# Chapter 16

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Chapter 16
DETERMINANTS OF THE MONEY SUPPLY

OVERVIEW AND TEACHING TIPS

Chapter 16 lays out the basic models of the money supply process that make use of
the concept of the money multiplier. The chapter makes extensive use of numerical
examples and intuitive reasoning so the student does not become bogged down in
algebraic manipulations of money multiplier formulas. The advantage of this
approach is that students are less likely to forget intuitive reasoning than they are to
forget formulas; thus their knowledge of the money supply process may not be
forgotten soon after the final exam.

I have found that going over the summary Table 1 with students in class is an
excellent device to help them review the money supply model; it gives them an
overall and complete picture of how the money supply is determined.

Chapter 16 ends with two applications that should convince students that the
analysis they have learned is not mere theorization but a useful means of explaining
data that is continually featured in the press and in history books. The first shows
how the money supply model can explain the movements in the money supply in the
1980-1999 period. The second then examines how the bank panics during the 1930s
affected the money supply. Students find this discussion to be especially stimulating
because bank panics are dramatic events that capture their interest

This chapter includes an appendix that derives the M2 money multiplier and
explains the intuition behind it. Some instructors may want to cover this material in
class because it shows how money supply analysis can be extended to other
practice in using the concepts they have learned in the chapter.

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WITHOUT ASTERISKS

Chapter 16
DETERMINANTS OF THE MONEY SUPPLY

2.    False. There would still be leakage into currency and excess reserves that
would limit the increase in deposit expansion. We can also see this in
Equation (4) because the denominator will not equal zero if rD = 0; therefore
the money multiplier will not be infinite.

4.    The rise in banks' holdings of excess reserves relative to checkable deposits
meant that the banking system in effect had fewer reserves to support
checkable deposits. Thus the money multiplier fell and this led to a decline
in the money supply.

6.    M1 remains unchanged, while M2 (which includes money market mutual
fund balance) increases. When Jane's funds go to the money market mutual
fund, they are first deposited in the mutual fund's bank account, leaving
reserves in the banking system unchanged. Because money market mutual
funds are not subject to reserve requirements, required reserves are
unchanged and the amount of deposits will remain unchanged if depositor
ratios remain unchanged. M1 thus remains unchanged, but M2 increases
because there are now a larger amount of money market mutual fund shares
(which are included in M2).

8.    The rise in interest rates in a boom increases the cost of holding excess
reserves and the incentives to borrow from the Fed. Therefore, {ER/D}
falls, which increases the amount of reserves available to support checkable
deposits, and the volume of discount loans increases, which raises the
monetary base. The result is a higher money supply during a boom.
Similarly, when interest rates fall during a recession, the money supply also
has a tendency to fall because {ER/D} rises and the volume of discount
loans falls.

10.   The level of {ER/D} would rise because excess reserves would be more
attractive to hold because of the interest they would earn.

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12.   The money supply falls. The rise in {C/D} means that there has been a shift
from deposits which undergo multiple expansion to currency which does
not. Thus overall level of multiple expansion declines, and the money
multiplier and money supply fall.

14.   The increase in loan demand will cause interest rates to rise. The rise in
interest rates increases the cost of holding excess reserves and the incentives
to borrow from the Fed. Therefore, {ER/D} falls, which increases the
amount of reserves available to support checkable deposits, and the volume
of discount loans increases, which raises the monetary base. The result is a
higher money supply.

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Chapter 16   Determinants of the Money Supply

The Money Supply Model and the Money Multiplier
Deriving the Money Multiplier
Intuition Behind the Money Multiplier
Factors That Determine the Money Multiplier
Changes in the Required Reserve Ratio, rD
Changes in the Currency Ratio, {C/D}
Changes in the Excess Reserves Ratio, {ER/D}
Additional Factors That Determine the Money Supply
Changes in the Nonborrowed Monetary Base,
MBn
Changes in Discount Loans, DL, from the Fed
Market Interest Rate and the Discount Rate
Overview of the Money Supply Process
Application: Explaining Movements in the
Money Supply, 1980-1999
Application: The Great Depression Bank
Panics
Appendix to Chapter 16: The M2 Money Multiplier

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