MONEY SUPPLY
We have seen that M1 is also called Money Supply:
M1 = cash in the hands of
the public + deposits (bank money)
The Central Banks try to control the money
supply in the system, as together
with the demand for money it
determines the interest rate in the short term.
The interest rate influences the
volume of investment, which effects the level of balanced production
and therefore the level of employment.
When the Central Banks try to influence the
interest rates, they want to gain
stability in the prices and
the exchange rate.
How can the central
banks influence the money supply?
Let's try and explain the relationship between
Money Supply (MO) and Monetary
base (MB):
MO = Cash in
the hands of the public (Lm) + Deposits (Dv)
MB = Cash in
the hands of the public (Lm) + Bank reserves (R)
If we divide the first equation by the second
we have:
MO / MB = (Lm + Dv)
/ (Lm + R)
Then:
MO = ((Lm + Dv) / (Lm
+ R)) * MB
Now we are going to divide the numerator and
the denominator, in brackets, by Dv:
We will call the "Lm / Dv" quotient
"x" and it represents the proportion of the deposits that the
public make in cash.
We will call the "R / Dv"
quotient "y" and it represents the mandatory bank reserve, that's
to say, the proportion of the deposits that the banks have to
keep in liquid (cash points or reserves in the Central Bank)
to attend to money that people want to withdraw.
Then,
OM = ((x + 1) / (x +
y)) * MB
The quotient (x + 1) / (x + y) is always
greater than 1:
In the short term, you can suppose
that "x" is constant, that's to say, that people tend to maintain
a determined percentage of their money in cash and that this
percentage is stable.
Therefore, the value of this quotient
will depend on "y" that is the mandatory bank reserve.
Let's look at an example:
The MB of a country is 1000 euros,
of that proportion the people keep 20% in cash and the mandatory
bank reserve is 10%. Here is an equation to work out the MO.
MO
= ((0,2 + 1) / (0,2 + 0,1)) * 1.000 = 4.000 euros
The Central Bank decides to increase
the mandatory bank reserve to 20%:
MO
= ((0,2 + 1) / (0,2 + 0,2)) * 1.000 = 3.000 euros
In short, the central banks can act on MO through:
The Monetary Base, as we saw
in the previous lesson. Although its control is not absolute
(the monetary base can be effected by factors that the Central
Bank does not control).
Mandatory bank reserve "y":
if the mandatory bank reserve increases, the MO decreases and
if the mandatory bank reserve decreases, the MO increases (under
the hypothesis that "x" is constant which in real
life does no always have to be fulfilled). .
In short, the central
banks have the possibility to act on the monetary offer but they
do not have absolute control.
How strange, everyone
is so quiet....is there anyone there? Where is everyone?...
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