As we noted earlier, the central bank can control the stock
of base money by its open market operations but private sector
decisions determine how big the stock of money associated with
that stock of base money will be. The relationship between the
stock of base money and the stock of money proper was shown in
the last lesson as follows:
1. mm = M/H
= (C + D) / (C + R)
= (C/D + 1) / (C/D + R/D) =
(c + 1) / (c + f)
where M is the nominal stock of money which is the sum of the
stocks of currency in circulation C and deposits in the banking
system D, and H is the stock of base or high-powered
money, which is the sum of currency in circulation plus commercial bank
reserves R. Ultimately, the important parameters determining
the relationship between the stock of base money and the money supply are
the public's desired ratio of currency to deposits c and the banking
systems desired ratio of reserves to deposits f .
To control the money supply, the central bank must continually adjust H to
offset the effects of changes in c and f on
mm and therefore M.
The central bank's control over the money supply is also affected by
government operations in the foreign exchange market designed to influence or
maintain fixed the country's foreign exchange rate. When the central bank,
acting on behalf of the government, changes the country's stock of official
reserves of foreign exchange it buys and sells short-term securities
denominated in foreign currency in return for domestic currency. When it
does this it puts domestic base money in and out of circulation in the same
way as if it were to buy and sell domestic government bonds. The
resulting changes in base money have the usual multiplier effects
on the domestic money supply.
The distinction between domestic base money created by central bank purchases
of foreign exchange reserves (foreign-currency denominated assets) and
purchases of domestic bonds is an important one for understanding small open
economy equilibrium under fixed exchange rates. In fact, we can divide the
stock of domestic high-powered money into two parts---the part that arose
from the central bank's purchase of domestic-currency denominated assets, here
labelled Dsc, and the part that arose from the purchase of official
reserves of foreign exchange R
2. H
= R + Dsc
where Dsc and R are called the domestic and foreign
source components of the stock of base or high-powered money.
An increase in either of these components, holding the other
constant, will increase the stock of domestic base money. Of
course, the central bank may increase the stock of official
reserves and hold base money constant by selling an equal amount
of domestic securities at the same time. In this case it is said
to be sterilizing the effects of the increase in foreign exchange
reserves on the money supply.
The central bank can use methods other than open market
purchases and sales of domestic securities and foreign exchange
to affect the domestic money supply. It can change the stock of
base money by shifting the treasury's deposits, which it manages
on behalf of the government, between deposit accounts with the
commercial banks and deposit accounts with itself. The latter
deposit accounts are not part of the stock of high-powered money
because the commercial banks can not use them as a base for loan
and deposit expansion. Another way in which the central bank could
expand base money is to simply lend money to the treasury which the
latter then spends. In terms of the terminology above, the
above two policy actions also count as changes in Dsc. The
central bank could also engineer a change in the money supply by persuading
the government to induce or force the commercial banks to hold a ratio of
reserves to their deposit liabilities different than they would otherwise
choose to hold---this would lead to a change in mm .
It is time for a test. Always figure out your own answers to the questions
before looking at the ones provided.
You should now understand that there are two dimensions
to money creation---the creation of base money when the central
bank purchases bonds in the open market, and the multiple expansion of
deposits when the public deposits funds in the commercial banks
and the banking system further expands deposits using these funds
as reserves. We now explore the process of high-powered money
creation in more detail, linking it with the government's purchase and
sale of official reserves of foreign exchange.