𝑒+𝑐
c = {Currency in circulation / Total Deposits} = currency ratio
e = {Excess Reserves /Total Deposits} = excess reserves ratio
r = Required Reserve Ratio
i. r (required reserve ratio) applies only for Demand deposits (DD) NOT on saving and
time deposits because they are more stable.
ii. {r, c, e} are negatively related to money multiplier
❖ Quantitative Easing and the Money Supply, 2007–2017
Fed initiated
No change in
lending programs Huge increase in
Money supply
(Discount Loans) the monetary
Global financial because money
and large-scale base
crisis 2007 supply because
asset-purchase "Quantitative
excess reserves
programs (Open Easing"
rose dramatically
Market Purchase)