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How Effective Are Money Supply Instruments?

Money. While its functional form has changed over thousands of years, it remains ever-present in virtually all economic transactions. From bartering in earlier societies (using commodities or eventually coins with intrinsic value) there’s been a stark move to our present-day money system that uses fiat money (notes or coins that have value because the central bank guarantees said value). This article will discuss how the money supply is conducted today and how sustainable certain methods are in actuality.

The money supply is equal to the currency held by households and demand deposits. Said deposits are determined by fractional reserve banking. This is a system of financial intermediation where banks keep a fraction of their deposits in reserve. If we assume a single bank starts with an amount of cash (£1,000, for example). The bank makes loans with that £1,000 by assigning total deposits of that amount to borrowers – which will be used to make expenditures by them over time. Then those receiving the payments obtain ownership of such deposits. The bank retains a fraction of its deposits, k, according to the required reserve-deposit ratio to meet sudden liquidity needs (such as people withdrawing deposits unexpectedly). The Bank of England has this set at 12.5%.

As long as the number of new deposits approximately equals the number of withdrawals, the bank need not keep all deposits in reserve and thus will have an incentive to lend (the reasoning behind fractional reserve banking). For an initial £1,000 which generates £1,000 of deposits, the bank can make a second round of lending (1 – k)1000. This lending comes into the bank as further deposits and the bank lends on (1 – k) of that increase so the second round of lending then generates ((1 – k)^2)1000 of lending for the third round and so forth. This continues for n lending rounds and as n tends to infinity, the total increase in demand deposits (thus the increase in money supply) is equal to 1000÷k (=80). Thus, one can see, if the central banks increase the reserve requirements, it can lead to multiple contractions of deposits, and vice versa.

Money supply does, however, depend on households holding currency according to their currency-deposits ratio as well as banks holding currency according to their reserve-deposit ratio (as exemplified earlier). The total number of sterling held by the public, currency and banks as reserves is known as the monetary base. So, the money supply is determined by the monetary base which if behavioural assumptions (currency-deposit ratios and reserve-deposit ratios) are kept constant, is controlled by central banks. This is an important step to understanding money supply, but how and what instruments do central banks use?

One such way is through open market operations. The central bank uses its savings to buy government bonds from the public, because money leaves the central banks and goes into the public, purchases by the public increases the money in circulation. Secondly, the central bank can act as a lender of last resort, this is lending covered by assets directly to banks through a discount window (central bank charges a discount rate on loans, lower than the interest rate, to change the monetary base through reserves). This does however have some moral hazard implications – “too big to fail”. Banks know that they can take excessive risks as they will be bailed out, such as the global financial crises. Thus, to prevent excessive risk, policies were undertaken including braking up banks into “investing” and “savings” arms so that only one arm has to be bailed out. Thirdly, through auction, the central bank can announce in advance the number of funds they will lend and banks bid for them.

However, there is of course a caveat. While central banks have substantial power, households and retail banks make decisions that can cause unprecedented changes in the money supply. For example, in the global financial crisis (as mentioned earlier) banks suffered loan default and became insolvent, being unable to raise money on money markets (as the inter-bank market became very selective in lending). Therefore, the central bank stepped in with emergency liquidity, but the money supply didn’t increase significantly. Why? This was because, banks chose to hold voluntarily higher reserves and households held more cash (both the reserve-deposit ratio and currency-deposit ratio was higher), hence the money multiplier was lower and money supply didn’t increase as expected.

Hopefully, this has given readers an understanding of money supply, a topic that is vital to our modern money system. If you have any questions, please leave them down below.

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