Chapter 16 Determinants of the Money Supply © 2005 Pearson Education Canada Inc The Simple Deposit Multiplier from Chapter 15 Simple Deposit Multiplier 1 D = R r Deriving the formula R = DR = r D D = R r 1 D = R r © 2005 Pearson Education Canada Inc 16-2 Critique of the Simple Model The simple model of multiple deposit creation shows how the Bank of Canada can control D by setting R. That simple model however, ignores 1. the public’s decisions regarding how much C to hold, 2. the banks’ decisions regarding the amount of R they wish to hold, and 3. borrowers’ decisions on how much to borrow from banks. Recall also that the Bank of Canada can exert more precise control over MB ( = C + R) than over R © 2005 Pearson Education Canada Inc 16-3 The Money Supply Model Because the Bank of Canada can exert more precise control over MB than it can over R, in Chapter 16 we derive a multiplicative relation between M and MB, M = m MB, where m is the money multiplier. m relates the change in M to a given change in © 2005 Pearson Education MB. Canada Inc 16-4 Money Multiplier M = m MB Deriving Money Multiplier R = DR DR = r D R = (r D) Adding C to both sides R + C = MB = C + (r D) 1. Tells us amount of MB needed support D and C 2. An extra $1 of MB that arises from an extra $1 of C does not support any additional D. That is, the C component of MB does not lead to a multiple deposit creation as the R component does. © 2005 Pearson Education Canada Inc 16-5 (Continued) To put it differently, An in MB that goes into C is not multiplied, whereas an that goes into supporting deposits is multiplied We have MB = C + (r D) To deal with currency drains, we also assume that C = c D where c is the currency ratio. Hence, MB = (c D) + (r D) © 2005 Pearson Education = (c + r ) D Canada Inc 16-6 D MB cr M = (c D) + D = (1 + c) D 1 c M MB cr 1 c m cr m 0, there is a positive ©relation between M and each of MB 2005 Pearson Education n and A. Canada Inc 16-11 Overview of the Money Supply Process M = m (MBn + A) 1 c M ( MBn A) cr Open market purchases MBn and for given c, r , and A lead to an in M. Open market sales MBn and for given c, r , and A lead to a in M. Hence M is positively related to MBn For given MBn , c, and r , an in A will MB and lead to a multiple in M. For given MBn , c, and r , an in A will MB and lead to a multiple in M. Hence M is positively related to © 2005 Pearson Education A Canada Inc 16-12 Factors Determining Money Supply © 2005 Pearson Education Canada Inc 16-13 Application: The Great Depression Bank Panics Let’s use the money supply model to explain the collapse in the U.S. during the Great Depression, 19301933. Between October 1930 and March 1933 there were a number of bank failures in the U.S. For example, in the first bank crisis (from October 1930 to January 1931), 256 banks failed in November 1930 with $180 million of deposits and another 532 banks failed in December 1930 with over $370 million of deposits The most dramatic failure was that of the Bank of the United States (with over $200 million in deposits) which many people ©associated with a central bank 2005 Pearson Education Canada Inc 16-14 Deposits at Failed Banks: 1929–33 © 2005 Pearson Education Canada Inc 16-15 e, c: 1929–33 © 2005 Pearson Education Canada Inc 16-16 Money Supply and Monetary Base: 1929–33 © 2005 Pearson Education Canada Inc 16-17 ... Thus in addition to the effects on M of c and r , the expanded model stipulates that M is also affected by changes in MBn and A. In fact, because m > 0, there is a positive ©relation between M and each of MB... 1. the public’s decisions regarding how much C to hold, 2. the banks’ decisions regarding the amount of R they wish to hold, and 3. borrowers’ decisions on how much to borrow from banks. Recall also that the Bank of Canada can exert more ... Also notice that 3.3 0.25 0.05 This is the deposit multiplier when c = 25% and r = 5%. It tells us that given the behavior of the public as represented by c = 25% and that of banks as represented by r = 5%, a $1 in MB will lead to a