Chapter 4:

The Money supply Process

• The Money supply Process
• 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?
• In this chapter, we answer these questions by providing a
detailed description of the money supply process and the
mechanism that determines the level of the money supply.
• Because deposits at banks are by far 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, and
describes the basic principles of the money
supply.
• Four Players in the Money Supply Process
• The “cast of characters” in the money supply story is
as follows:
1. The central bank—the government agency that
oversees the banking system and is responsible for
the conduct of monetary policy; in Ethiopia, it is
called the National Bank of Ethiopia.
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 are purchased by the depository
institutions
• Of the four players, the central bank—is the
most important.
Money Supply: Definition
• The quantity of money is defined as the
number of dollars held by the public, and we
assumed that the central bank controls the
supply of money by increasing or decreasing
the number of dollars in circulation through
open market operations.
• This explanation is a good starting point for
understanding what determines the supply of
money, but it is incomplete, because it omits
the role of the banking system in this process.
• In this section we see that the money supply is
determined not only by the Central bank
policy but also by the behavior of households
(which hold money) and banks (in which
money is held).
• We begin by recalling that the money supply
includes both currency in the hands of the
public and deposits at banks that households
can use on demand for transactions, such as
checking account deposits.
• That is, letting M denote the money supply, C
currency, and D demand deposits, we can
write
• Money Supply = Currency + Demand Deposits
M = C + D
• To understand the money supply, we must
understand the interaction between currency
and demand deposits and how the Central
bank policy influences these two components
of the money supply.
• 100-Percent-Reserve Banking
• We begin by imagining a world without banks.
In such a world, all money takes the form of
currency, and the quantity of money is simply
the amount of currency that the public holds.
• For this discussion, suppose that there is
$1,000 of currency in the economy.
• Now introduce banks. At first, suppose that
banks accept deposits but do not make loans.
The only purpose of the banks is to provide a
safe place for depositors to keep their money.
• The deposits that banks have received but have not lent
out are called reserves.
• Some reserves are held in the vaults of local banks
throughout the country, but most are held at a central
bank, such as the Federal Reserve.
• In our hypothetical economy, all deposits are held as
reserves: banks simply accept deposits, place the
money in reserve, and leave the money there until the
depositor makes a withdrawal or writes a check against
the balance.
• This system is called 100-percent-reserve banking.
• Suppose that households deposit the
economy’s entire $1,000 in Firstbank.
• Firstbank’s balance sheet—its accounting
statement of assets and liabilities—looks like
this:
• The bank’s assets are the $1,000 it holds as
reserves; the bank’s liabilities are the $1,000 it
owes to depositors. Unlike banks in our
economy, this bank is not making loans, so it
will not earn profit from its assets.
• The bank presumably charges depositors a
small fee to cover its costs.
• What is the money supply in this economy?
Before the creation of Firstbank, the money
supply was the $1,000 of currency.
• After the creation of Firstbank, the money
supply is the $1,000 of demand deposits.
• A dollar deposited in a bank reduces currency
by one dollar and raises deposits by one
dollar, so the money supply remains the same.
• If banks hold 100 percent of deposits in
reserve, the banking system does not affect
the supply of money.
 • Fractional-Reserve Banking
• Now imagine that banks start to use some of their
deposits to make loans—
• The advantage to banks is that they can charge interest
on the loans. The banks must keep some reserves on hand
so that reserves are available whenever depositors want
to make withdrawals. But as long as the amount of new
deposits approximately equals the amount of
withdrawals, a bank need not keep all its deposits in
reserve.
• Thus, bankers have an incentive to make loans. When
they do so, we have fractional-reserve banking, a system
under which banks keep only a fraction of their deposits
in reserve.
• Here is Firstbank’s balance sheet after it
makes a loan:
• This balance sheet assumes that the reserve–deposit
ratio—the fraction of deposits kept in reserve—is 20
percent. Firstbank keeps $200 of the $1,000 in
deposits in reserve and lends out the remaining $800.
• Notice that Firstbank increases the supply of money
by $800 when it makes this loan. Before the loan is
made, the money supply is $1,000, equaling the
deposits in Firstbank.
• After the loan is made, the money supply is $1,800:
the depositor still has a demand deposit of $1,000,
but now the borrower holds $800 in currency. Thus,
in a system of fractional-reserve banking, banks
create money.
• The creation of money does not stop with
Firstbank. If the borrower deposits the $800 in
another bank (or if the borrower uses the
$800 to pay someone who then deposits it),
the process of money creation continues.
Here is the balance sheet of Secondbank:
• Secondbank receives the $800 in deposits,
keeps 20 percent, or $160, in reserve,and
then loans out $640. Thus, Secondbank
creates $640 of money. If this $640 is
eventually deposited in Thirdbank, this bank
keeps 20 percent, or $128, inreserve and
loans out $512, resulting in this balance sheet:
• The process goes on and on. With each
deposit and loan, more money is created.
• Although this process of money creation can
continue forever, it does not create an infinite
amount of money. Letting rr denote the
reserve–deposit ratio, the amount of money
that the original $1,000 creates is
• Total Money Supply = [1 + (1 - rr) + (1 - rr)2 +
(1 – rr)3 + ... ] × $1,000
= (1/rr) × $1,000.
• Each $1 of reserves generates $(1/rr) of money. In our
example, rr = 0.2, so the original $1,000 generates
$5,000 of money.
• The banking system’s ability to create money is the
primary difference between banks and other financial
institutions.
• Financial markets have the important function of
transferring the economy’s resources from those
households that wish to save some of their income for
the future to those households and firms that wish to
borrow to buy investment goods to be used in future
production.
• The process of transferring funds from savers to
borrowers is called financial intermediation.
• Many institutions in the economy act as financial
intermediaries: the most prominent examples are
the stock market, the bond market, and the banking
system.
• Yet, of these financial institutions, only banks have
the legal authority to create assets (such as checking
accounts) that are part of the money supply.
• Therefore, banks are the only financial institutions
that directly influence the money supply.
• Note that although the system of fractional-reserve
banking creates money, it does not create wealth.
When a bank loans out some of its reserves, it gives
borrowers the ability to make transactions and
therefore increases the supply of money.
• The borrowers are also undertaking a debt obligation
to the bank, however, so the loan does not make
them wealthier.
• In other words, the creation of money by the banking
system increases the economy’s liquidity, not its
wealth.
• A Model of the Money Supply
• Now that we have seen how banks create money,
let’s examine in more detail what determines the
money supply. Here we present a model of the
money supply under fractional-reserve banking.
• The model has three exogenous variables:

 The monetary base B is the total number of dollars

held by the public as currency C and by the banks as
reserves R. It is directly controlled by the Federal
Reserve.
 The reserve–deposit ratio rr is the fraction of
deposits that banks hold in reserve. It is
determined by the business policies of banks and
the laws regulating banks.

 The currency–deposit ratio cr is the amount of

currency C people hold as a fraction of their
holdings of demand deposits D. It reflects the
preferences of households about the form of
money they wish to hold.
• Our model shows how the money supply
depends on the monetary base, the reserve–
deposit ratio, and the currency–deposit ratio.
• It allows us to examine how Fed policy and the
choices of banks and households influence the
money supply.
• We begin with the definitions of the money
supply and the monetary base:
M = C + D,
B = C + R.
• The first equation states that the money supply
is the sum of currency and demand deposits.
• The second equation states that the monetary
base is the sum of currency and bank reserves.
• To solve for the money supply as a function of
the three exogenous variables (B, rr, and cr),
we first divide the first equation by the second
to obtain
• Then divide both the top and bottom of the
expression on the right by D.

• Note that C/D is the currency–deposit ratio cr, and

that R/D is the reserve–deposit ratio rr.
• Making these substitutions, and bringing the B from
the left to the right side of the equation, we obtain
• This equation shows how the money supply
depends on the three exogenous variables.
• We can now see that the money supply is
proportional to the monetary base.
• The factor of proportionality, (cr + 1)/(cr + rr),
is denoted m and is called the money
multiplier.
• We can write
M = m × B.
• Each dollar of the monetary base produces m
dollars of money.
• Because the monetary base has a multiplied
effect on the money supply, the monetary
base is sometimes called high-powered
money.
• Here’s a numerical example.
• Suppose that the monetary base B is $800 billion,
the reserve–deposit ratio rr is 0.1, and the
currency–deposit ratio cr is 0.8. In this case, the
money multiplier is

• and the money supply is

M = 2.0 × $800 billion = $1,600 billion.
• Each dollar of the monetary base generates two
dollars of money, so the total money supply is
$1,600 billion.
• We can now see how changes in the three
exogenous variables—B, rr, and cr—cause the money
supply to change.

1. The money supply is proportional to the monetary

base. Thus, an increase in the monetary base
increases the money supply by the same percentage.
2. The lower the reserve–deposit ratio, the more loans
banks make, and the more money banks create from
every dollar of reserves. Thus, a decrease in the
reserve–deposit ratio raises the money multiplier
and the money supply.
3. The lower the currency–deposit ratio, the
fewer dollars of the monetary base the public
holds as currency, the more base dollars
banks hold as reserves, and the more money
banks can create. Thus, a decrease in the
currency–deposit ratio raises the money
multiplier and the money supply.
• Banks may choose to hold excess reserves—that is,
reserves above the reserve requirement (required
reserve).
• The higher the amount of excess reserves, the higher
the reserve–deposit ratio, and the lower the money
supply.
• As another example, the Fed cannot precisely control
the amount banks borrow from the discount
window. The less banks borrow, the smaller the
monetary base, and the smaller the money supply.
• Hence, the money supply sometimes moves in ways
the Fed does not intend.