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Chapter 16 Determinants of the Money Supply 16.1 © 2008 Pearson Education Canada The Money Supply Model • Define money as currency plus chequable deposits: M1 • The Bank of Canada can control the monetary base better than it can control reserves • Link the money supply (M) to the monetary base (MB) and let m be the money multiplier M m MB 16.2 © 2008 Pearson Education Canada Deriving the Money Multiplier • Assume the desired level of currency (C) and excess reserves (ER) grows proportionately with chequable deposits (D) Then: c = (C / D) = currency ratio r = DR / C = desired reserve ratio e = (ER / D) = excess reserve ratio 16.3 © 2008 Pearson Education Canada Deriving the Money Multiplier (Cont’d) • The monetary base (MB) equals reserves (R) plus currency (C) MB = R + C = ( (r x D) + ER ) + C • Shows the monetary base needed to support existing amounts of r, D, ER and C • An increase in MB going into C is not multiplied, but an increase in MB going into D is multiplied via the deposit multipler 16.4 © 2008 Pearson Education Canada The Money Multiplier in Terms of the Currency Ratio • After several computations M = (1+c)/(c+r) x MB where m = (1+c)/(c+r) M = m x MB and MB = 1/m x MB • While there is a multiple expansion of deposits, there is no such expansion for currency 16.5 © 2008 Pearson Education Canada Factors that Determine the Money Multiplier • Changes in the currency ratio c – The money multiplier and the money supply are negatively related to c • Changes in the desired reserve ratio r – The money multiplier and the money supply are negatively related to r • Market Interest Rates • Expected Deposit Outflows 16.6 © 2008 Pearson Education Canada Additional Factors • Open market operations are controlled by the Bank of Canada • The Bank of Canada cannot determine the amount of borrowing by banks from the Bank of Canada 16.7 © 2008 Pearson Education Canada • Split the monetary base into two components MB = MBn + BR therefore M = m (MBn + BR) MBn = nonborrowed monetary base MB = monetary base BR = borrowed reserves from the Bank of Canada 16.8 © 2008 Pearson Education Canada • Since M = m (MBn + BR) • The money supply (M) is - positively related to the non-borrowed monetary base MBn - positively related to the level of borrowed reserves (BR) from the Bank of Canada 16.9 © 2008 Pearson Education Canada Money Supply Response 16.10 © 2008 Pearson Education Canada Deposits of Failed Commercial Banks in U.S. in the Depression 16.11 © 2008 Pearson Education Canada Desired Reserves and Currency Ratios 16.12 © 2008 Pearson Education Canada M1 and the Monetary Base 16.13 © 2008 Pearson Education Canada