Kenneth R. Szulczyk
Risk could raise the currency-deposit ratio. During a financial panic, people convert their
deposits into currency, harming the economy. When depositors convert deposits into
currency, banks’ reserves decrease, shrinking the money supply. Unfortunately, a
contracting money supply could trigger a recession. Underground activities raise the currency-deposit ratio. People participate in illegal
activities do not want the government to know about them, so they deal exclusively with
currency. Bank accounts leave transaction records. Currency-deposit ratio would increase
if people evaded taxes or participated in illegal activities.What would happen if the Fed bought a T-bill from you for $10,000? Subsequently, you
take the Fed check to a bank and ask the bank to pay in cash. In this case, the total bank reserves
would not change, but currency in circulation and monetary base rise by $10,000. Effect of an
open-market purchase on the monetary base is always the same, whether the proceeds from the
sale are in deposits or currency. When the Fed sells U.S. government securities, it decreases the
monetary base by the amount of government securities it has sold. Consequently, the Fed has
complete control over the monetary base.
Money multiplier equals the ratio between the money supply and the monetary base. We
define the notation as:
We define the money supply (M1) as the currency in circulation (C) plus checkable
deposits (D), written as M1 = C + D. Monetary base (B) equals banks’ reserves (R) plus currency in circulation (C), written as B
= C + R. Money multiplier (m) equals the ratio between the money supply (M1) and the monetary
base (B) or as M1=mB.We use a clever substitution. First, we start with the equation M1 = M1 and on the right-
hand side, multiply and divide by the monetary base, shown as Equation 10. The B’s would
cancel, and M1 still equals M1.
B
B
M1
M1=
( 10 )
Then we substitute M1 = C + D and B = C + R into the Equation 10 for the variables within
the brackets, yielding Equation 11.