Explain the Mechanism Behind the Money Multiplier. How Can the Monetary Authorities Influence Its Size and the Supply of Money?

Topics: Monetary policy, Fractional-reserve banking, Central bank Pages: 6 (1757 words) Published: July 16, 2013
Title: Explain the mechanism behind the money multiplier. How can the monetary authorities influence its size and the supply of money?

Thursday 16th December 2010

Word count: 1599

Money is a general accepted means of payment for the purchase and selling of goods and services (Pilbeam 2010). These could include purchasing loans, settling debts. Money is also used to as a common unit of account, where prices for products and services can be easily compared. Money can also act as a store of value, where individuals or institutions can deposit them in commercial banks to earn interest over time.

The money multiplier defines the relationship between the money supply and the monetary base. The money multiplier was originally developed by Brunner and Meltzer and it has become the standard concept to explain how the policy actions of central banks influence the money stock. It also has been used in empirical analyses of money stock control and the impact of monetary policy actions on other economic variables. The behaviour of the money multiplier has changed considerably over time. From 1870 to 1970, it was relatively stable, fluctuating within narrow limits. Since the 70s it has more than doubled in magnitude. During the last ten years the demand for cash by the public has fallen and the demand for bank deposits has increased considerably. The private sector has made greater use of the banks because they have offered interest rates on deposits in order to attract business. As intermediaries, banks have expanded their assets, and bank lending has increased because of shifts in supply rather than in demand. At the same time, banks have been able to lower their cash reserves and expand their lending. This essay will carefully derive the money multiplier mechanism and it will also explain how monetary authorises can influence its size and the money supply in the economy.

Mishkin (2010) stated that high-powered money or the monetary base is the sum of the central’s monetary liabilities (currency in circulation and reserves) and the Treasury’s monetary liabilities (treasury currency in circulation like bank notes and coins) and whereas money supply is the quantity of money. According to Mishkin (2010), the money multiplier tells us how much the money supply changes for a given change in the monetary base.

In the first round (Thomas 2010), high-powered money is held either in currency or deposits at commercial banks by the public and this is represented by, where changes in money supply are equal to changes in high-powered money. If individuals hold a fraction in the form of currency, then [1] This will then effect the bank deposits, where changes in bank deposits will be the remainder where [2]

Banks would then keep a fraction of its increase as reserves which is represented by r, which is represented by [3]

Substituting equation [2] into equation [3] would give
[4]

(1-r) is then available to commercial banks to extend credit either by loans or purchase securities and this is represented as follows:
[5]

The second round begins with individuals receiving loans of from banks. The individuals hold a portion of the increased money holdings as currency, and the remaining fraction of as deposits. The change in deposits is

[6]

where the Individuals then deposit them back into the banks, not who will hold some of the increase as reserves and extend credit with what is left, which is

[7]

The third and final round, the expression is written as:
[8]

This process continues to infinity and it is in the form of a geometric series as follows:

[9]

The subtraction of the two geometric series then results in:

[10]

And the expression can be rewritten as: [11]

We can now derive the money multiplier as (1+CU*/CU*+r), where CU* is the...

References: Bank of England (2010) Available at: http://www.bankofengland.co.uk/ [Accessed 14th December 2010]
BBC (2007) Available at: http://news.bbc.co.uk/1/hi/business/6997765.stm [Accessed: 12th December 2010]
Mishkin, F.S (2010) The Economics of Money, Banking and Financial Markets 9th edn Pearson Boston
Pilbeam, K. (2010) Finance and Financial Markets 3rd edn Palgrave Macmillan Hampshire
Randall, J (2010) Interviews with leaders in business and finance. Sky News. 14th December 2010
Thomas, G. (2010) Money Supply & The Money Multiplier, the Adjustment Process and the Money Supply in an Open Economy Lecture Notes 2 & 3 [6BUS0341]. University of Hertfordshire 15th December, 2010.
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