Chapter 4: The money supply process

Contents of the chapter

4.1 Players in the Money Supply Process
4.2 Central Bank Balance Sheet and Control of the monetary
base
4.3 Multiple Deposit Creation by banking system
4.4 Monetary Supply Model and Money Multiplier
4.5 Over view of the Money Supply Process, Endogeneity of
money supply

1
 4.1 Introduction

 Movements in the money supply affect interest rates and

the overall health of the economy and thus affect us all.

 Because of its far-reaching effects on economic activity, it

is important to understand

 How the money supply is determined?

 Who controls it?

 What causes it to change?

 How might control of it be improved?

2
Cont’d

 Because deposits at banks are the largest component of the

money supply, Understanding how these deposits are created is

the first step in understanding the money supply process.

 This chapter provides

 An overview of how the banking system creates deposits,

 Describes the basic principles of the money supply

3
 The four players in the money supply process

 The central bank –oversees the banking system and is

responsible for the conduct of monetary policy.

 Banks (depository institutions) –accept deposits and make

loans, commercial , savings and loan associations, mutual

savings banks, and credit union

 Depositors( savers) – individuals and institutions that hold

deposits in banks.

 Borrowers from banks (lenders)– individuals and

institutions that borrow from the depository institutions

4
 Function of central bank
 Of the four players, the central bank—the National
Bank—is the most important.
 The NB’s conduct of monetary policy involves actions that
affect its balance sheet - holdings of assets and liabilities
 CB is the apex institution in the banking & monetary
structure of a country
 The principles on which a CB is run different from ordinary
banking principle
 An ordinary bank runs to offer profits, but a CB is primarily
meant to promote the financial & economic stability of the
country .
 Stabilize the nation's currency, keep unemployment low,
and prevent inflation 5
 Issue New Currency

 Monopoly of note-issue vested in the CB ensures

uniformity which helps in facilitating exchange & trade

 It strives to brings stability in the monetary system &

creates confidence in the public.

 The CB can restrict/expand the supply of cash according

to requirements of the economy.

 Thus, it provides elasticity to the monetary system.

6
4.2 The central bank balance sheet and the monetary
base

4.2.1 Central Bank’s Balance Sheet

 The operation of the Fed and its monetary policy affect its
balance sheet - its holdings of assets and liabilities.

 Just as any other bank has a balance sheet that lists its assets
and liabilities, so does the central bank

7
8
 Balance Sheet of banks other than NB
Asset (Use of funds Liabilities ( Source of funds

Reserves & securities Checkable deposit (DD)

Cash item in collection and deposit saving &time deposit
@ other banks discount loan

securities (gov’t , federal , state ) small denomination time deposit (

<1&00,000 and ld td
Loans ( business, consumer etc) borrowing
Other asset (physical capital building capital

9
 balance sheet of general
Public
Asset Liabilities
-securities Consumer loan(borrowing) from
Demand deposit bans
Or other sources
Currency other liabilities
Saving /time
deposits
Other non financial Capital (Net worth)
asset

10
 Liabilities of CB(NBE)
 they are an important part of the money supply story,
 Because increases in either or both will lead to an increase in the money
supply
 1. Central bank notes (currency) outstanding….issued BY CB
 Is the amount of this currency that is in the hands of the
public( pieces of paper/notes in your wallet).
 (Currency held by depository institutions is also a liability of the
NBE, but is counted as part of the reserves liabilities .)
 referred to as the monetary liabilities of the Central bank
 Treasury currency(coins)= the Treasury's monetary liabilities
(Treasury currency in circulation …Treasury liabilities
 Currency in circulation (C )=Treasury currency + Central bank
currency 11
 2. Reserves

 Reserve: consist of deposits at the Fed plus currency

that is physically held by banks (called vault cash because it
is stored in bank vaults)
 Reserve requirements :Regulation making it obligatory for depository institutions
to keep a certain fraction of their deposits in accounts with the Fed(NBE in our
case)
 Required reserves :that are held to meet the Fed’s requirement that for every
dollar of deposits at a bank, a certain fraction must be kept as reserves
 Required reserve ratio The fraction of deposits that the Fed requires be kept as
reserves
 Currently, national banks doesn’t pay the interest in
reserve

12
 All banks have an account at the Central bank in
which they hold deposits.

 Reserves are assets for the banks but liabilities for the
Fed,

 Because the banks can demand payment on them at

any time and the Fed is required to satisfy its
obligation by paying Federal Reserve notes.

 An increase in reserves leads to an increase in the level

of deposits and hence in the money supply

13
 Total reserves can be divided into two categories:

 Required reserves - reserves that the Fed requires banks

to hold and

 Excess reserves - any additional reserves the banks

choose to hold. those liabilities of the Central bank do
not pay interest,

 For example, the Fed might require that for every birr of
deposits at a depository institution, a certain fraction (say,
10 cents) must be held as reserves.

 This fraction (10%) is called the required reserve ratio.

14
15
 Asset -
 [Link]
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)

 Changes in the asset items lead to changes in reserves and

then changes in the money supply.

 These assets earn interest income

 Although it returns most of its earnings to the federal

government, the Fed does spend some of it on “worthy causes,” such
as supporting economic research.

16
Cont’d

2. Discount loans

these are loans the Central Bank (Fed) makes 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.

 Since it earns interest for central bank

3. coin: is the smallest item in the balance sheet,

consists of Treasury currency (mostly coins) held by the Central
bank. 17
Cont’d

 The Federal Reserve exercises control over the monetary

bases
 Purchases or sale of government securities in the open market

 Its extension of discount loans to banks.

 The primary way in which the Fed causes changes in the

monetary base is through its open market operations.

 A purchase of bonds by the Fed is called an open market

purchase, and a sale of bonds by the Fed is called an open
market sale.

18
 4. Gold and SDR certificate accounts

 Special drawing rights (SDRS) are issued to

governments by the International Monetary Fund (IMF) to
settle international debts and have replaced gold in
international financial transactions

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.

19
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 buildings owned by the Central bank
4.2.2 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
 Is also high –powered money
 Is the sum monetary liabilities of the Central bank n and
treasury monetary liabilities

20
MB = (Central bank notes(currency) + Treasury currency
(coin) + reserves = C + R
 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.

21
22
 4.2.3 CONTROL OF THE MONETARY BASE
The Central bank exercises control over the monetary base
via 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)

 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.

23
Open Market Purchase from a Bank

 Suppose that the Fed/NBE purchases $100 of bonds from a bank

and pays for them with a $100 check.

 The bank will either deposit the check in its account with the
Fed or cash it in for currency, which will be counted as vault
cash.

 Either action means that the bank will find itself with
$100 more reserves and a reduction in its holdings of
securities of $100.

24
The T-account

25
Cont’d

 The Fed’s liabilities have increased by the additional $100 of

reserves,

 While its assets have increased by the $100 of additional

securities that it now holds.

 The net result of this open market purchase is that reserves

have increased by $100, the amount of the open market
purchase.

 Because there has been no change of currency in circulation,

the monetary base has also risen by $100.
26
 Open Market Purchase from the Nonbank Public

 To understand what happens when there is an

open market purchase from the nonbank public,
we must look at two cases.

 First, let’s assume that the person or corporation

that sells the $100 of bonds to the Fed deposits the
Fed’s check in the local bank.

 The nonbank public’s T-account after this

transaction is:

27
Cont’d

28
Cont’d

 When the bank receives the check, it credits the

depositor’s account with the $100 and then deposits
the check in it account with the Fed, thereby
adding to its reserves.

 The banking system’s T-account becomes:

29
Cont’d

 The effect on the Fed’s balance sheet is that it has

gained $100 of securities in its assets column, while
it has an increase of $100 of reserves in its
liabilities column

30
 The net result of the Fed’s open market purchase from the non-bank
public is identical to the effect of its open market purchase from a
bank:
 Reserves increase by the amount of the open market purchase, and
the monetary base increases by the same amount.
 The analysis reveals that 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.
 If the proceeds are kept in Currency, the open market
purchase has no effect on reserves; if the proceeds are kept
as deposits, reserves increase by the amount of the open
market purchase 31
 The effect of an open market purchase on
the monetary base, however, is always the
same (the monetary base increases by the
amount of the purchase) whether the seller
of the bonds keeps the proceeds in deposits
or in currency.
 The impact of an open market purchase on
reserves is much more uncertain than its
impact on the monetary base.

32
Cont’d

 If, however, the person or corporation selling the

bonds to the Fed cashes the Fed’s check either at a
local bank or at a Federal Reserve bank for
currency, the effect on reserves is different.

 This seller will receive currency of $100 while

reducing holdings of securities by $100.

33
Cont’d

 The Fed now finds that it has exchanged $100 of

currency for $100 of securities, so its T-account is:

34
 2. Open Market Sale
 Reduces the monetary base by the amount of the sale

 Reserves remain unchanged

 The effect of open market operations on the monetary base is much

more certain than the effect on reserves

 If the Central bank sells $100 of bonds to a bank or the nonbank public;
the monetary base will decline by $100. For example, if the Central
bank sells the bonds to an individual who pays for them with currency,
the buyer exchanges $100 of currency for $100 of bonds, and the
resulting T-account is

35
 T-Account
NONBANK PUBLIC FEDERAL RESERVE SYSTEM

Assets Liabilitie Assets Liabilities

s

Securities …………+$100 Securities - Currency in

$100 circulation - $100

Currency - $100
The effect of the open market sale of $100 of bonds is to reduce the
monetary base by an equal amount, although reserves remain
unchanged
in cases in which the buyer of the bonds is a bank or the buyer pays for
the bonds with a check written on a checkable deposit account at a
local bank lead to the same $100 reduction in the monetary base(the
36
level of reserves has fallen by $100)
 Shifts from Deposits into Currency
 Even if the Fed does not conduct open market
operations, a shift from deposits to currency will
affect the reserves in the banking system. However,
such a shift will have no effect on the monetary base,
another reason why the Fed/NB has more control over
the monetary base than over reserves.
 When a customer who opened the at national banks
decides to withdraw the $100 balance in cash and
vows never to deposit it in a bank again. The effect
on the T-account of the nonbank public is:
 The net effect on the monetary liabilities of the Fed
is a wash; the monetary base is unaffected by
customers’ disgust at the banking system. But
reserves are affected. Random fluctuations of
reserves can occur as a result of random shifts into
currency and out of deposits, and vice versa
37
  NONBANK PUBLIC
Asset Liabilities
Checkable deposits -100
Currency +100

BANKING System
Asset Liabilities
Reserves -100 Checkable deposits -100

FEDERAL RESERVE SYSTEM

Asset Liabilities
Currency in circulation +100
Reserves -100
The banking system loses $100 of deposits and hence $100 of
reserves: 38
 Discount Loans
 The monetary base is also affected when the Central bank
makes a discount loan to a bank

 The monetary liabilities of the Central bank have now

increased by $100 and the monetary base, too, has increased
by this amount.

 However, if a bank pays off a loan from the Central bank,

thereby reducing its borrowings from the Central bank by
$100
39
T-Account on discount loan made by FED to Banking system
 Banking system FED system
Asset Liabilities Asset Liabilities

Reserves +$100 Discount loan Discount Reserves +$100

+100 Loan +100

However, if a bank pays off a loan from the Fed, thereby reducing its
borrowings from the Fed by $100. he net effect on the monetary
liabilities of the Fed, and hence on the monetary
base, is then a reduction of $100. as T- account represented as follows
Banking system Federal Reserve system
Asset Liabilities Asset Liabilities
Reserves -$100 Discount loan Discount Reserves -$100
-100 Loan -100

40
 4.2.4 Overview of the Central Bank's
Ability to Control the Monetary Base
 Fed has complete control of the monetary base
through its open market operations and discount
loan.
 But Two important items that are not controlled by
the Fed but affect the monetary base are float and
Treasury deposits at the Fed. float and Treasury
deposits undergo substantial short-run variations.
 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 Fed from accurately controlling it
 Float = cash items in a process of collection minus
deferred/delayed Availability cash items
41
4.3 Multiple deposit creation: a simple model
 Creation of credit means that the commercial banks by taking

in deposits and making loans expand the money supply.

 Creation of credit is one of the important functions of

commercial banks.

 Credit creation is the multiple expansion of banks demand

deposits. Or Required reserve is required from the demand deposit

 When the Fed supplies the banking system with $1 of

additional reserves, deposits increase by a multiple of this
amount—a process called multiple deposit creation

42
Cont’d

 Banks advance a major portion of their deposits to the

borrowers and keep smaller part of them for the payment

to the customers on demand

 This tendency on the part of the commercial banks to

make loans several times of the excess cash reserves kept

by the bank is called creation of credit

43
 4.3.1 Deposit Creation: The Single Bank

 Suppose that the $100 open market purchase described earlier was
conducted with the Commercial Bank of Ethiopia.

Commercial Bank of Ethiopia

Assets Liabilities
Securities -$100
Reserves +$100

 Because the bank has no increase in its checkable deposits, required

reserves remain the same, and the bank finds that its additional $100
of reserves means that its excess reserves have increased by $100.

44
 Let's say that the bank decides to make a loan equal
in amount to the $100 increase in excess reserves
 Assume that the bank does not want to hold
excess reserves because it earns no interest on
them. In such cases, if the bank makes the loan, it
sets up a checking account for the borrower and
puts the proceeds of the loan into this account.
 In this way, the bank alters its balance sheet by
increasing its liabilities by $100 of checkable
deposits and at the same time increasing its assets
by the $100 loan. The T-account looks like this.
Commercial Bank of Ethiopia
Asset Liabilities
Securities -$100 Checkable deposits +$100
Reserves +$100
Loans +100 45
 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.
 In its current balance sheet position, the Commercial Bank
of Ethiopia still has excess reserves and so might want to
make additional loans. However, these reserves will not
stay at the bank for very long
 The borrower took out a loan not to leave $100 idle at the
Commercial Bank of Ethiopia but to purchase goods and
services from other individuals and corporations. When
the borrower makes these purchases by writing checks,
they will be deposited at other banks, and the $100 of
reserves will leave the Commercial Bank of Ethiopia

46
 Asset Liabilities
The final T-account
Securities -$100 of the Commercial Bank of Ethiopia is
Loans +$100

A single bank cannot safely make loans for an amount

greater than the excess reserves it has before it makes
the loan.
Thus, we need to say that a single bank cannot creates
multiple deposit expansion

47
Multiple deposit creation by banking system
 Expansion of banking systems creates multiple deposit. When previous
loan made by CBE deposited at Wegagen bank …that this bank and all
other banks hold no excess reserves. Wegagen's T-account becomes
Wegagen bank

Asset Liabilities
Reserves +$100 Checkable deposits +$100

 If the required reserve ratio is 10%, this bank will now find itself with
a $10 increase in required reserves, leaving it $90 of excess reserves.
Because Wegagen Bank CBE does not want to hold on to excess
reserves, it will make loans for the entire amount.

48
 Its loans increase by 90 and checkable deposits will increase
by $100.
Wegagen Bank T-account
Assset Liabilites
Reserve +10 Checkable deposit 100
Loans +90
If the money spent by the borrower to whom Wegagen bank lent the $90 is
deposited in another bank such as Awash I. bank …Awash T- account will be

Asset liabilities
Reserves Checkable deposits
+$90 $90
Checkable deposit in banking system incease by 90 and a total increase of
$190 ($100 at Bank wegagen plus $90 at Bank Awash).( 100 wegagen+ 90
Awash)

49
 Awash bank will want to modify its balance sheet further. It
must keep 10% of $90 ($9) as required reserves and has 90%
of $90 ($81) in excess reserves and so can make loans of this
amount. Bank B will make an $81 loan to a borrower, who
spends the proceeds from the loan.
 Awash banks’ T-account will be
ASSET LAIBILITIES
Reserves +9 Checkable deposit +90
Loan +81
The $81 spent by the borrower from Awash International Bank will be
deposited in another bank (Dashen Bank). Consequently, from the
initial $100 increase of reserves in the banking system, the total
increase of checkable deposits in the system so far is $271 (=$100
+$90 + $81)

50
 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 Dashen Bank, Abyssinia Bank, United Bank, and so on), as
depicted in Table 4.3. Therefore, the total increase in deposits from the
initial $100 increase in reserves will be $1000: The increase is tenfold,
the reciprocal of the 0.10 reserve requirement. Multiple deposit creation
process would continue until ER gone /used up (ER=0).
 If the banks choose to invest their excess reserves in
securities, the result is the same. If Wegagen Bank had
taken its excess reserves and purchased securities instead of
making loans, the he effect on deposit expansion is the
same and its T-account would have looked like this:
WEGAGEN BANK
Asset Liabilities
Reserves +$10 Checkable deposit
+$100
Securities +$90
51
ABLE 4.3 Creation of Deposits (assuming 10 percent
reserve requirement and a $100 increase in reserves )

52
 The multiple increases in deposits generated from an
increase in the banking system's reserves is called the
simple deposit multiplier. In our example with a 10 percent
required reserve ratio, the simple deposit multiplier is 10.
 More generally, the simple deposit multiplier equals the
reciprocal of the required reserve ratio, expressed as a
fraction (10 = 1/0.10), so the formula for the multiple
expansions of deposits can be written as

53
 When the Central Bank withdraws reserves(
by OMO SALE OF Securities) from the
banking system, there should be a multiple
contraction of deposits. … the same manner
1000 multiple contraction of deposits takes
place……..( Reading assignment )

54
 Deriving the Formula for Multiple Deposit
Creation(Simple deposit multiplier
 Our that banks do not hold on to any assumption excess
reserves means that the RR=R
 RR= r* D … r = required reserve ratio
 Substituting r * D for RR in the first equation,
 R = r*D and dividing both sides of the preceding equation by r
gives us &taking delta for both sides to indicate change
 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

55
  cont’d
 For the banking system as a whole, deposit creation
(or contraction) will stop only when all excess
reserves in the banking system are gone;
 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,
ER = 0).
 Accordingly, a given level of reserves in the banking
system determines the level of checkable deposits
when the banking system is in equilibrium (ER = 0);
put another way, the given level of reserves supports a
given level of checkable deposits.
NB: Under multiple deposit creation model, changes in the public's
holdings of currency and banks' holdings of excess reserves have
not effect on deposit creation 56
57
 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.
 The actual creation of deposits is much less mechanical
than the simple model indicates. If proceeds from
Wegagen’s $90 loan are not deposited but are kept in
cash, nothing is deposited in, Awash International Bank,
and the deposit creation process stops dead in its tracks.

58
 The total increase in checkable deposits is only $100-
considerably less than the $1000 we calculated. So if some
proceeds from loans are used to raise the holdings of
currency, checkable deposits will not increase by as much as
our streamlined model of multiple deposit creation tells us.
 Another situation ignored in our model is one in which banks
do not make loans or buy securities in the full amount of
their excess reserves.
 If Wegagen Bank decides to hold on to all $90 of its excess
reserves, no deposits would be made in Awash International
Bank, and this would also stop the deposit creation process.
The total increase in deposits would again be only $100 and
not the $1000 increase in our example. Hence if banks choose
to hold all or some of their excess reserves, the full
expansion of deposits predicted by the simple model multiple
deposits creation does not occur
59
 Our examples rightly indicate that the Central Bank is not the
only player whose behavior influences the level of deposits
and therefore the money supply.
 Banks' decisions regarding the amount of excess reserves they
wish to hold and
 depositors' decisions regarding how much currency to hold can
cause the money supply to change
 Central banks’ power of setting the required reserve ratio and
the level reserves,/OMO/ , Credit control ,
 Their detail interaction described under the money supply
model topic

60
The Money Supply Model
 This model assumes the important role of depositors and
banks.
 In deriving a model of a money supply process, we consider
a simple definition of money (C + D) = M1.
 The central bank can control the monetary base better than it
control reserves, link the money supply ( ) to monetary
base (MB).

∆
Where;
∆

 This link is achieved by deriving a money multiplier m (a

ratio that relates a change in money supply to a given
change in the monetary base)

61
 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).
 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 than 1. a $1 change
in the monetary base leads to more than a $1 change in
the money supply.
 The money multiplier reflects the effect on the money
supply of other factors besides the monetary base,

62
Determinants of money multiplier
 Depositors' decisions about their holdings of currency
and checkable deposits are one set of factors affecting
the money multiplier

 The reserve requirements imposed by the Fed/central

bank on the banking system.

 Banks' decisions about excess reserves also affect the

money multiplier.

63
 Assume that the desired level of currency & excess reserve grows
proportionally with checkable deposit. the ratios of these
items to checkable deposits are constants in equilibrium:

c = C / D - currency ratio

e = ER / D - excess reserve ratio

 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

64
Cont’d

65
Cont’d

66
 It reveals the amount of the monetary base needed to support the
existing amounts of checkable deposits, currency, and excess
reserves
 An increase in the monetary base that goes into currency is not
multiplied, 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.
 whereas an increase that goes into supporting deposits is
multiplied

 An additional dollar of MB that goes into ER does not support any

additional deposits or currency.
 NB: Central Bank sets the required reserve ratio rD to be less than
1. T
 Thus $1 of reserves can support more than $1 of deposits, and the
multiple expansions of deposits can occur.

67
Cont’d

 The reason 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.

 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.

 For a given level of reserves, a higher amount of excess

reserves implies that the banking system in effect has
fewer reserves to support deposits

68
Cont’d

69
Cont’d

70
71
72
 Factors That Determine the Money
Multiplier

 Let us look at how this multiplier changes in response to

changes in the variables in our model: {C/D}, {ER/D}, and r.

 Changes in the Required Reserve Ratio (r)

 If the required reserve ratio on checkable deposits increases,
ceteris paribus, 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.

73
Cont’d

 The resulting deficiency in reserves then means that banks

must contract their loans, causing a decline in deposits and
hence in the money supply.

 The reduced money supply relative to the level of MB, which

has remained unchanged, indicates that the money multi-
plier has declined as well.

 The money multiplier and the money supply are negatively

related to the required reserve ratio rD

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Changes in the Currency Ratio (c)
 An increase in {C/D} means that depositors are converting
some of their checkable deposits into currency.

 In fact, checkable deposits undergo multiple expansions while

currency does not.

 Hence, when checkable deposits are being converted into

currency, there is a switch from a component of the money
supply that undergoes, multiple expansion to one that does not.

 The overall level of multiple expansion declines, and so must

the multiplier.

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Changes in the Excess Reserves Ration {ER/D}=e

 When banks increase their holdings of excess reserves

relative to checkable deposits, the banking system in

effect has fewer reserves to support checkable deposits.

 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.

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