oney supply are (a) currency (notes and coins) issued by the government and held by the public (other than banks), (b) travelers checks, and (c) checking account deposits in banks (Colander, 2004).
When a bank issues loans, some of the money advanced to borrowers will be withdrawn from the loan-creating bank, which will eventually be deposited in other banks. In such a scenario, the loan creating bank loses cash (although it does not lose any assets overall). The cash loss (reflected in the ratio of cash to total assets (is the "cash leakage". There is no cash leakage in the banking system, as a whole, as "cash leakages" simply reflect relocations of cash assets within the banking system.
The Federal Reserve System engages in open market operations because the securities markets are a convenient and efficient means through which the Board of Governors may either increase or decrease the money supply. Purchases by the System in the open market of federal debt obligations increase the money supply. Sales of federal debt obligations in the open market decrease the money supply.
The reserve requirement for a member bank prescribes what proportion of a bank's deposits must be retained by the bank. The remaining proportion of a bank's deposits may be legally loaned to borrowers at interest. The reserve requirement is a means of regulating the money supply (Board of Governors, Federal Reserve System, 2004). A reduction in the reserve requirements has the effect of loosening, or increasing, the money supply, while an increase in the reserve requirements has the effect of tightening, or decreasing, the money supply.
The equation of exchange describes the relationships between (a) the level of the money supply, (b) the velocity of money, (c) the price level (inflation), and (d) the real level of output (production in the economy. The equation of exchange is as follows: M*V = P*Q (Colander, 2004). In the equation of exchan...