• BEO2000 Financial Institutions & Monetary Theory
• Lecture 3: Money Supply and Money Creation
• Primary Sources:
• Mishkin , 2007, pp. 341-347 & pp. 352-359.
• McLeay et al. 2014, Money Creation in the Modern Economy, pp. 1-14.
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Explain how banks create money via the money multiplier model (i.e., exogenous
approach);
• b. Understand criticisms of the money multiplier approach to money creation;
• c. Review the endogenous approach to money creation;
• d. Critically evaluate both approaches and discuss potential implications for monetary policy.
• Measurement of Money
• No single correct measure of money circulation exists.
• Narrow measures:
– Typically includes currency in circulation and demand deposits (e.g.) cash, coins and
balances held in checking and savings accounts.
• Broad measures:
– Typically refers to the total amount of monetary assets available in an economy at a
specific time.
• Monetary Aggregates
The monetary aggregates common to the Australian economy are:
• Money base is currency plus deposits of banks with the RBA, and other private non-
bank deposits with the RBA.
• M1 is currency plus bank current deposits from the private non-bank sector.
• M3 is M1 plus all other ADI deposits from the private non-ADI sector.
• Broad money is M3 plus other short-term liquid AFI (i.e., all financial intermediaries)
liabilities held by the private sector except those held by other AFIs.
• Australian Money Supply
• Exogenous Money Creation: FRB
• Fractional-reserve banking (FRB) is a system in which banks hold a fraction of their deposits
as reserves.
, • Required reserves represent the minimum amount of funds a bank must hold in
its cash vault or deposit with the central bank against certain liabilities (e.g. deposit).
• NB: Australian banks have no required reserve requirements.
• Excess reserves are the cash reserves beyond those required.
• Total reserves is the fraction of a bank’s total deposits that are held in reserves.
• Exogenous Money Creation
• Exogenous Money Creation
Money Creation Scenarios
• Two main assumptions for scenarios:
1. $1000 currency in circulation
2. All currency ends up in a bank (i.e., no currency drain/leakage)
SCENARIO 1: No Banks
D = 0 and M = C = $1000.
• Exogenous Money Creation
SCENARIO 2: 100 Percent Reserve Banking
• Exogenous Money Creation
SCENARIO 3: Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3: Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3 (cont.): Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3 (cont.): Fractional-Reserve Banking
• To find the total amount of money created...
• Exogenous Money Creation
• Deriving the ‘true’ money multiplier
• Define monetary base as: (i) currency plus (ii) reserves.
• Define ‘true’ money multiplier as:
Where: m = ‘true’ money multiplier;
c = currency deposit ratio
rr = required reserve deposit ratio
• Lecture 3: Money Supply and Money Creation
• Primary Sources:
• Mishkin , 2007, pp. 341-347 & pp. 352-359.
• McLeay et al. 2014, Money Creation in the Modern Economy, pp. 1-14.
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Explain how banks create money via the money multiplier model (i.e., exogenous
approach);
• b. Understand criticisms of the money multiplier approach to money creation;
• c. Review the endogenous approach to money creation;
• d. Critically evaluate both approaches and discuss potential implications for monetary policy.
• Measurement of Money
• No single correct measure of money circulation exists.
• Narrow measures:
– Typically includes currency in circulation and demand deposits (e.g.) cash, coins and
balances held in checking and savings accounts.
• Broad measures:
– Typically refers to the total amount of monetary assets available in an economy at a
specific time.
• Monetary Aggregates
The monetary aggregates common to the Australian economy are:
• Money base is currency plus deposits of banks with the RBA, and other private non-
bank deposits with the RBA.
• M1 is currency plus bank current deposits from the private non-bank sector.
• M3 is M1 plus all other ADI deposits from the private non-ADI sector.
• Broad money is M3 plus other short-term liquid AFI (i.e., all financial intermediaries)
liabilities held by the private sector except those held by other AFIs.
• Australian Money Supply
• Exogenous Money Creation: FRB
• Fractional-reserve banking (FRB) is a system in which banks hold a fraction of their deposits
as reserves.
, • Required reserves represent the minimum amount of funds a bank must hold in
its cash vault or deposit with the central bank against certain liabilities (e.g. deposit).
• NB: Australian banks have no required reserve requirements.
• Excess reserves are the cash reserves beyond those required.
• Total reserves is the fraction of a bank’s total deposits that are held in reserves.
• Exogenous Money Creation
• Exogenous Money Creation
Money Creation Scenarios
• Two main assumptions for scenarios:
1. $1000 currency in circulation
2. All currency ends up in a bank (i.e., no currency drain/leakage)
SCENARIO 1: No Banks
D = 0 and M = C = $1000.
• Exogenous Money Creation
SCENARIO 2: 100 Percent Reserve Banking
• Exogenous Money Creation
SCENARIO 3: Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3: Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3 (cont.): Fractional-Reserve Banking
• Exogenous Money Creation
SCENARIO 3 (cont.): Fractional-Reserve Banking
• To find the total amount of money created...
• Exogenous Money Creation
• Deriving the ‘true’ money multiplier
• Define monetary base as: (i) currency plus (ii) reserves.
• Define ‘true’ money multiplier as:
Where: m = ‘true’ money multiplier;
c = currency deposit ratio
rr = required reserve deposit ratio
