NSS Exploring Economics 6

Chapter 8

Money supply and money creation

Questions
p.38
Think it over
1.
Can a magician create money?
2.
Can a bank create money from deposits?
p.42
Discuss
8.1
Suggest possible reasons for the following.
a. M1 includes only demand deposits, not savings and time deposits with licensed banks.
b. M2 includes only deposits with licensed banks, not deposits with restricted licence
banks and deposit-taking companies.
c. M3 includes only NCDs issued by deposit-taking institutions held by the public, not
those held by deposit-taking institutions.
p.45
Test yourself
8.1
What are the immediate effects of each of the following asset transfers on M1, M2 and M3,
respectively?
a. Ms B withdraws HK$1,000 cash from her savings account.
b. An immigrant converts US$1 million into HK$7.8 million. He then deposits half of it in
his current account and uses half of it to buy NCDs issued by a restricted licence bank.
p.47
Discuss
8.2
Which types of deposits can the initial deposit and deposits created be for the creation of M2
and M3, respectively?
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p.54
Test yourself
8.2
Suppose there is an initial cash deposit of $1,000. If the required reserve ratio is 100%, what
will the maximum increases in deposits, loans, money supply and reserves be, respectively?
Discuss
8.3
Suppose the required reserve ratio is 10% and Louis deposits $500 into a bank. Will the
increases in deposits, loans and money supply attain their maximum possible values when
each of the following happens?
a. Banks decide to hold excess reserves.
b. Demand for loans is insufficient.
c. Cash leakage exists.
p.57
Test yourself
8.3
Refer to Fig. 8.14. Illustrate how Processes A, B, C and D affect the balance sheets of Banks
X and Y, respectively.
pp.64-68
Exercises
Multiple Choice Questions
1.
Which of the following statements about the issue of currency in Hong Kong is correct?
A. Notes are issued by the three note-issuing banks but coins are issued by the Hong Kong
Government.
B. To issue notes, note-issuing banks have to buy Certificates of Indebtedness from the
Exchange Fund.
C. Notes are fully backed by foreign currency but coins are not.
D. All of the above

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2.
Which of the following statements about the definitions of money supply in Hong Kong is
correct?
A. M1 is equal to the sum of legal tender held by the public and demand deposits with
licensed banks.
B. M2 is equal to the sum of M1 and deposits with licensed banks.
C. M3 is equal to the sum of M2 and time deposits with restricted licence banks and
deposit-taking companies.
D. All of the above
3*.
Suppose Hong Kongs money supply (in $ billion) in a certain year was:
Total issue of legal tender

12

Legal tender in circulation

Demand deposits

10

Savings and time deposits with licensed banks

20

Negotiable certificates of deposit issued by licensed banks

12

Negotiable certificates of deposits issued by licensed banks and held by

authorised institutions

Time deposits with restricted licence banks and deposit-taking companies

15

The money supply M2 (in $ billion) is

A. 22.
B. 34.
C. 41.
D. 56.
4*.
Andrew withdraws $100,000 from his time deposits with a deposit-taking company and
remits $60,000 overseas. Then he deposits $20,000 as a time deposit and $15,000 as a
demand deposit with a licensed bank. He keeps the remaining $5,000 in a safe at home. How
will the money supply be affected by the above events?
A. M1 increases by $15,000.
B. M2 increases by $35,000.
C. M3 remains unchanged.
D. M3 decreases by $60,000.

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5.
Which of the following assumptions is necessary for money creation?
A. The initial deposit does not come from deposits of other banks.
B. Banks keep no excess reserves.
C. Banks can lend as much as they like.
D. There is no cash leakage.
6*.
Which of the following may reduce the actual reserve ratio of a banking system?
A. An increase in the required reserve ratio
B. An increase in the demand for bank loans
C. An increase in the amount of cash leakage
D. An increase in the default risk of bank loans
7.
A bank has total deposits of $1,000 million. It has reserves of $180 million but the required
reserve ratio is 20%. Which of the following will help the bank fulfil the reserve
requirement?
A. Customers deposit $20 million in the bank.
B. Customers withdraw $20 million from the bank.
C. The bank borrows $20 million from the inter-bank market.
D. The bank lends $20 million to customers.
8.
The following is the balance sheet of a banking system.
Assets ($)
Reserves
Loans

Liabilities ($)
200
600

Deposits

800

From the balance sheet, we can conclude that

A. the required reserve ratio is 25%.
B. the banking system holds no excess reserves.
C. the banking system cannot create new loans.
D. the actual banking multiplier is 4.

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9.
Suppose a person deposits $400 cash in his current account. If both the actual and legal
reserve ratios are 20%, the maximum possible change in
A. M1 is a decrease of $400.
B. M1 is an increase of $1,600.
C. bank loans is an increase of $2,000.
D. reserves is uncertain.
10.
The following is the balance sheet of a banking system.
Assets ($)
Reserves
Loans

Liabilities ($)
400
1,100

Deposits

1,500

If the required reserve ratio is 20%, which of the following statements is correct?
A. The banking system has excess reserves of $200.
B. The banking system can expand its total deposits to $2,500.
C. The maximum amount of loans the banking system can make is $1,600.
D. The money supply can increase by $400.
Short Questions
1.
What are monetary base and money supply M1? What are their differences?

(8 marks)

2.
What are the three definitions of money supply in Hong Kong?

(6 marks)

3*.
Savings deposits can also be used to settle payments by EPS and PPS. Why are savings
deposits NOT included in M1?
(3 marks)
4.
What is the immediate effect on money supply M1 in each of the following situations?
a. A depositor puts $8,000 cash into a current account.
(2 marks)
b. A bank lends $100,000 cash to a borrower.
(2 marks)
c. A borrower repays a bank loan of $5,000,000 by cash.
(2 marks)
d. A depositor withdraws $1,000,000 cash from a time deposit account with a restricted

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licence bank.

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5*.
After receiving a cash deposit, a banking system can create deposits, loans and money. Under
what conditions would the increase in money supply be smaller than and equal to the increase
in deposits, respectively?
(6 marks)
6.
Describe the process of credit contraction that results from a cash withdrawal. State the
assumptions behind the calculation of the maximum contraction.
(8 marks)
Structured Questions
1.
Suppose Hong Kongs money supply (in $ billion) on a certain day was:

a.
b.

c.

Total issue of legal tender

100

Legal tender held by all deposit-taking institutions

20

Demand deposits

200

Deposits with licensed banks

600

Negotiable certificates of deposit (NCDs) issued by

licensed banks and held by the public

150

Deposits with restricted licence banks (RLBs) and

deposit-taking companies (DTCs)

180

NCDs issued by RLBs and DTCs

120

NCDs issued by RLBs and DTCs and held by the public

40

Calculate M1, M2 and M3, respectively.

(6 marks)
Suppose on the next day, some customers withdrew $30 billion from their savings
deposits. They used $10 billion to buy NCDs from restricted licence banks and
deposited $15 billion into their time deposit accounts with licensed banks. They held the
remaining $5 billion in cash. How did the above transactions affect M1, M2 and M3,
respectively?
(6 marks)
Suggest TWO possible transactions that may cause M3 to drop.
(2 marks)

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2.

The table below shows the balance sheet of a banking system. The required reserve ratio
is 20%.
Assets ($ billion)
Cash
Loans

a.
b.

Liabilities ($ billion)
40
40

Demand deposits

80

Find the actual banking multiplier and the maximum banking multiplier.
(3 marks)
Without any new deposits or withdrawals, what are the maximum possible changes in
deposits, loans, money supply and reserves? State the assumptions in arriving at your
answers.
(12 marks)

3*. The following table shows the balance sheet of a banking system.
Assets ($ million)
Reserves
Loans

Liabilities ($ million)

500
1,000

Deposits

1,500

Suppose the legal reserve ratio is 20%. The following are independent events.
a. Winnie receives $100 million remittance from her relatives overseas. She deposits the
remittance into the banking system. What are the maximum possible changes in
deposits, loans, money supply and reserves?
(9 marks)
b. If some depositors withdraw $300 million from their deposits, what are the maximum
possible changes in deposits, loans, money supply and reserves?
(9 marks)

Answers
p.38
Think it over
1.
Man cannot create material.
2.
A bank can create money (credit available for use) from deposits. The principle is discussed
in the text, p.45.

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p.42
Discuss
8.1
a. With demand deposits, people can settle payments immediately by drawing cheques.
However, for savings and time deposits, people cannot settle payments before
converting them into cash and/or demand deposits. Hence, M1 includes only demand
deposits, not other deposits.
b. This is because deposits with LBs are more liquid than deposits with RLBs and DTCs.
Deposits with LBs include demand deposits, savings deposits and time deposits of any
maturity, but deposits with RLBs and DTCs include time deposits only. In addition, the
maturity of deposits at DTCs cannot be less than three months.
Deposit interest at LBs is also lower and LBs generally have a greater number of
branches than RLBs and DTCs. Hence, it is less costly for people to withdraw money
from LBs than from RLBs and DTCs.
c. Only NCDs held by the public are available to be used (after converting them into
cash). NCDs held by deposit-taking institutions are not available to be used as they are
held to fulfil the liquidity ratio requirement. Thus, only the former is included in M3, not
the latter.
p.45
Test Yourself
8.1
a. M1 = CP + DL = +$1,000 + $0
= +$1,000
M2 = M1 + SL + TL + NCDL
= +$1,000 $1,000 + $0 + $0
= $0
M3 = M2 + TR+D + NCDR+D
= $0 + $0 + $0 = $0

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b.

M1 = CP + DL
= $0 + HK$3.9 million
= +HK$3.9 million
M2 = M1 + SL + TL + NCDL
= +HK$3.9 million + $0 + $0 + $0
= +HK$3.9 million
M3 = M2 + TR+D + NCDR+D
= +HK$3.9 million + $0 + HK$3.9 million
= +HK$7.8 million

p.47
Discuss
8.2
M2: all deposits with licensed banks
M3: all deposits with licensed banks, restricted licence banks and deposit-taking companies

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p.54
Test Yourself
8.2
Maximum increase in deposits
Initial deposit

1
rrr

1
$1,000
100%
Maximum increase in loans
1
Initial loan
rrr
1
$0
$0
100%
Maximum increase in money supply
Change in cash held by the public Maximum increase in demand deposits
$1,000

- $1,000 $1,000 $0
Maximum increase in reserves
Maximum increase in deposits - Maximum increase in loans
$1,000 - $0 $1,000

Discuss
8.3
The increases in deposits, loans and money supply will not attain their maximum possible
values as the conditions for maximum creation are violated.
a. When banks hold excess reserves, they can loan a smaller amount of their deposits.
b. When the demand for loans is insufficient, banks can loan a smaller amount of their
deposits.
c. When cash leakage exists, smaller amounts of bank loans are redeposited into the
banking system for further lending.

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p.57
Test Yourself 8.3

Process A: Changes in the balance sheet of Bank X

Assets ($)
Reserves

1,000

Reserves
200
Loans
800

1,000

Liabilities ($)
Deposits

1,000

Process C: Changes in the balance sheet of Bank Y

Assets ($)
Reserves

Deposits

Process B: Changes in the balance sheet of Bank X

Assets ($)

Liabilities ($)

800

Liabilities ($)
Deposits

800

Process D: Changes in the balance sheet of Bank Y

Assets ($)
Reserves
160
Loans
640

Liabilities ($)
Deposits

800

pp.64-68
Exercises
Multiple Choice Questions
1. B
Option A is incorrect. The $10 note is issued by HKMA, not the three note-issuing
banks.
Option C is incorrect. Both notes and coins are fully backed by US dollars.
2.

A
Option B is incorrect. Demand deposits have already been included in M1.
M2 = M1 + (SL + TL + NCDL).
Option C is incorrect. M3 = M2 + TR+D + NCDR+D.

3.

C
M2 = Legal tender in circulation + Demand deposits + Savings and time deposits with
licensed banks + (NCDs issued by licensed banks NCDs issued by licensed
banks and held by authorised institutions)
= $[4 + 10 + 20 + (12 5)] billion
= $41 billion

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4.

D
The transfer of assets includes:

TR+D = -$100,000

$60,000 remitted is not a component of the money supply

TL = +$20,000

DL = +$15,000

CP = +$5,000
Hence, M1 = CP + DL = +$5,000 + $15,000 = +$20,000
M2 = M1 + SL + TL + NCDL = +$20,000 + $0 + $20,000 + $0 = +$40,000
M3 = M2 + TR+D + NCDR+D = +$40,000 + (-$100,000) + $0 = -$60,000

5.

A
The others are conditions of maximum creation, instead of conditions of money creation.

6.

B
Option A is incorrect. This will either raise the actual reserve ratio (if it is smaller than
the new required reserve ratio), or leave it unchanged (if it is larger than or equal to the
new required reserve ratio).
Option B is correct. This may increase bank loans and so may reduce the actual reserves
held by the banking system and lower the actual reserve ratio.
Option C is incorrect. This reduces the total amount of deposits created but has little
effect on the actual reserve ratio.
Option D is incorrect. This reduces banks willingness to lend and raises the actual
reserve ratio.

7.

C
Option A is incorrect. After the deposit, the new total deposits = $1,020 million and the
new actual reserves = $200 million. However, the new required reserves = $1,020
million 20% = $204 million, which is larger than the new actual reserves.
Option B is incorrect. After the withdrawal, the new total deposits = $980 million and
the new actual reserves = $160 million. However, the new required reserves = $980
million 20% = $196 million, which is larger than the new actual reserves.
Option C is correct. After borrowing, the total deposits are still $1,000 million but the
new actual reserves are $200 million, which is just equal to the required reserves of $200
million.
Option D is incorrect. After lending, the total deposits are still $1,000 million and the
new actual reserves = $160 million. However, the required reserves are still $200
million, which is larger than the new actual reserves.

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8.

D
Since the required reserve ratio is not given, we do not know whether options A, B and
C are correct or not. Since the actual reserve ratio = $200/$800 = 25%, the actual
banking multiplier = 1/25% = 4.

9.

B
With a cash deposit of $400, the maximum possible change in deposits
= $400 1/20% = $2,000.
The maximum possible change in loans = ($400 80%) 1/20% = $1,600.
Maximum possible change in money supply (M1)
= CP + Maximum increase in demand deposits = -$400 + $2,000 = $1,600.
Maximum possible change in reserves
= Maximum change in deposits Maximum change in loans = $2,000 $1,600 = $400.

10. C
Option A is incorrect. Excess reserves = Actual reserves Required reserves
= $400 ($1,500 20%) = $100.
Option B is incorrect. Maximum increase in deposits
= Excess reserves (Initial deposit) 1/20% = $100 1/20% = $500.
Maximum amount of total deposits = $1,500 + $500 = $2,000.
Option C is correct. Maximum increase in loans
= Excess reserves (Initial loan) 1/20% = $100 1/20% = $500.
Maximum amount of total loans = $1,100 + $500 = $1,600.
Option D is incorrect. Maximum increase in money supply
= CP + Maximum increase in demand deposits = $0 + $500 = $500.
Short Questions
1.
The monetary base (M0) is the total amount of currency issued in an economy. It consists of
the currency in the hands of the non-bank public (called cash (CP)) and the currency in the
hands of banks (called reserves (R)) (i.e. M0 = CP + R). (2 marks)
The money supply (M1) is the total amount of money (medium of exchange and store of
value) available in an economy. It consists of the currency in the hands of the non-bank
public and demand deposits with licensed banks (DL) (i.e. M1 = CP + DL). (2 marks)
The monetary base includes the reserves of banks which are legal tender but are not available
for use (mostly required reserves) and are not included in the money supply. The money
supply includes demand deposits with banks which are not currency issued and are not
included in the monetary base. (4 marks)
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2.

Money supply definition 1 (M1) is equal to the sum of legal tender notes and coins held
by the public and demand deposits with licensed banks. (2 marks)
Money supply definition 2 (M2) is equal to the sum of M1, savings deposits and time
deposits with licensed banks and negotiable certificates of deposit issued by licensed
banks held by the public. (2 marks)
Money supply definition 3 (M3) is equal to the sum of M2, time deposits with restricted
licence banks and deposit-taking companies, and negotiable certificates of deposit issued
by restricted licence banks and deposit-taking companies held by the public. (2 marks)

3.
Due to the high cost of setting up and operating the EPS and PPS system, EPS and PPS have
not been widely adopted as a means of settling payments, e.g., not accepted by stalls in public
markets or transport companies. Thus, savings deposits are not commonly accepted as a
medium of exchange and a means of payment, and are not included in M1 at present.
(3 marks)
4.
a.
b.
c.
d.

Given that CP = -$8,000 and DL = +$8,000,

M1 = CP + DL = -$8,000 + $8,000 = $0. (2 marks)
Given that CP = +$100,000 and DL = $0,
M1 = CP + DL = +$100,000 + $0 = +$100,000. (2 marks)
Given that CP = -$5,000,000 and DL = $0,
M1 = CP + DL = -$5,000,000 + $0 = -$5,000,000. (2 marks)
Given that CP = +$1,000,000 and DL = $0,
M1 = CP + DL = +$1,000,000 + $0 = +$1,000,000. (2 marks)

5.
M1 = CP + DL. An increase in the money supply would be smaller than an increase in
deposits if there is a simultaneous decrease in legal tender held by the public. This happens
when the initial deposits come from cash held by the public. (3 marks)
On the other hand, an increase in the money supply would be equal to an increase in deposits
if there is no change in legal tender held by the public. This happens when the initial deposits
come from excess reserves held by the banking sector or from cash held by the foreign sector,
e.g., remittances. (3 marks)

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6.
Let rrr be the required reserve ratio. Suppose Mr A withdraws cash (= C) from his current
account in Bank X and banks keep no excess reserves. For the deposit C, Bank X keeps only
C rrr as required reserves and has to call back loans of C (1 rrr), say from Ms B, to meet
the withdrawal. Assuming no cash injection into the banking system, Ms B has to withdraw
cash [= C (1 rrr)] from Bank Y to repay the loan. Since banks keep no excess reserves, for
the deposit C (1 rrr), Bank Y keeps only C (1 rrr) rrr as required reserves and has to
call back loans of C (1 rrr) (1 rrr), say from Mr C, to meet Ms Bs withdrawal. This
brings further withdrawals and decreases in deposits. The process of money contraction
continues until the banking system is no longer short of reserves. (4 marks)
Maximum decrease in deposits in the banking system
= C + C (1 rrr) + C (1 rrr)2 + C (1 rrr)3 +
= C 1 / [1 (1 rrr)] = C 1/rrr
= Initial withdrawal Maximum banking multiplier (1 mark)
Maximum decrease in loans
= C (1 rrr) + C (1 rrr)2 + C (1 rrr)3 + C (1 rrr)4 +
= [C (1 rrr)] 1 / [1 (1 rrr)] = [C (1 rrr)] 1/rrr
= Initial decrease in loans Maximum banking multiplier (1 mark)
The assumptions behind the calculation are that (a) banks keep no excess reserves; (b) there
is no cash injection into the banking system. (2 marks)
Structured Questions
1.
a. M1 = Legal tender held by the public + Demand deposits
= (Total issue of legal tender Legal tender held by all deposit-taking institutions)
+ Demand deposits
= $(100 20 + 200) billion = $280 billion (2 marks)
M2 = M1 + Savings deposits and time deposits with licensed banks
+ NCDs issued by licensed banks held by the public
= M1 + (Deposits with licensed banks Demand deposits)
+ NCDs issued by licensed banks held by the public
= $(280 + 600 200 + 150) billion = $830 billion (2 marks)
M3 = M2 + Time deposits with restricted licence banks and deposit-taking companies
+ NCDs issued by restricted licence banks and deposit-taking companies held by
the public
= $(830 + 180 + 40) billion = $1,050 billion (2 marks)

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b.

c.

2.
a.

Given that SL = -$30 billion, NCDR+D = +$10 billion, TL = +$15 billion and
CP = +$5 billion
M1 = CP + DL = +$5 billion + $0 = +$5 billion (2 marks)
M2 = M1 + SL + TL + NCDL = +$5 billion $30 billion + $15 billion + $0
= -$10 billion (2 marks)
M3 = M2 + TR+D + NCDR+D = -$10 billion + $0 + $10 billion = $0 (2 marks)
The following are some possible transactions. For example, people remit money to a
foreign country; people buy foreign products or assets, etc; people buy government
bonds issued by the monetary authority directly.
(Mark the first TWO possible transactions. 1 mark each.)

Actual banking
=
multiplier

1
Actual reserve ratio

1
$40 billion / $80 billion

= 2 (2 marks)

Maximum banking
=
multiplier
=
b.

1
Required reserve ratio

1
20%

5 (1 mark)

Without any new deposits or withdrawals, the banking system can lend its excess
reserves = Actual reserves Required reserves
= $40 billion ($80 billion 20%) = $24 billion. (1 mark)
Without cash leakage, the initial loan is redeposited. (1 mark)
Hence,
Maximum increase in loans = Maximum increase in deposits
= Initial loans or deposits Maximum banking multiplier (2 marks)
= $24 billion 1/20% = $120 billion (1 mark)
Maximum increase in money supply = CP + DL = $0 + $120 billion = $120 billion
(2 marks)
Maximum increase in reserves = Maximum increase in deposits Maximum increase in
loans = $120 billion $120 billion = $0 (2 marks)
The assumptions of maximum creation are no excess reserves, sufficient borrowing and
no cash leakage. (3 marks)

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3.
a.

b.

With a new deposit of $100 million, the new actual reserves = $600 million, which is
also the final amount of reserves after the credit creation process. (1 mark)

Final amount of reserves = Final amount of deposits rrr

Final amount of deposits = Final amount of reserves 1/rrr
= $600 million 1/20% = $3,000 million
Maximum increase in deposits = $3,000 million $1,500 million
= $1,500 million (2 marks)

Final amount of loans = Final amount of deposits Final amount of reserves

= $3,000 million $600 million = $2,400 million
Maximum increase in loans = $2,400 million $1,000 million = $1,400 million
(2 marks)

Maximum increase in money supply

= Change in cash held by the public + Maximum increase in deposits
= $0 + $1,500 million = $1,500 million (2 marks)
(Note: As the initial deposit comes from remittances from a foreign country, there is
no change in CP.)

Maximum increase in reserves = $600 million $500 million = $100 million

(2 marks)
(Note: Students can use the alternative method to answer this question.)
After a withdrawal of $300 million, the new actual reserves = $200 million (= $500
million $300 million), which is also the final amount of reserves after the credit
contraction process. (1 mark)

Final amount of reserves = Final amount of deposits rrr

Final amount of deposits = Final amount of reserves 1/rrr
= $200 million 1/20% = $1,000 million
Maximum change in deposits = $1,000 million $1,500 million = -$500 million
(2 marks)

Final amount of loans = Final amount of deposits Final amount of reserves

= $1,000 million $200 million = $800 million
Maximum change in loans = $800 million $1,000 million= -$200 million
(2 marks)

Maximum change in money supply

= Change in cash held by the public + Maximum change in deposits
= +$300 million $500 million = -$200 million (2 marks)

Maximum change in reserves = $200 million $500 million = -$300 million

(2 marks)
(Note: Students can use the alternative method to answer this question.)

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