The Supply of Money and Central Banks

The supply of money in a modern economy consists of the sum of banknotes, coins, and deposits in current (checking) accounts in commercial banks held by households and firms. This definition of the money supply is usually known as M1.

Deposits of credit institutions and other institutions participating in the interbank market and the foreign exchange market are not considered to be part of the money supply. These deposits are not used for the transactions of the general public.

12.2.1 Central Banks and Their Functions

The aggregate money supply of an economy, whether defined narrowly or broadly, is critically influenced by the actions of central banks. A central bank (sometimes known as a reserve bank, or monetary authority) is an institution, usually public, that manages the currency in an economy (namely, its money supply and interest rates in so-called money markets). Central banks also usually oversee the domestic commercial banking system. In contrast to a commercial bank, a central bank possesses a monopoly on issuing notes and coins, which serve as the state’s legal tender.

The primary function of a central bank is to control the nation’s monetary conditions, through active duties, such as issuing notes and coins, managing short-term interest rates, setting reserve requirements for commercial banks, and acting as a lender of last resort to the banking sector (and possibly the state) during times of financial crisis. These duties usually determine a country’s monetary policy.

Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior.

Prior to the seventeenth century, money was mostly commodity money, typically gold, silver, or bronze coins. Bronze coins were used for low-denomination transactions, and silver and gold coins for higher-denomination transactions. However, promises to pay (bank notes) circulated widely and were accepted as money at least 500 years earlier in both Europe and Asia. Paper currency first developed during the Tang Dynasty in China in the seventh century, although true paper money did not appear until the eleventh century, during the Song Dynasty. The usage of paper currency later spread throughout the Mongol empire. European explorers like Marco Polo introduced the concept to Europe during the thirteenth century. Paper money originated in two forms: drafts, which were receipts for precious metals held on account, and bills, which were issued with a promise to convert to precious metals at a later date.

As the first public bank to offer accounts not directly convertible to coin, the Bank of Amsterdam, established in 1609, is considered to be the precursor to modern central banks. The central bank of Sweden (“Sveriges Riksbank” or simply “Riksbanken”) was founded in Stockholm from the remains of the failed bank Stockholms Banco in 1664 and answered to parliament (known as the Riksdag of the Estates). One role of the Swedish central bank was lending money to the government. The establishment of the Bank of England, the model for most modern central banks, was devised by Charles Montagu, First Earl of Halifax, in 1694. He proposed a loan of 1.2 million to the government. In return, the subscribers would be incorporated as The Governor and Company of the Bank of England, with long-term banking privileges, including the issue of notes. The Royal Charter was granted on July 27, 1694, through the passage of the Tonnage Act of that year.

Although some scholars would point to the 1694 establishment of the Bank of England as the origin of central banking, the Bank of England did not originally have the same functions as a modern central bank (namely, to regulate the value of the national currency, to finance the government, to be the sole authorized distributor of banknotes, and to function as a lender of last resort for banks suffering a liquidity crisis). The modern central bank evolved slowly through the eighteenth and nineteenth centuries before reaching its current form.³

12.2.2 Central Banks and the Money Supply

The determination of the money supply by central banks is not a simple process. It depends on the rules under which the central bank participates in money and asset markets and regulates the financial system, on its relations with the government, and on the goals envisaged in its charter.⁴

The monetary base in an economy is defined as the sum of coins and banknotes held by the public plus the reserves of commercial banks held at the central bank. Thus, the monetary base B is equal to

where C is currency (coins and notes) held by the nonbank public (households and firms), and R is the reserves of commercial banks. An alternative name for the monetary base is high-powered money, sometimes denoted as M₀.

The monetary base is the monetary aggregate that a central bank can control better than any other aggregate, as the central bank decides how much currency to issue and can also control the reserves of commercial banks either directly or indirectly.

The money supply is defined as the total of coins and banknotes held by the public plus deposits of households and firms in commercial banks. Thus, the money supply M is determined by

where D denotes deposits in commercial banks.

The relationship between the monetary base and the money supply is given by

where m is the so-called money multiplier. The money multiplier depends on two crucial parameters: the ratio of currency to deposits chosen by the nonbank public (c = C/D) and the reserve ratio of commercial banks (r = R/D).

To the extent that these two ratios are stable, there is a stable proportional relationship between the monetary base and the money supply. Thus, by controlling the monetary base, the central bank can control the money supply. To the extent that either the ratio of currency to deposits of the nonbank public or the reserve ratio of commercial banks are volatile, the control of the money supply by the central bank entails difficulties, because of the volatility of the money multiplier. However, the central bank can still exercise some control over the money multiplier through minimum reserve requirements for commercial banks and other instruments (such as short-term interest rates) that may affect the currency-deposit ratio of the nonbank public or the reserve ratio of commercial banks.

It is clear from the above that the central bank is not the only institution that affects the money supply. The behavior of the nonbank public (in choosing to hold money in the form of either currency or deposits) and the behavior of commercial banks (in deciding the ratio of their reserves to their deposits) also affect the money supply.

Thus, ultimately, the money supply is determined by three factors:

1. the number of notes and coins issued by the central bank;

2. the choices of the nonbank public between holding money in the form of notes and coins and deposits in commercial banks; and

3. the choices of commercial banks between holding reserves with the central bank against their deposits, versus lending to the nonbank public (households and firms) or investing in other interest yielding assets (such as shares and bonds).

Because the central bank can largely determine the monetary base (and indirectly, the cash deposit ratio of the nonbank public and the reserve ratio of commercial banks) it can, to some extent, exert indirect control on the money supply. However, bank regulation and financial innovations in payments are important factors that determine bank-created money, and they are among the reasons the money multiplier may be unstable and not easily controlled by central banks. As noted by Bernanke [2006, p. 2] at the beginning of his term as chairman of the Federal Reserve Board, “In practice, the difficulty has been that, deregulation, financial innovation, and other factors have led to recurrent instability in the relationships between various monetary aggregates and other nominal variables.”

The main economic goals of a central bank are usually stated in its statutes. They are the control of inflation; the stability of the financial system; and in some cases, the support of the general economic policies of the government. In what follows, we shall ignore many of the institutional details that relate to how a central bank operates and will instead make two alternative simple assumptions.

First, let us assume that the central bank has full control of the money supply. This is an assumption with a long history in macroeconomic analysis, although it is not particularly realistic.

Alternatively, let us assume that the central bank follows a policy of determining (pegging) the nominal interest and committing to providing unlimited credit to households, businesses, and commercial banks at this rate. This policy of interest rate determination (which many find to be a more realistic description of how central banks operate in modern economies) means that the money supply is determined by the demand for money at the nominal interest rate determined by the central bank. Although rules for the money supply are sometimes mentioned, most of our analysis of monetary policy in chapters 14–20 will be in terms of interest rate rules.

12.3