Base Multiplier Approach to Money Supply

Base Multiplier Approach to Money Supply Traditionally, it has been shown controversially that money supply is determined using the base multiplier approach. ‘The multiplier model of the money supply, originally developed by Brunner (1961) and Brunner and Meltzer (1964) has become the standard model to explain how the policy actions of the Central Bank influence the money stock’   [1] . However, there is more than sufficient evidence to suggest that monetary authorities do not determine the money supply and that the flow of funds approach makes more sense. Consequently, I will compare and contrast the base multiplier and the flow of funds approaches to the determination of money supply and determine which occurs in reality in view of the present economic climate. Under the base multiplier approach, the monetary authority (Bank of England) ‘sets the size of the monetary base, which in turn determines the stock of broad money as a multiple of the base’.   [2]   This process is described below: Ms = Cp + Dc (Equation 1) In the equation above, Ms refers to the broad money supply, Cp refers to private sector (excluding banks) notes and coins and Dc refers to bank deposits. The next equation is for the monetary base (B) is as follows: B = Cb + Db + Cp (Equation 2) In Equation 2, Cb refers to banks’ notes and coins while Db refers to deposits with the Bank of England. Both combined they can be called reserves R and can be substituted into the equation above to form Equation 3. B = R + Cp (Equation 3) The quantity of money can now be expressed as a multiple of the base as follows:   [3]    (Equation 4) The next stage is to divide through by bank deposits to obtain the Equation 5 as follows: If = ÃŽÂ ± and = ÃŽÂ ², then the equation above becomes Equation 6 below: The symbol ÃŽÂ ± is the private sector’s cash ratio, while ÃŽÂ ² represents bank reserves. Under the multiplier approach the money supply equation is then obtained by multiplying both sid es of the equation with the monetary base B. Therefore, Equation 7 becomes: The rationale behind this is that assuming ÃŽÂ ± and ÃŽÂ ² are fixed or stable, the money supply is ‘a multiple of the monetary base and can change only at the discretion of the authorities since the base consists entirely of central bank liabilities. The Flow of Funds approach says that money supplied is determined by open market operations. It presents the opposite view to the multiplier approach as those in favor believe that other factors determine the supply of money, not monetary authorities or policymakers, it looks at the demand for money not just the supply side. They also believe that banks are able to obtain reserves from central banks as required and are not a constraint. Under this approach credit or loans credit by the private sector create deposits and not the other way round as put forward by the base multiplier approach. The flow of funds model of money supply determination is as follows: Ms = Cp + Dc, the same definition of broad money supply as was used in the base multiplier approach (Equation 8) The next equation focuses on the changes in money supply, i.e: