Money Supply

Money market is in equilibrium when demand for money is equal to supply of

money:

M
 L(Y , i)
P

So far we have discussed the determinants of demand for money and assume

that money supply is just a constant stock i.e. M  M .

Question: What is supply of money?

One answer to this question is “Money is what money does”. A more rigorous

answer to this question as given by one economist is as follows:

Money supply, the liquid assets held by individuals and banks. The money supply

includes coin, currency, and demand deposits (checking accounts). Some economists consider

time and savings deposits to be part of the money supply because such deposits can be managed

by governmental action and are involved in aggregate economic activity. These deposits are

nearly as liquid as currency and demand deposits. Other economists believe that deposits in

mutual savings banks, savings and loan associations, and credit unions should be counted as part

of the money supply.

M1

M1 money supply includes coins and currency in circulation—the coins and bills that circulate

in an economy that are not held by the U.S. Treasury, at the Federal Reserve Bank, or in bank
vaults. Closely related to currency are checkable deposits, also known as demand deposits. These

are the amounts held in checking accounts. They are called demand deposits or checkable

deposits because the banking institution must give the deposit holder his money “on demand”

when a check is written or a debit card is used. These items together—currency, and checking

accounts in banks—make up the definition of money known as M1, which is measured daily by

the Federal Reserve System. Traveler’s checks are also included in M1, but have decreased in

use over the recent past.

M2

A broader definition of money, M2 includes everything in M1 but also adds other types of

deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which

you cannot write a check directly, but from which you can easily withdraw the money at an

automatic teller machine or bank. Many banks and other financial institutions also offer a chance

to invest in money market funds, where the deposits of many individual investors are pooled

together and invested in a safe way, such as short-term government bonds. Another ingredient of

M2 is the relatively small (that is, less than about $100,000) certificates of deposit (CDs) or time

deposits, which are accounts that the depositor has committed to leaving in the bank for a certain

period of time, ranging from a few months to a few years, in exchange for a higher interest rate.

In short, all these types of M2 are money that you can withdraw and spend, but which require a

greater effort to do so than the items in M1.

Monetary Base
Money supply is the quantity of money available in an economy for immediate use. It equals the

currency held by public (CC) plus demand deposits at banks (DD) and monetary base is the sum

of total currency in circulation (CC) and the amount held by banks as reserves (R).

Money supply : MS  M 1  CC  DD

Monetary base: MB  CC  R

Where CC  currency in circulation, DD  demand deposits , R  Reserve

To understand the link between CC, DD, and R etc., we need to understand two related concepts

namely loan multiplier and deposit multiplier. We may understand the links with a very simple

example. Suppose a commercial bank receive a bank deposit of $ X (e.g central bank may print

$ X and deposit in the commercial bank against someone name). What commercial bank would

with this deposit? Most likely, commercial bank will hold a fraction of money like aX and lend

rest of the money i.e. (1-a)X. We can easily summarize this example with the help of following

table:

D =  Deposits R   Reserves L   Loan

$X $aX $(1-a)X
(1-a)X a(1-a)X
(1-a)(1-a)X= (1  a ) X
2

(1  a ) 2 X a (1  a ) 2 X (1  a )(1  a ) 2 X  (1  a )3 X
(1  a )3 X a (1  a )3 X (1  a ) 4 X
… … ….
… … …

 D  a
X  R  X  L  a
(1  a ) X
 Example:- If someone deposits $50, the bank must reserve 10% of that $50, or
$5 total. Then, the bank lends out $45. Then other banks experience deposits of
$45, of which $4.50 is retained, and $40.50 is lent out. And this cycle
continues… see the table below for the continuation of this example:

Step # $ deposited $ reserved $ lent out by bank Total deposits so far

1 $50 $5 $45 $50

2 $45 $4.50 $40.50 $95

3 $40.50 $4.05 $36.45 $135.50

4 $36.45 $3.64 $32.81 $171.95

5 $32.81 $3.28 $29.53 $204.76

6 $29.53 $2.95 $26.58 $234.29

7 $26.58 $2.66 $23.92 $260.87

8 $23.92 $2.39 $21.53 $284.79

9 $21.53 $2.15 $19.38 $306.32

10 $19.38 $1.94 $17.44 $325.70

Totals $325.70 $32.56 $293.14 Ends at $325.70

Deposit Multiplier

D  X  (1  a )X  (1  a) 2 X  (1  a )3 X  ......... (I)

D  (1  (1  a )  (1  a )2  (1  a )3  ............)X (II)

From (II) we can derive the following deposit multiplier (DM)

 D 1 1
 
X 1  (1  a ) a

1
4
If a  0.25 , then DM will be equal to 0.25 .

Loan Multiplier (LM)

Using the third column of the above table we can derive the following loan multiplier:

L  (1  a)X  (1  a ) 2 X  (1  a )3 X  .........

L  (1  a )[1  (1  a )  (1  a ) 2  ........]X

L  1  1 a
 (1  a )[1  (1  a)  (1  a) 2  ........]  (1  a)   a
M 1  (1  a) 

L 1
 LM   1  DM  1
X a

Result: LM  DM  1

For example if a  0.25 then DM  1/ 0.25  4 and LM  4  1  3

If X  $100 then total deposits will be equal to $4*100  $400 and Total loan = $300

and Total reserve will be equal to $100.

From the above example, we learn that bank ability of creating multiple deposits give rise

to increase in the money supply.

Money Multiplier
 Money supply: MS  CC  DD

Monetary Base: MB  CC  R

We assume that CC  cDD , R   DD where 0  c  1, 0    1 . Substitution these

expressions in M and MB definitions we get:

MS  M 1  cDD  DD  (1  c) DD (1)

MB  M 1  cDD   DD  (c   ) DD (2)

Combining (1) and (2) we get:

(1  c ) MB
MS 
(c   ) (3)

From () we can derive the following money multiplier:

MS M 1 1  c
 
MB MB c   (4)

Suppose c  0.25 and   0.15 then in this case:

MS M 1 1  0.25
   1.25 / 0.4  3.125
MB MB 0.25  0.15

It means that if central bank increase monetary base by $100 then money supply

will increase by $312.5.

Money Multiplier and the required reserves at Fed/Central bank

 Almost every central bank required that each commercial bank

should keep a certain proportion of their deposits (demand deposits and

time deposits) at central bank. This money still belongs to commercial

bank and central bank use this money to help out the commercial bank

at the time of need. Now commercial banks hold two types of reserves;

(i) own reserves, (ii) central bank reserves. The following tables us to

understand this concept

D =  Deposits Private reserve Central bank reserve L   Loan

PR  CBR
Private   Reserves
$X $ aX $bX $(1  a  b) X
$(1  a  b) X a(1  a  b) X b(1  a  b) X (1  a  b)2 X
(1  a  b) 2 X a (1  a  b) 2 X b(1  a  b)2 X (1  a  b)3 X
…. …. …..
… … ….
… … …
X aX (1  a  b) X
 D  a  b  PR  a  b b  L  a  b
 CBR  a  b X
=

1 1 a  b
Deposit multiplier = DM = a  b , Loan Multiplier =LM= a  b

The M2 Money Multiplier

The M2 supply of money is defined as follows:

 M 2  CC  DD  TD  MMF (5)

Private reserve of the commercial bank = r DD  r TD

d T

Where CC=currency in circulation, DD = demand deposit, TD = time deposit,

and MMF = money market fund + money market deposit account + overnight loan

M 2  CC  DD  TD  MMF  cDD  DD   T DD   MMF DD (6)

MB  CC  R  cDD  aDD  bTD  cDD  aDD  b T DD (7)

M 2  CC  DD  TD  MMF  (1  c   T   MMF ) DD (8)

MB  CC  R  cDD  aDD  bTD  (c  a  b T ) DD (9)

Combining (8) and (9) we get:

(1  c   T   MMF )
M2 MB
(c  a  b T )

M 2 (1  c   T   MMF ) M 1 1  c
   
MB (c  a  b T ) MB c   (10)