10.

7 Mechanical theories of
the money supply: money
supply identities

Group 5
 Where

1. Elementary BR = reserves held by banks

Demand Deposit D = demand deposits in banks

Equation ρ = required reserve ratio

→ elementary deposit creation formula to

maximize banks’ profit

→ however, it fails to take note of the behavior of

banks and public in deposit expansion process
2. Common
money-supply Where

formula D = demand deposits

BR = banks’ reserves

C = currency in the hands of the public

M0 = monetary base = BR + C.
3. The Friedman
and Schwartz
money-supply
formula ● This equation separates the basic determinants of the
money stock into changes in the monetary base and
changes in the “monetary base multiplier,” defined as
(∂M/∂M0)
● This multiplier is itself determined by D/BR, the reserve
ratio, and C/D, the currency ratio.
● The reserve ratio reflects the required reserve ratio and
the banks’ demand for free reserves.
● The currency ratio reflects the public’s behavior in its
demand for currency
4. Cagan (1965) ● Cagan (1965) examined the contributions of the three
elements B, C/M and BR/D, to M2 over the business
Equation ●
cycle and in the long term.
the dominant factor influencing the long-term growth in
the money stock was the growth in the monetary base
● cyclical movements of money stock shows by changes
in C/M ratio

(rise in spending in cyclical upturns increases currency

holdings, which lowers the money supply)

● the reserve ratio had only a minor impact and changes

in the monetary base exerted only an irregular
influence.
 Where
5. Differentiated
Deposit and t = T/D

Reserve Formula G = G/D

T = time/savings deposits

G = government deposits

→ differentiates deposits into various types

→ differentiates reserve requirements

Conclusion

❏ Mechanical theories of the money supply showed in formulas 1 - 4 use

identities rather than behavioral functions to calculate money supply
❏ Choosing which one to use depends on the rules and regulations about
reserve ratios, the availability of statistical data, and further behavioral
assumptions
❏ In practice, theories of the money supply go beyond these identities and add
relevant identity in a behavioral theory