ECOS2004, Money and Banking
Tutorial 5
Answer guide
1. Suppose that, as a result of increased uncertainty about the reliability of the electronic
payments network, there is a sudden surge in the demand for currency by households. As a
result, households withdraw a total of $250m from their bank accounts.
(a) Show the effect that this has on the balance sheets of the commercial banks and the central
bank.
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 Deposits -250
Central Bank
Assets ($m) Liabilities ($m)
Bank reserves -250
Currency +250
(b) If the central bank took no offsetting action, what effect might this have on the level of
interest rates.
Interest rates would rise. This situation is essentially the same as in our earlier theoretical analysis
of what happens in a simple economy when there is an increase in the demand for money and the
money supply is fixed.
Now that we have introduced commercial banks into the analysis we can identify two mechanisms
that would push up the level of interest rates in this situation. First, since banks are now short of
desired reserves, they will compete harder in the interbank borrowing/lending market for a share
of the available reserves. Banks will be more reluctant to lend in this market and willing to pay
more to borrow. Second, banks would compete harder to attract deposits, as this would be a way
for individual banks to rebuild reserves. Higher interest rates on deposits would in turn help to
attract some of the lost deposits back into the system, since the opportunity cost of holding
currency would go up.
(c) What action can the central bank take to offset this effect?
If the central bank didn’t want interest rates to rise they could use open market operations to
restore the level of bank reserves to its original level. They could do this by buying securities from
the banks. This is illustrated below (the effects of the securities transactions are shown in
brackets):
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 (+250 )= 0 Deposits -250
Securities (-250)
Central Bank
Assets ($m) Liabilities ($m)
Securities (+250) Bank reserves -250 (+ 250) = 0
Currency +250
2. Suppose that the government decides to borrow $15bn in order to prepare for a possible
large increase in its future spending. It issues bonds of that value which are then purchased
by commercial banks. For the time being, the government leaves these funds on deposit
with the central bank.
(a) Show the effect of this action on the balance sheets of the central bank and the commercial
banks. Hence, what is the effect on the monetary base?
Central Bank
Assets ($b) Liabilities ($b)
Bank reserves -15
Government deposits +15
Commercial banks
Assets ($b) Liabilities ($b)
Securities +15
Reserves -15
The assets of the central bank are unchanged. Government deposits at the CB will increase by $15bn
as a result of the sale of bonds. Bank reserves fall because the banks have to make payments of that
amount into the government’s deposit account at the CB.
(b) What is the effect on the broad money supply?
Direct effect: There is no direct effect on the broad money supply because the investors who are
buying the bonds are banks. Bank reserves are not a component of broad money and there is no direct
transaction involving bank depositors.
Indirect effect: The reduction in bank reserves is likely to result in a contraction in bank lending and
hence deposits of the commercial banks. That is, the reverse of the deposit creation process illustrated
in lectures. The eventual effect on broad money would be a multiple of the original $15bn given by
the money multiplier.
(c) If the government now spends the $15bn by making stimulus payments into household bank
accounts, show how this affects the balance sheets of the central bank and the commercial
banks.
The government payments add to bank reserves and reduce the amount of government deposits at
the CB. Household deposits at commercial banks will increase (the effects of these payments are
shown in the bracketed figures below).
Central Bank
Assets ($b) Liabilities ($b)
Bank reserves -15 (+15) = 0
Government deposits +15 (-15) = 0
Commercial banks
Assets ($b) Liabilities ($b)
Securities 15
Reserves -15 (+15)=0 Deposits (+15)
At this point, the level of reserves is back to its original starting point. However, there has now been
a direct increase in household deposits of $15bn as a result of the government payments.
(d) Now suppose that the RBA undertakes a quantitative easing (QE) program whereby it
purchases $15bn of bonds from the banks. Show the overall effect of these combined
actions on the balance sheets of the central bank and the commercial banks.
The bond purchases will add to bank reserves and will undo the earlier increase in commercial banks’
holdings of securities. Changes from part (c) are shown in brackets.
Central Bank
Assets ($b) Liabilities ($b)
Securities (+ 15) Bank reserves 0 (+15) = 15
Commercial banks
Assets ($b) Liabilities ($b)
Securities 15 (-15) = 0
Reserves 0 (+15) = 15 Deposits 15
3. Based on your answers to the previous question, describe the combined impact of the fiscal
expansion and central bank QE program: how does this affect the money supply, household
financial assets and the level of government debt to the private sector?
The money supply is increased. The direct effect is an increase in bank reserves and deposits of $15bn.
There will also be an indirect effect on broad money through the operation of the money multiplier.
Household financial assets are increased because of the direct increase in bank deposits.
Government debt to the private sector is unchanged in net terms. The initial increase in government
bonds held by the banks is reversed by the QE operation, so the additional government bonds that
have been issued are now held by the central bank.
4. Continuing from your answer to question 2, in what circumstances might it make sense for
governments and central banks to use such a combination of policies? And what are the
risks that might be associated with it?
The net effect of what has been set out above is an expansion of the money supply - in other words,
money creation by the government and central bank. Bank reserves and deposits have been directly
increased. Typically this combination of policies is regarded as inflationary. Other things equal, theory
predicts that a sustained expansion of the money supply would increase the price level and may also
add to inflation expectations. This is the main risk associated with a combination of fiscal expansion
and QE. However, a case for temporary use of such policies may exist in situations where there would
otherwise be a significant risk of deflation or economic recession. That is, a limited amount of
monetary expansion may be called for if needed to offset severe deflationary forces.
5. Suppose that banks are required to hold reserves equal to at least 8 per cent of their
deposits and hold no excess reserves. Also suppose that desired holdings of currency by
the non-bank public are 3 per cent of deposits. Calculate the following using the money
multiplier model set out in the lectures (all answers to 2 decimal places):
a. The simple deposit multiplier
This is given by 1/r, where r is the reserve ratio. Here 1/r =1/.08 = 12.5
b. The money multiplier
𝟏 + 𝒄 𝟏. 𝟎𝟑
𝒎= = = 𝟗. 𝟑𝟔
𝒄 + 𝒓 𝟎. 𝟏𝟏
c. Explain why the money multiplier is less than the simple deposit multiplier
The simple deposit multiplier ignores the fact that as deposits increase, the non-bank public will
typically want to increase their holdings of currency as well. This means that as the deposit creation
process continues, there are leakages into both reserves and currency holdings. If the currency ratio
c = 0, then the simple deposit multiplier and the money multiplier would be the same (both equal to
1/r).
d. What is the effect on the total money supply if reserves are increased by $75m?
∆𝑴 = 𝒎 ∗ 𝟕𝟓 = $𝟕𝟎𝟐𝒎
6. Suppose the total money supply is $200bn, and the parameters r and c are the same as in
the previous question. Calculate the following (in $bn, to two decimal places):
a. The monetary base
𝑴 𝟐𝟎𝟎
𝑴𝑩 = = = $𝟐𝟏. 𝟑𝟕𝒃𝒏
𝒎 𝟗. 𝟑𝟔
b. The stock of currency held by the non-bank public
We can calculate this as follows:
M = D + C = D*(1 + c)
So D = M/(1 + c) = $200bn/(1.03) = $194.17bn
Then C = M – D = $200bn - $194.17bn = $5.83bn
Alternatively, we can use:
C = c.D = (0.03)*194.17 = $5.83bn
c. Bank reserves
Here we can use: MB = C + R
So R = MB – C = $21.37bn - $5.83bn = $15.54bn
Alternatively, we can use:
R = r.D = (0.08)*194.17 = $15.53bn
(There is a small rounding error in the two above calculations.)
d. If the currency ratio doubles as a result of economic uncertainty and the central
bank keeps the monetary base unchanged, what is the effect on the total money
supply?
The new value of the money multiplier is:
m = (1 + c)/(c + r) = 1.06/.14 = 7.57
The new value of broad money is:
M = 7.57*$21.37bn = $161.77bn
So the money supply has fallen by (200 – 161.77) = $38.23bn
7. Use the RBA web site to obtain the following data:
(a) Dec 2021 values for the money base, currency and broad money (use
seasonally adjusted figures where available)
These figures (and those needed for question 8) can be found in Table D3 in the RBA web site.
Dec 2020 ($bn) Dec 2021 ($bn)
Money base (column N) 205.3 515.4
Currency (column J) 93.1 98.8
Broad money (column M) 2439.4 2670.1
Using the information from part (a) above and the definitions provided in lectures, calculate:
(b) The reserve ratio (Dec 2021)
R = MB – C = $416.6bn
D = M – C = $2571.3bn
r = R/D = 16.2 per cent
(c) The ratio of currency to deposits
c = C/D = 98.8/2571.3 = 3.84 per cent
(d) The money multiplier
m = M/MB = 2670.1/515.4 = 5.18
8. From the above data source, do the same calculations for Dec 2020. Also calculate the
percentage increases in the money base and in broad money over the year to December
2021. What explains the difference between these growth rates?
The basic calculations for Dec 2020 are as follows:
R = MB – C = $112.2bn
D = M – C = $2346.3bn
r = R/D = 4.78 per cent
c = C/D = 93.1/2346.3 = 3.97 per cent
m = M/MB = 2439.4/205.3 = 11.88
Growth rate of MB = ((515.4/205.3) – 1)*100 = 151.0 per cent
In other words, the money base more than doubled over the year.
Growth rate of M = ((2670.1/2439.4) – 1)*100 = 9.5 per cent
Hence, the rate of growth of broad money was much less than the rate of growth of the money
base. This corresponds with the calculation that the money multiplier has fallen during that period
and the reserve ratio has substantially increased.
Explanations: The large increase in the money base can be explained by the combination of
increased fiscal deficits plus QE that was occurring during that period. The way this works was seen
in the answers to question 2 – 4.
A corresponding increase in broad money would have required a major expansion of bank lending
(and hence deposit creation) in response. The fact that this did not happen could be explained by
the fact that this was a period of economic downturn (due to the pandemic) and hence there was
little demand for increased borrowing from banks.
9. Give a brief summary of the differences between the classical and modern views of the
money supply process.
Classical view
• Quantity setting by the CB
• CB determines the monetary base
• This determines broad money through the money multiplier
• Causation runs from monetary base to broad money, interest rates, prices and output
Modern view
• Rate setting by CB
• Interest rates directly affect prices and output
• These in turn affect M and MB
• So causation runs from the economy to the monetary aggregates, rather than the other way
round
• Deposit creation through bank lending is a consequence of developments in the wider
economy
10. According to the Bank of England, what is wrong with the classical view?
• Banks in practice are not constrained in their lending decisions by the availability of reserves
• They have enough flexibility to base their lending decisions on other factors such as demand
for credit, the quality of borrower, and wider economic conditions
• Central banks in practice have to supply sufficient reserves to keep the banking system
functioning smoothly, so they can’t use the quantity of reserves as a constraining mechanism
on bank lending
• Instead, central banks use the policy interest rate (the price of reserves, rather than the
quantity) as their instrument of economic management
• By setting the policy interest rate, CBs can influence the entire rate structure of the economy
• This in turn will affect the demand for credit and hence the amount of lending by banks, the
deposit creation process and hence also the money supply
• Hence, the classical view is a misunderstanding of the strategy and conduct of monetary policy
in a modern financial system
