Base Multiplier Approach to Money Supply

Base Multiplier Approach to Money SupplyTraditionally, it has been shown controversially that money provide is determined using the base multiplier factor cuddle. The multiplier model of the bills 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 shopworn1. However, in that respect is more than sufficient evidence to suggest that monetary politics do not determine the money supply and that the flow of pecuniary resource get 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) institutes the size of the monetary base, which in turn determines the stock of broad money as a multiple of the base.2Thi s process is described belowMs = Cp + Dc ( par 1)In the equation above, Ms refers to the broad money supply, Cp refers to private sector (excluding swears) notes and coins and Dc refers to bank deposits.The next equation is for the monetary base (B) is as followsB = 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 follows3(Equation 4)The next stage is to divide through with(predicate) by bank deposits to obtain the Equation 5 as followsIf = and = , then the equation above becomes Equation 6 belowThe symbol is the private sectors cash ratio, while represents bank reserves.Under the multiplier approach the money supply equation is then obtained by multiplying both sides of the equation with the monet ary base B. Therefore, Equation 7 becomesThe rationale behind this is that assuming and are fixed or stable, the money supply is a multiple of the monetary base and can transfer 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 give market operations. It presents the opposite view to the multiplier approach as those in favor believe that another(prenominal) 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 followsMs = Cp + Dc, the same definitio n 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.eMs = Cp + Dc (Equation 9)A change in deposit is matched by a corresponding change in loans, which can be further divided into loans to the private sector (Lp) and loans to the UK authorities (Lg)Dp = Loans = Lp + Lg (Equation 10)Equation 9 could therefore be re-written as Equation 11 as followsMs = Cp + Lp + LgThe flow of funds approach was developed at a time when the UK government needed to borrow from banks to meet its requirements as issuing bonds was not sufficient. This had halt macrocosm the case for a while, as the UK government was able to meet its requirements solely through the issue of bonds. Consequently, Lg can be further broken cut down to take into effect the monetary implications of the public sector deficit4Lg = PSNCR Cp Gp + ext (Equation 12)PSNCR stands for public sector net cash requirement Gp represents sale of gover nment bonds to the general public and ext represents the monetary effect of official transactions in foreign exchange by the central bank (and this is equal to zero in a floating exchange rate regime)5Consequently, by substituting Equation 12 into Equation 11, obtainsMs = Cp + Lp + PSNCR Cp Gp + ext, which becomes Equation 13 as followsMs = PSNCR Gp + ext + LpEquation 13 shows a link between loan demand and the state of the miserliness.6As the total come in of goods and services produced within an economy dumbfounds, the demand for credit and a corresponding will also increase to finance the growth according to the flow of funds model. Deposits will also grow to match the increase demand.The differences of opinion between those in favor of the base multiplier approach and the flow of funds approach comes from how they view how money supply is determined. The base multiplier approach believes that money supply is exogenously determined while the flow of fund approach believes i t is endogeneticly determined.Despite the differences, they do agree on the image of the Quantity Theory of Money (QTM). QTM states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.7Heakal explains that if the amount of money in an economy doubles, price levels also doubles causing inflation. The consumer therefore pays twice as much for the same amount of the good or service.8The theory is denoted by the Fisher Equation MV = PT where M is the money supply, V is the velocity of circulation (i.e. the number of times money changes hands in an economy)9 P is the average price level and T the volume of transactions of goods and services.Both approaches agree on the formula but disagree on the assumptions. In the case of the base multiplier approach, Friedman believes that V is constant (http//www.risklatte.com/BraveEconomist/02.php), and T is constant in the short term, while the flow of funds approach b elieves that V is a variable, with their rationale being that since consumer and businesses spending needs determine the number of times money changes hands in the economy, then V cannot be constant.While there is agreement that there is a direct relationship between the money supply and the level of prices of goods and services sold, the nature of that relationship is disputed. The base multiplier approach goes on the assumption that a change in money supply directly influences price levels and/or a change in supply of goods and services.10The endogenous argument believes the relationship works the other way round, i.e. that changes in price levels or in supply of goods and services results in changes in the money supply.So instead of the money supply being determined by the monetary authorities as the base multiplier approach believe, the flow of funds approach believe that it is actually interest rates that determine the money supply. Consequently, the role central banks or monet ary authorities have played is only to set interest rates and let the commercial banks and consumers do the rest through demand and supply.In reality, it is clear that the endogenous view is more viable. In cost of velocity of circulation, statistical analysis shows that v rises during booms and deregulation and falls during slumps and reregulation11, therefore, making redundant the argument of people like Friedman that v is constant. Furthermore, the role of the central bank as a takeer of last resort makes their ability to control the money supply almost impossible.12This is because they are guaranteed to provide funds to commercial banks as appropriate. This was seen in numerous instances during the recent global recession. For example, at the start of the economic crisis in 2007, the Chancellor of the Exchequer authorised the Bank of England to provide a runniness support facility to Northern Rock against appropriate collateral and at an interest rate premium. This liquidity facility will be available to wait on Northern Rock to fund its operations during the current period of turbulence in financial markets while Northern Rock works to secure an refined resolution to its current liquidity problems13.We have seen that the two approaches to money supply determination are influenced by the exogenous and endogenous views. The exogenous view lends credibleness to the base multiplier approach and asserts that an external agent monetary authorities or the policymaker determines the supply of money, while the endogenous approach believes this is done through expand market operations. The only way the policymaker intervenes, according to endogenous views is by setting interest rates. Thereafter, the commercial banks and their customers take over the process which of demanding and supplying credit which last determines the money supply in an economy. The base multiplier approach will never and has never been used, the flow of funds model is thought of as b eing a better model for the money supply as it takes account of demand and supply.In reality the endogenous approach of the flow of funds is at work. Contrary to the exogenous approach insinuating that the money supply is independent of interest rates, the endogenous approach believes that the higher the demand for loans the higher the interest rates which encourages banks to lend more. Therefore modern economies recognise that the policymaker sets short-term interest rates and the quantities of money and credit are demand-determined.