Transcript 1. Money supply 1.1. Concept of money supply

Money and Credit
Lecture 7
Money supply
Content
1. Money supply
1.1. Concept of money supply
1.2. Formation of the money supply and its factors
2. The mechanism of change in volume of money in circulation
3. Factors and the structure of monetary multiplier
Main definitions:
o money supply
o interest rate
o reserve requirements
o monetary base
o monetary multiplier
o bank reserves
o …………..
1. Money supply
1.1. Concept of money supply
The essence of the money supply is that economic agents at any
time have a certain stock of money that they can under favorable
circumstances direct into traffic.
Money supply
Microlevel
Demand and supply are constantly
alternating - with an increase of interest
economic entity will act on the market
with the money supply, while reducing –
with the demand for money
Macrolevel
issue of money is considered as money
supply growth on the money market
and the withdrawal of money from
circulation - a contraction of the money
supply
As between the two forces of money market the
money demand changes primarily under the
influence of factors that are formed within the
real economy and money supply has largely
exogenous nature, only the demand for money
can be a primary factor in the interaction with
the money supply.
Money supply in its dynamics must constantly
navigate and adapt to changes in money
demand.
1.2 Formation of the money supply and its factors
As the factors of
forming the
money supply
can be changes
of:
reserve requirements;
discount rate;
typical market interest rates;
interest rates on demand deposits;
amount of wealth of economic subjects;
shadow entrepreneurship;
state of confidence in banks, banking panic.
Reserve requirements
causes opposite change of factor (t)
multiplication of money because it is
determined by m = l / r, where r - required
reserve rate.
The lower rate (r), the higher the multiplier
factor, and thus more total money supply, and
vice versa.
Discount rate
affect the monetary base. When the interest
rate decreases the demand of commercial banks
on refinancing loans decreases, as a result
balances on their correspondent accounts at the
central bank decrease, i.e. the monetary base,
excess reserves of banks and their ability to lend
are also decreasing and thus the level of the
multiplier.
Typical market interest rates
With the growth of interest rates on loans from
commercial banks opportunities to get
refinancing loans extend even with within an
increase in the discount rate, resulting in
increasing the monetary base and bank reserves
ratio and multiplication ratio that promotes the
money supply.
However, in this situation the demand for bank
loans can decrease, the excess reserves increase
and multiplication of deposit money shorten.
Amount of wealth of economic subjects
Lead to changes of relationship between deposit
and cash components of money supply: the poorer
economic actors, the greater part of the money they
hold in cash and vice versa.
As part of the deposit causes multiplier process and
cash – does not, change of their ratio leads to a
change in total money supply.
Thus, with the increase of wealth deposit
component of the money supply will grow faster
than cash, which will increase the multiplier effect
and increase the money supply. Reduction of wealth
has the opposite effect on the money supply.
Shadow entrepreneurship
causes changes in the structure of monetary
reserves for cash. This weakens the
multiplicative increase in deposits as cash
proceeds from the sales of bank and is not used
for the purpose of lending.
The fall of multiplication reduces the supply of
money in the form of deposit is much larger
than the mass of cash increases.
Therefore, the total money supply is shrinking
with the growth of the shadow economy.
State of confidence in banks, banking panic
Negatively influences on multiplicative increase in deposits , as causes
the withdrawal of money from deposits or hinder their growth. The
increase of cash component of the money supply does not compensate
for the loss of the deposit component, because of the multiplier effect
they far exceed the amount of cash withdrawals.
In the increasing of distrust in banks multiplication rate can be reduced
and that`s why banks are forced to increase their excess reserves and
reduce lending in order to enhance its liquidity in case the outflow of
deposits.
Thus, the total money supply reduces in proportion to the fall of
confidence in banks, and during periods of panic such reduction
becomes avalanche that can paralyze the entire country's payment
system.
Interest rates on demand deposits;
encourages banks to attract cash on current
deposits and expansion of deposit multiplier
process, resulting in increase of the money supply.
Basically for demand deposits banks can not pay
the interest income as they are "short" money,
which brings banks limited revenues. But modern
banking practice has proved feasibility and benefits
of income for such deposits, which leads to opening
of special deposit accounts.
2. The mechanism of changing the volume of money in
circulation
The issue of cash is a monopoly of the NBU, although the
production of cash into circulation may be carried out not only
by the NBU, but the commercial banks too. But if the
commercial bank does not cover the issue of cash proceeds in
cash from its customers, then to cover the deficit it can not
issue money, but can purchase it from the central bank.
The issue of non-cash money by the central bank is made in
the following ways:
 providing loans to commercial banks by its refinancing;
 through the purchase of securities from commercial banks;
 through the purchase of foreign currency from commercial
banks and their customers to replenish gold reserves.
The mechanism of money creation by
commercial banks is slightly more complicated
than the issue mechanism of the NBU and
implies the monetary multiplication of free
reserves and deposits.
Monetary multiplier - the process of creating
new bank deposits (non-cash money) with
lending customers by banks on the basis of
additional (free) reserves received by the bank
from the outside.
Free reserve - a combination of cash of commercial bank
that is currently available for the bank and can be used
for active operations.
In addition to free, there is a total banking reserve,
which is the full amount of money funds that are
currently available for the bank and are not used for
active operations.
Some general reserve banks must keep in cash and do not
use for current needs. This part is called as required
reserve.
Its volume is determined under the reserve requirements
rates set by the NBU in percentage to total bank
liabilities. The difference between total and required
reserves is a free reserve of bank.
3. Factors and the structure of monetary multiplier
Monetary base - is the consolidated rate of reserve
money of the banking system, on which through the
monetary multiplier the money supply is formed.
Then the money supply (Ms) is directly proportional
to the monetary base (Mh) and depends on the
monetary multiplier (Mi):
Ms = Mh*m