An increase in public sector debt therefore based on the above
analysis results in an increase in money supply. However, it must
be noted that the increase in public sector debt has to be financed.
It can be financed by:
(i) borrowing from the non-bank public by selling government
bonds to them. Non-bank public pays the government by
drawing down their deposits. End result, no change in
money supply.
(ii) borrowing from the commercial banks by selling
government bonds to them. If commercial banks had some
excess reserves, money supply will still increase. But if they
had no excess reserves, then money supply will fall.
(iii) borrow from the central bank ie. print money. The revenue
that a government raises by printing money is called
seignorage.(Any government that has the authority to
issue money can use seignorage).
Saturday, June 21, 2008
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Friday, June 20, 2008
Public Sector Debt and the Money Supply
Public Sector Debt and the Money Supply
Public sector debt arises when there is an excess of government
spending over its receipts. If the debt or the budget deficit arises
because of an increase in government spending e.g. government
purchased something from the non-bank public, then the following
would have happened:
recipients of the payment from the government would have
deposited the money in their banks. An increase in D means
that M has increased;
The commercial bank will now claim the payment from the
government. There reserves increase, which therefore
results in a multiple expansion of bank deposits.
Public sector debt arises when there is an excess of government
spending over its receipts. If the debt or the budget deficit arises
because of an increase in government spending e.g. government
purchased something from the non-bank public, then the following
would have happened:
recipients of the payment from the government would have
deposited the money in their banks. An increase in D means
that M has increased;
The commercial bank will now claim the payment from the
government. There reserves increase, which therefore
results in a multiple expansion of bank deposits.
Sunday, June 15, 2008
Fixed exchange rate 2
A balance of payment deficit on the other hand, results in an
excess demand for foreign currency. To prevent the domestic
currency from depreciating, the central bank intervenes by selling
foreign currency in the foreign currency market. This reduces the
central bank’s reserves of foreign currency and also the money
supply in the country as the domestic currency in now no longer in
the domestic market.
Under a fixed exchange rate system, the money supply equation
becomes:
Ms = m x (Hd + Hf)
where: Hd is the domestic component of high-powered money
Hf is the foreign component (include gold, foreign
currencies)
The central banks has control over Hd but not Hf as the latter
depends on the external surplus or deficit.
excess demand for foreign currency. To prevent the domestic
currency from depreciating, the central bank intervenes by selling
foreign currency in the foreign currency market. This reduces the
central bank’s reserves of foreign currency and also the money
supply in the country as the domestic currency in now no longer in
the domestic market.
Under a fixed exchange rate system, the money supply equation
becomes:
Ms = m x (Hd + Hf)
where: Hd is the domestic component of high-powered money
Hf is the foreign component (include gold, foreign
currencies)
The central banks has control over Hd but not Hf as the latter
depends on the external surplus or deficit.
Wednesday, June 4, 2008
Fixed exchange Rate
Fixed exchange Rate:
When a country is on a fixed exchange rate system, on the other
hand, a balance of payment surplus or deficit will result in a change
in the domestic money supply.
Starting off again with a balance of payment surplus, the excess
supply of domestic currency (or excess demand for domestic
currency) would have resulted in an appreciation of the domestic
currency. To keep the exchange rate fixed, the central bank will
intervene and it will buy foreign currency . This increases the
central banks’ reserves of foreign currency. Money supply in the
country likewise increases as more domestic currency is placed on
the market.
When a country is on a fixed exchange rate system, on the other
hand, a balance of payment surplus or deficit will result in a change
in the domestic money supply.
Starting off again with a balance of payment surplus, the excess
supply of domestic currency (or excess demand for domestic
currency) would have resulted in an appreciation of the domestic
currency. To keep the exchange rate fixed, the central bank will
intervene and it will buy foreign currency . This increases the
central banks’ reserves of foreign currency. Money supply in the
country likewise increases as more domestic currency is placed on
the market.
Money supply in an open economy
Money supply in an open economy
So far our discussion is based on a closed economy.
In an open economy the domestic money supply can be affected
depending on the type of exchange rate system the country
is on.
Flexible Exchange rate system
Under a flexible exchange rate system, the country’s balance of
payment will always balance. Should the country experience a
balance of payment surplus for example or a situation of an
an excess supply of foreign currency (or an excess demand for
domestic currency), the domestic currency will appreciate vis-à-vis
the foreign currency. The appreciation makes domestic goods more
expensive and imported goods cheaper resulting in a decline in
domestic X and an increase in imports.
In a flexible exchange rate
ssystem, a surplus in the balance of payment results in an
appreciation of the domestic currency which then eliminates the
surplus. Vice versa had we started off with a balance of payment
deficit , the excess demand for foreign currency (or excess supply
of domestic currency) would have resulted in a depreciation of the
domestic currency vis-à-vis the foreign currency.
This now makes domestic goods cheaper relative to imports. The increase in net
exports therefore reduces the deficit in the balance of payment.
Since the balance of payment always balances through the
adjustments in the exchange rate, there will be no effect on the
domestic money supply.
So far our discussion is based on a closed economy.
In an open economy the domestic money supply can be affected
depending on the type of exchange rate system the country
is on.
Flexible Exchange rate system
Under a flexible exchange rate system, the country’s balance of
payment will always balance. Should the country experience a
balance of payment surplus for example or a situation of an
an excess supply of foreign currency (or an excess demand for
domestic currency), the domestic currency will appreciate vis-à-vis
the foreign currency. The appreciation makes domestic goods more
expensive and imported goods cheaper resulting in a decline in
domestic X and an increase in imports.
In a flexible exchange rate
ssystem, a surplus in the balance of payment results in an
appreciation of the domestic currency which then eliminates the
surplus. Vice versa had we started off with a balance of payment
deficit , the excess demand for foreign currency (or excess supply
of domestic currency) would have resulted in a depreciation of the
domestic currency vis-à-vis the foreign currency.
This now makes domestic goods cheaper relative to imports. The increase in net
exports therefore reduces the deficit in the balance of payment.
Since the balance of payment always balances through the
adjustments in the exchange rate, there will be no effect on the
domestic money supply.
Determinants of the reserve-deposit ratio
Determinants of the reserve-deposit ratio:
Regulatory requirements: An increase in the required
reserve ratio will increase the reserve-deposit ratio.
Increase in the discount rate: Makes it more expensive for
commercial banks to borrow from the central bank should
there reserves be insufficient.
Market interest rate: An increase in market interest rate
increases the opportunity cost of holding excess reserves
and therefore reduces the reserve-deposit ratio.
Business cycle : rr tends to rise during recessions as banks
tend to view loans as very risky and therefore are more
incline to hold more excess reserves.
Average variability of deposit flows: When there is an
increase in the average variability of deposit flows, banks
require a greater cushion against outflows and tend to
increase their reserve-deposit ratio.
From the above we can see that contrary to the vertical money
supply curve we assumed before, money supply is now positively
related to interest rate.
From the above we can see that contrary to the vertical money
supply curve we assumed before, money supply is now positively
related to interest rate.
Determinants
Riskiness of deposits:
During banking panics, an increase in
the perceived riskiness of deposits increases the currency-
deposit ratio. (e.g in a recession, people may also view bank
deposits as risky and therefore cr increases, which in turn
reduces m and the money supply (an increase in cr enlarges
the denominator more than the numerator as cr is added to a
larger number in the numerator and a smaller number in the
denominator).
During banking panics, an increase in
the perceived riskiness of deposits increases the currency-
deposit ratio. (e.g in a recession, people may also view bank
deposits as risky and therefore cr increases, which in turn
reduces m and the money supply (an increase in cr enlarges
the denominator more than the numerator as cr is added to a
larger number in the numerator and a smaller number in the
denominator).
Determinants of the currency-deposit ratio
Determinants of the currency-deposit ratio:
cr is affected by the cost and convenience of obtaining cash.
The more convenient it is and hence the lower the cost, the
lower is the currency-deposit ratio.
Seasonal factors: The currency-deposit ratio tends to be
higher during festive periods.
Expected returns on deposits: An increase in interest rates
offered on deposits, increases the public’s demand for such
deposits and therefore reduces the currency-deposit ratio.
Some conclusions
How much control does the central bank have over money supply?
The central bank’s control of the money supply is not precise. It
has in fact to wrestle with two problems that arises due to the
fractional reserve banking system. For one, the central bank does
not control the amount of money that households choose to hold as
deposits in banks (cr). Secondly, the central bank also does not
control the amount of money that banks choose to lend or to put it
another way it does not control the amount of reserves banks
choose to hold (rr). From the above equation, we can see that the
central bank controls the money supply indirectly through its
direct control of the monetary base and by influencing the size of
m by changing the reserve requirement. The central bank however,
cannot control cr nor the entire rr (or more specifically ER/D)
While the simple multiplier (1/RRR) is stable because the central
bank almost never changes the RRR, the real-world multiplier m
can vary quite a bit from year to year.
From the equation, it is clear that m changes when there is a change
in cr and rr. What therefore determines cr and rr?
Three instruments of monetary policy
Three instruments of monetary policy
As mentioned earlier, the central bank does not control the money
supply directly but it does so indirectly by changing the monetary
base or the reserve-deposit ratio.
To achieve either of these, the central bank can use the following
monetary tools, open market operations, the reserve requirement
and the discount rate.
Open Market Operations
This refers to the buying and selling of government bonds by the
central bank.
General summary: When the central bank conducts open market
purchase, it increases the H and therefore M. When the central bank
conducts open market sales, it reduces H and the money supply.
Discount rate
A bank that is short of reserves can borrow either from the central
bank or from other banks to make good its deficiency. The cost
of borrowing from the central bank is the discount rate. When banks borrow from the central bank, their reserves increase, allowing them to make more loans and therefore create more money
Reserve requirements
An increase in the reserve requirement forces banks to hold more
money multiplier and therefore reduces the money supply for any
level of the monetary base. Vice versa.
As mentioned earlier, the central bank does not control the money
supply directly but it does so indirectly by changing the monetary
base or the reserve-deposit ratio.
To achieve either of these, the central bank can use the following
monetary tools, open market operations, the reserve requirement
and the discount rate.
Open Market Operations
This refers to the buying and selling of government bonds by the
central bank.
General summary: When the central bank conducts open market
purchase, it increases the H and therefore M. When the central bank
conducts open market sales, it reduces H and the money supply.
Discount rate
A bank that is short of reserves can borrow either from the central
bank or from other banks to make good its deficiency. The cost
of borrowing from the central bank is the discount rate. When banks borrow from the central bank, their reserves increase, allowing them to make more loans and therefore create more money
Reserve requirements
An increase in the reserve requirement forces banks to hold more
money multiplier and therefore reduces the money supply for any
level of the monetary base. Vice versa.
What affects Money supply?
What affects Money supply?
The H. An increase in H increases M; vice versa.
The rr. The higher is rr (i.e. the more reserves banks hold
out of the deposits), the smaller is m and M; vice versa.
The cr. The higher is cr (i.e. the more cash people want to
hold), the less banks will be able to create money. Hence,
a higher cr results in a smaller m and M; vice versa.
The H. An increase in H increases M; vice versa.
The rr. The higher is rr (i.e. the more reserves banks hold
out of the deposits), the smaller is m and M; vice versa.
The cr. The higher is cr (i.e. the more cash people want to
hold), the less banks will be able to create money. Hence,
a higher cr results in a smaller m and M; vice versa.
Reserve-deposit ratio
The reserve-deposit ratio (rr) This refers to the fraction of
deposits banks hold in reserves. The rr depends not only on
the laws regulating the banks but also on the business
policies of banks. In addition to the required reserves, banks
hold some excess reserves to meet unexpected withdrawals.
Therefore rr is determined partly by government regulations
and partly by the banks decision on how much of their
deposits they want to lend.
The currency-deposit ratio(cr) refers to the amount of
currency (C) people hold as a fraction of their deposits (D).
This ratio reflects the public’s preference about the form
of money they wish to hold. ( This ratio is determined by
the public and depends on the amount of money the public
wants to hold as currency versus the amount it wants to
hold as deposits. The public can raise the currency-deposit
ratio to any level it wants by withdrawing currency from
banks (which increases currency held and reduces deposits).
Likewise by depositing currency in banks, the public can
lower the currency-deposit ratio.
deposits banks hold in reserves. The rr depends not only on
the laws regulating the banks but also on the business
policies of banks. In addition to the required reserves, banks
hold some excess reserves to meet unexpected withdrawals.
Therefore rr is determined partly by government regulations
and partly by the banks decision on how much of their
deposits they want to lend.
The currency-deposit ratio(cr) refers to the amount of
currency (C) people hold as a fraction of their deposits (D).
This ratio reflects the public’s preference about the form
of money they wish to hold. ( This ratio is determined by
the public and depends on the amount of money the public
wants to hold as currency versus the amount it wants to
hold as deposits. The public can raise the currency-deposit
ratio to any level it wants by withdrawing currency from
banks (which increases currency held and reduces deposits).
Likewise by depositing currency in banks, the public can
lower the currency-deposit ratio.
A Model of the Money Supply
A Model of the Money Supply
Let’s now examine in greater detail what determines the money
supply.
To do this let’s go back to the definition of money supply.
Money Supply:
M = C + D
The monetary base (H or high powered money) comprises
of notes and coins held by the public (C) and banks reserves
(R – this refers to only the required reserves). C as we know is part
of the money supply.
The monetary base is therefore:
H = C + R
It is the narrowest definition of money supply, consisting of the
most liquid forms of money.
The central bank has direct control over H but not over M.
Let’s now examine in greater detail what determines the money
supply.
To do this let’s go back to the definition of money supply.
Money Supply:
M = C + D
The monetary base (H or high powered money) comprises
of notes and coins held by the public (C) and banks reserves
(R – this refers to only the required reserves). C as we know is part
of the money supply.
The monetary base is therefore:
H = C + R
It is the narrowest definition of money supply, consisting of the
most liquid forms of money.
The central bank has direct control over H but not over M.
Thursday, May 29, 2008
Fractional reserve banking system
Fractional reserve banking system
The fractional reserve banking system is a system where banks
only hold a fraction of their deposits as reserves (R). These reserves
are kept in the banks’ vaults and as deposits with the central bank.
The function of these reserves is to back individual and business
deposits at the bank. What determines how much of their deposits
banks keep as reserves? This reserve-deposit ratio (re) depends on
the required reserve ratio that is set by the Central Bank. The
required reserve ratio determines the minimum amount of reserves
banks have to hold by law. The remaining deposits called the excess
reserves can be used for making loans.
Under the fractional reserve banking system, banks are able to create money when they make loans as in the process of lending new deposits (D) are created. Assuming that banks lend out all their excess reserves and that the public deposits whatever loan amount they receive.
The fractional reserve banking system is a system where banks
only hold a fraction of their deposits as reserves (R). These reserves
are kept in the banks’ vaults and as deposits with the central bank.
The function of these reserves is to back individual and business
deposits at the bank. What determines how much of their deposits
banks keep as reserves? This reserve-deposit ratio (re) depends on
the required reserve ratio that is set by the Central Bank. The
required reserve ratio determines the minimum amount of reserves
banks have to hold by law. The remaining deposits called the excess
reserves can be used for making loans.
Under the fractional reserve banking system, banks are able to create money when they make loans as in the process of lending new deposits (D) are created. Assuming that banks lend out all their excess reserves and that the public deposits whatever loan amount they receive.
Friday, May 23, 2008
Money Supply 2
Money Supply
Ignoring the different types of deposits and the different
distinctions between the different measurements of money supply,
a country’s money supply simply consists of currency in the hands
of the public deposits at banks:
M = C + D
In order for us to understand what affects a country’s money supply
we need to take a look at (i) the mechanism by which the central
bank and the commercial banks “create” money; (ii) understand
that the actions of the central bank has a multiplier effect on the
money supply. At the end you will understand why in practice the
central bank cannot always control money supply precisely.
In a 100% reserves banking system, all deposits are held by
commercial banks as liquid assets to meet customers withdrawal.
These liquid assets (currency in the banks’ vaults) that are held are
termed the banks reserves.
Ignoring the different types of deposits and the different
distinctions between the different measurements of money supply,
a country’s money supply simply consists of currency in the hands
of the public deposits at banks:
M = C + D
In order for us to understand what affects a country’s money supply
we need to take a look at (i) the mechanism by which the central
bank and the commercial banks “create” money; (ii) understand
that the actions of the central bank has a multiplier effect on the
money supply. At the end you will understand why in practice the
central bank cannot always control money supply precisely.
In a 100% reserves banking system, all deposits are held by
commercial banks as liquid assets to meet customers withdrawal.
These liquid assets (currency in the banks’ vaults) that are held are
termed the banks reserves.
Thursday, May 15, 2008
Money Supply
Introduction
In Introduction to Economics, assumed that the money supply
is controlled directly by the central bank. This was a useful
simplification but literally not true. The central bank’s control of
money supply is only indirect. Three groups actually affect the
country’s money supply. They are the central bank, commercial
banks and the public.
In this topic we want to (i) understand how banks create
money (ii) look at the ways the central bank can control the money
supply in the country; and (iii) understand why the central bank
does not have a precise control of the country’s money supply.
In Introduction to Economics, assumed that the money supply
is controlled directly by the central bank. This was a useful
simplification but literally not true. The central bank’s control of
money supply is only indirect. Three groups actually affect the
country’s money supply. They are the central bank, commercial
banks and the public.
In this topic we want to (i) understand how banks create
money (ii) look at the ways the central bank can control the money
supply in the country; and (iii) understand why the central bank
does not have a precise control of the country’s money supply.
Sunday, May 4, 2008
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