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The Money-Creation Model: Graphic Illustration

Ching-chong Lai , Juin-jen Chang & Ming-ruey Kao
c a b c a b

Institute of Economics Institute of Economics, Academia Sinica

Sun Yat-Sen Institute for Social Sciences and Philosophy, Academia Sinica Taiwan Version of record first published: 07 Aug 2010.

To cite this article: Ching-chong Lai , Juin-jen Chang & Ming-ruey Kao (2004): The Money-Creation Model: Graphic Illustration, The Journal of Economic Education, 35:1, 79-88 To link to this article: http://dx.doi.org/10.3200/JECE.35.1.79-88

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The Money-Creation Model: Graphic Illustration

Ching-chong Lai, Juin-jen Chang, and Ming-ruey Kao

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Abstract: The authors propose a pedagogical apparatus embodying a solid microfoundation with emphasis on the publics choice between currency and demand deposits being an optimal decision. On the basis of the pedagogical exposition, the authors explain how money supply is related to the combined behaviors of the central bank, commercial banks, and the public. Key words: money creation, money multiplier, pedagogy JEL codes: A22, E51 Authors of macroeconomics and money and banking textbooks usually adopt the T-account pedagogy to illustrate the money-creation process and the money multiplier. Thornton, Ekelund, and Delorme (1991) and Gamble (1991) have developed a graphic technique for teaching the money-creation process.1 The graphic analyses they propose provide some new insights to help students understand the creation of the money supply. We propose an alternative pedagogical exposition to illustrate how money supply is related to the combined behaviors of the central bank, commercial banks, and the public.2 Our graphic analysis emphasizes that the publics choice between currency and demand deposits is an optimal decision, and has three advantages. First, it provides a solid microfoundation for money-creation theory that traditional macroeconomics and money and banking textbooks lack (or neglect). Although an appropriate microfoundation for money-creation theory is often ignored by economists, such an analysis can give students a more complete picture concerning the roles played by the three protagonists (the central bank, commercial banks, and the public) in money creation. Second, most macroeconomics textbook authors (e.g., Burda and Wyplosz 1997, 223; Barro 1997, 669670; Jansen, Delorme, and Ekelund 1994, 475) point out that the currency-deposit ratio varies over time or across countries or both. They also indicate that a change in the composition of the publics money
Ching-chong Lai is a research fellow of economics at Institute of Economics and Sun Yat-Sen Institute for Social Sciences and Philosophy and Institute of Economics, Academia Sinica, and a professor of economics at National Taiwan University, Taiwan (e-mail: ccLai@ssp.sinica.edu.tw). Juin-jen Chang is an associate research fellow of economics at Institute of Economics, Academia Sinica, and an associate professor of economics at Fu-Jen Catholic University, Taiwan. Ming-ruey Kao is an associate research fellow of economics at Sun Yat-Sen Institute for Social Sciences and Philosophy, Academia Sinica, Taiwan. The authors are indebted to Hirschel Kasper and an anonymous referee for helpful suggestions.

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holding often plays a crucial role in affecting money supply. However, perhaps for ease of explanation, these textbook authors take the ratio of the publics currency to demand deposits as given. To reflect these practical observations, it is more plausible that the publics currency-deposit ratio should be an endogenous variable and result from a rational decision on the part of the public. From this perspective, our analysis is more realistic when compared with the traditional approach in macroeconomics textbooks. Third, the graphic analysis we have developed not only provides a more complete picture of money-creation theory, but it also captures the traditional wisdom with some special cases. This is useful for the student who wishes to understand both the adequacy and the limitations of the conventional money-creation theory as it appears in most textbooks. THE DEPOSITORS OPTIMAL DECISION Let C and D denote currency held by the public and demand deposits, respectively. The money supply M can thus be expressed as M = C + D. (1)

Branson (1989, 353) documented that commercial banks obtain reserves from two sources. First, the Federal Reserve (Fed) purchases bonds from commercial banks through open-market operations, leading commercial banks to obtain nonborrowed reserves RU. Second, the Fed makes discount loans to commercial banks, causing these commercial banks to have borrowed reserves RB. On the other hand, commercial banks allocate their total reserves in three ways. First, because the Fed requires that a certain fraction of deposits be kept as reserves, commercial banks hold required reserves RR. Second, in addition to required reserves, commercial banks may choose to hold excess reserves RE. Third, the depositors may convert some of their deposits into currency C, and thus these reserves are used as currency in the hands of the public. This gives the following relationship3: RU + RB = RR + RE +C . Let r be the required reserve ratio. The relationship between required reserves RR and demand deposits D may then be expressed by RR = rD. Accordingly, the above equation may alternatively be expressed by C = RU + RB RE rD. (2)

Assuming that depositors are concerned about their holdings of currency and demand deposits, their utility function can be expressed by the following: U = U(C,D),UC > 0,UCC < 0,UD > 0,UDD < 0. (3)

The depositors optimal decision is to choose the best combination of currency and demand deposits that maximizes their satisfaction level, subject to the constraint reported in equation (2). The currency-demand deposits decision is shown in Figure 1. The constraint line CL describes the feasible combinations faced by the depositors. As indicated in equation (2), the vertical intercept of the
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RU + RB RE IC 2 IC1 IC0 CL 0 D

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FIGURE 1. Depositors decisionmaking.

C, M

M0

MM 0 D0 Q0 C0 D0 45 D0 IC0 CL0 D

RU 0 + RB0 RE 0 C0

FIGURE 2. Depositors optimal choice and money supply determination.

CL line is RU + RB RE, and the slope of the CL locus is r. In addition, the set of indifference curves (IC0, IC1, and IC2) that reflect the ranking of the depositors preferences is also illustrated in Figure 1. The depositors choose a combination of currency and demand deposits so they attain the highest level of satisfaction given the constraint line CL. Assume initially that nonborrowed reserves, borrowed reserves, excess reserves, and the required reserve ratio are RU0 , RB0 , RE0 , and r0 , respectively. As shown in Figure 2, the initial constraint line is CL0 , the vertical intercept of the CL 0 locus is RU0 + RB0 RE0 , and the slope of CL0 is r0 . Point Q0 , at which both IC0 and CL 0 are tangential to each other, represents the highest utility that can be reached by the depositors given the constraint. The best combination of currency and demand deposits is C0 and D0 . We then draw a 45 degree line MM0
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that passes through point Q0 , to serve as an auxiliary line. Given the definition of the money supply M = C + D, it is clear that the vertical intercept of the 45 degree line MM0 is the initial money supply M0 (i.e., M0 = C0 + D0 ).4 THE UNDERLYING FACTORS OF THE MONEY SUPPLY On the basis of our graphic apparatus, we can deal with the issue of how the Fed, commercial banks, and the public govern the actual money supply. In general, the Fed uses three major tools to affect the money supply: open-market operations, the required reserve ratio, and the discount rate. Commercial banks affect the money supply by changing their excess reserves. Depositors alter the money stock by adjusting their desired currency-deposit ratio. We now address the linkage between the money supply and the behavior of the Fed, commercial banks, and the public. The Feds Instruments Open-Market Operations. Open-market operations are purchases and sales of government bonds by the Fed, and it is the policy instrument that the Fed uses most often. The initial state in Figure 3 is the same as that in Figure 2. When the Fed engages in open-market operations to purchase government bonds from commercial banks, commercial banks will increase their holdings of nonborrowed reserves from RU0 to RU1. This increase will shift the constraint line right fromCL 0 to CL1. As indicated in Figure 3, the vertical intercept of the CL1 line (RU1 + RB0 RE0) is greater than that of the CL 0 line (RU0 + RB0 RE0). With this change in the constraint line, to maximize their utility, the depositors will choose point Q1, where the new constraint line CL1 is tangential to the indifference curve IC1. The corresponding optimal currency and demand deposits associated with

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C, M M1 M0 RU 1 + RB0 RE0 RU 0 + RB0 RE0 C1 C0 Q0 Q1 IC1 45 0 D0 D1 IC0 Q 2 CL0 CL1 Q1 Q0 D MM 0 MM 1

FIGURE 3. The effect of open-market purchases on the money supply.

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point Q1 are now C1 and D1, respectively. As is evident from Figure 3, when the Fed purchases government bonds from commercial banks in the open market, depositors will raise their holdings of currency from C0 to C1 and demand deposits from D0 to D1.5 We draw a 45 degree line MM1 that passes through point Q1 to serve as the auxiliary line. It is clear that the vertical intercept of the MM1 line (M1) is the new level of money supply after the Fed engages in open-market operations. By comparing the MM0 line with MM1, we can easily find that the vertical intercept of MM0 is smaller than that of MM1. This reveals that the money supply rises when the Fed engages in open-market operations to purchase government bonds from commercial banks. A Change in the Required Reserve Ratio. Next, consider what would happen if the Fed were to change the required reserve ratio (Figure 4). Again, let the initial state be point Q0, where IC0 is tangential to CL0 , and the combination of currency and demand deposits is C0 and D0, respectively. When the Fed raises the required reserve ratio from r0 to r1, the constraint line will rotate downward from CL 0 to CL1, because the vertical intercept of the constraint line remains intact, and the slope of the constraint line (in terms of absolute value) increases. Faced with the new constraint line CL1, utility maximizing depositors will move to point Q1, where the new constraint line CL1 is tangential to the indifference curve IC1. As shown in Figure 4, a rise in the required reserve ratio induces depositors to lower both currency (from C0 to C1) and deposits (from D0 to D1). By drawing a 45 degree line that passes through point Q1, the vertical intercept of the MM1 line (labeled M1 in Figure 4) reflects the new level of money supply. Given that the vertical intercept of MM0 is greater than that of MM1, we conclude that a rise in the required reserve ratio will lower the money supply. A Change in the Discount Rate. A graphic depiction that describes a change in the discount rate is presented in Figure 5; the initial state is the same as that in

C, M

M0 M1 RU 0 + RB0 RE0 C0 C1 MM 0 MM 1 Q0 IC0 IC1

Q1

CL1 0 D1 D0

CL0 D

FIGURE 4. The effect of changes in the required reserve ratio on the money supply.

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C, M

M0 M1 RU 0 + RB0 RE0 RU 0 + RB1 RE0 C0 C1 Q1 MM 1 MM 0

Q0 IC0 IC1 CL1

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CL0 D

D1 D0

FIGURE 5. The effect of changes in the discount rate on the money supply.

Figure 2. Commercial banks are inclined to borrow more at discounts from the Fed when the spread between the market interest rate and the discount rate increases. Accordingly, when the Fed raises the discount rate, commercial banks incur a higher cost for any reserves that they borrow from the Fed. In the face of a higher cost of loans, commercial banks have an incentive to lower their discount borrowing from the Fed. With this understanding, commercial banks will lower their borrowed reserves from RB0 to RB1 in response to a rise in the discount rate. As a result, the constraint line CL 0 will shift left to CL1, and the vertical intercept of the CL1 locus will be RU0 + RB1 RE0. Faced with the new constraint line, the depositors, to maximize utility, will choose point Q1, where the new constraint line CL1 is tangential to the indifference curve IC1. By comparing point Q1 with point Q0 , one sees that a reduction in borrowed reserves will induce depositors to lower their holdings of currency from C0 to C1 and deposits from D0 to D1. When a 45 degree line MM1 is drawn that passes through point Q1, the vertical intercept of the MM1 line (labeled M1 in Figure 5) is the new level of money supply. Given that the vertical intercept of MM0 is greater than that of MM1, we conclude that the money supply will decrease when the Fed raises the discount rate. Regarding the Feds three instruments, two points are worth noting. First, the Fed has complete control over the volume of open-market operations, but it cannot directly control the discount volume because commercial banks have the power to decide whether to accept discount loans. As a consequence, the Fed does not rely on discount policy as its principal tool for controlling the money supply. Second, in comparison with open-market operations and the discount policy, a change in the required reserve ratio is the least frequently used of the Feds policy instruments. An important reason for this is that commercial banks are forced to hold more noninterest-paying reserves when the Fed increases the required reserve ratio. This instrument is thus very costly to commercial banks.
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Commercial Banks Behavior We show the link between commercial banks activities and the money stock in Figure 6. The initial state in Figure 6 is the same as that in Figure 2. When commercial banks raise their holdings of excess reserves from RE0 to RE1, the constraint line will shift left from CL 0 to CL1. The vertical intercept of the CL1 locus is then RU0 + RB0 RE1. Faced with the new constraint line, depositors will choose point Q1, where the new constraint line CL1 is tangential to the indifference curve IC1, as their new optimum position. Comparing point Q1 with point Q0 makes clear that a rise in excess reserves will induce depositors to lower their holding of currency from C0 to C1 and demand deposits from D0 to D1. We then plot a 45 degree line MM1 that passes through point Q1, and the vertical intercept of the MM1 line (labeled M1 in Figure 6) is the new level of money supply. Given that the vertical intercept of MM0 is greater than that of MM1, we conclude that the money supply will decrease when commercial banks raise their holdings of excess reserves. Depositors Behavior Depositors can affect the level of money stock through changing their preference to hold currency relative to demand deposits. A change in depositors preference may occur when the economy experiences either bank runs or bank panics. Depositors might incur substantial losses on deposits and would thus have an incentive to have a greater preference for currency and less preference for deposits. Furthermore, when depositors subjectively anticipate a surge in inflation, the relative attractiveness of currency to deposits will rise because depositors will increase their consumption of goods. We illustrate in Figure 7 what would happen to the indifference curve when depositors alter their preference. When depositors are inclined to be more concerned about currency and less concerned about demand deposits, the set of indifference curves IC0, IC1, and IC2 will change to flatter ones IC0, IC1, and IC2.

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C, M

M0 M1 RU 0 + RB0 RE0 RU 0 + RB0 RE1 C0 C1 Q1 MM 0 MM 1 Q0 IC0 IC1 CL1

CL0 D

D1 D0

FIGURE 6. The effect of changes in excess reserves on the money supply.

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IC0 0

IC1

IC 2 IC1 IC0 IC2

FIGURE 7. A change in indifference map when depositors alter their preference.

C, M

M0 M1

MM 0 MM 1 Q1 IC1 Q0 I C0 IC0 CL0

C1 C0

D1

D0

FIGURE 8. The effect of changes in depositors preference on the money supply.

The initial state in Figure 8 is the same as that in Figure 2. Given that depositors exhibit a stronger preference for currency and less preference for demand deposits, the indifference map becomes flatter. Hence, at the initial equilibrium point Q0, the new indifference curve IC0 is flatter than the constraint line CL0, and the new equilibrium should occur at a point to the left of Q0 on the CL0 line. As shown in Figure 8, the new equilibrium is established at point Q1, where the constraint line CL 0 is tangential to the indifference curve IC1. At point Q1, the combination of currency and demand deposits is equal to C1 and D1. Accordingly, when depositors exhibit a greater preference for holding currency relative to demand deposits, they will raise their holding of currency from C0 to C1 and
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reduce their demand deposits from D0 to D1. When a 45 degree line MM1 is drawn that passes through point Q1, the vertical intercept of the MM1 line (labeled M1 in Figure 8) reflects the new level of money supply. By comparing the vertical intercepts of both lines MM0 and MM1, one sees that the vertical intercept of MM0 is greater than that of MM1. Consequently, the money supply will shrink when depositors exhibit a greater preference for holding currency relative to demand deposits. We would like to emphasize that our graphic apparatus could be used to analyze bank panics in both historical and contemporary experience. Faced with a crisis situation, the public is inclined to convert deposits into currency, leading to a rise in the currency-deposit ratio. Therefore, to meet the substantial surge in deposit outflows, the commercial banks will respond by raising their holdings of excess reserves. This response implies not only that the indifference curve will become flatter, but also that the CL line will shift to the left. Therefore, the money supply will fall dramatically. DISCUSSION The graphic pedagogy that we propose can be applied with a view to analyzing some alternative cases addressed in textbooks. Some textbook authors deal with an extremely simple case in which depositors do not hold any currency. This implies in Figure 3 that the depositors initial holdings of currency and demand deposits can be represented by point Q 0 (rather than Q 0 ) on the constraint line CL 0 in Figure 3. Given the restriction that depositors do not hold currency, when the Fed purchases government bonds from commercial banks in the open market, the depositors new combination of currency and demand deposits can be expressed by point Q 1 (rather than Q 1) on the constraint line CL1. It should be noted that, given C = 0, the change in demand deposits is equal to the change in money supply, and hence the distance between points Q 0 and Q 1 represents the change in money supply (M). With the distance between points Q 0 and Q 2 being the change in nonborrowed reserves (RU = RU1 RU0 ) and the slope of the CL1 line being equal to r, from points Q 0 , Q 1, and Q 2, we can infer the relationship r = RU/M. This implies that the money multiplier is the inverse of the required reserve ratio. Most textbook authors in the fields of macroeconomics and money and banking specify, perhaps for the ease of pedagogy, that the ratio of currency to demand deposits is a given parameter to depositors. In terms of our graphical pedagogy, this special specification implies that depositors do not view any substitution between C and D as being worthwhile. To be more specific, the depositors indifference curves shown in Figure 1 should become right angled. The corresponding utility function can be expressed algebraically as U = min(C/,D/). The terms and are constants and are the units of currency and demand deposits, respectively, that produce one unit of utility. Authors of microeconomics textbooks tell us that, given a fixed coefficient preference, a fixed proportional relationship between C and D must exist because the choices must lie at the vertices of the indifference curves. The graphic pedagogy that we have developed can be extended to the more general situation where the depositors choice includes currency, demand deposits, and time deposits. However, under such a situation, one needs a threeWinter 2004 87

dimensional graph to highlight the depositors optimal decision with regard to holding currency, demand deposits, and time deposits, as well as how the economys money supply is determined. This extension goes beyond the context of macroeconomics for undergraduate students, and hence we do not conduct any further investigation here. CONCLUDING REMARKS Most textbook authors in the field of macroeconomics as well as money and banking usually adopt the T-account pedagogy to illustrate the money-creation process and the money multiplier. We provide a graphic pedagogy as a supplement to the T-account pedagogy, with the salient feature of our pedagogical apparatus being that it embodies a solid microfoundation. On the basis of such a pedagogical exposition, we highlight that the Fed cannot completely control the money supply and that commercial banks and the public also play crucial roles in determining the level of money supply. We hope that our graphic illustration can enhance and deepen a students understanding of the money-creation process.
NOTES 1. Ekelund and Delorme (1987) also propose a graphic illustration, similar to Thornton, Ekelund, and Delorme (1991), to address the money-creation process. 2. The graphic apparatus we developed is similar to Chens (1973) analysis on puzzles of international monetary system. 3. The relationship is borrowed from Branson (1989, 353). 4. Given that the MM0 line in Figure 2 is a 45 degree line, the distance between points C0 and Q0 is then equal to that between point C0 and M0. Furthermore, the distance between points C0 and Q0 reflects the equilibrium amount of demand depositors D0. Accordingly, as exhibited in Figure 2, the vertical intercept of the MM0 line, M0, is equal to the sum of currency C0 and demand deposits D0 . 5. To be more consistent with reality, we assume that both currency and demand deposits are normal goods. 6. Given that the currency-deposit ratio is an exogenous variable, Ekelund, Thornton, and Delorme (1993) provided an alternative diagrammatic money-creation model to address bank panics.

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REFERENCES
Barro, R. J. 1997. Macroeconomics. 5th ed. Cambridge, Mass.: MIT Press. Branson, W. H. 1989. Macroeconomic theory and policy. 3rd ed. New York: HarperCollins. Burda, M., and C. Wyplosz. 1997. Macroeconomics: A European text. 2nd ed. Oxford: Oxford University Press. Chen, C. N. 1973. International monetary system: Conflicts and reform. (in Chinese). Academic Economic Papers 1 (March): 183202. Ekelund, Jr., R. B., and C. D. Delorme, Jr. 1987. Macroeconomics. Dallas, Tex.: Business Publications. Ekelund, Jr., R. B., M. Thornton, and C. D. Delorme, Jr. 1993. The anatomy of financial panics: American historical episodes. Rivista Internazionale di Scienze Economiche e Commerciali 40 (October-November): 91530. Gamble, Jr., R. C. 1991. The money-creation model: Another pedagogy. Journal of Economic Education 22 (Fall): 32529. Jansen, D. W., C. D. Delorme, Jr., and R. B. Ekelund, Jr. 1994. Intermediate macroeconomics. New York: West. Thornton, M., R. B. Ekelund, Jr., and C. D. Delorme, Jr. 1991. The money-creation model: An alternative pedagogy. Journal of Economic Education 22 (Fall): 31724.

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