Money Supply

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Money Supply
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Money Supply
We will focus our analysis of the demand for
money on two aggregates M1 and M2. M1 is supposed
to represent transactable balances. Recent data
on the monetary series can be obtained from the
H6 release.
Data from Feb. 5, 2007.
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Historical Data on Money Supply
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Historical Data on Money Supply
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Functions of Money

• Money is supposed to serve a variety of roles
• medium of exchange - money eliminates the mutual
  coincidence of wants needed in a barter economy.
  For this reason, many regard it as a public good.
• store of value - an asset that maintains its
  value over time. Inflation attacks money's role
  as a store of value. Sometimes, in extreme cases,
  called hyperinflations, money can even become
  valueless. An extreme example was in Weimar
  Germany. The wholesale price index rose from
  1,260 in January 1920 to 115,900,000,000,000 in
  June of 1924.
• unit of account - prices are denominated in the
  monetary unit.
• standard of deferred payment.

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Money Demand

• The demand for money is hypothesized to depend on
  two motives that were originally put forward by
  Keynes
• the transactions motive Money obtained to buy
  goods.
• b) the speculative motive - Looks at money demand
  in the context of an overall investment portfolio.

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Transactions Demand
In analyzing the transactions demand, we are
concerned with the tradeoff between being liquid
and interest foregone. Suppose you are paid 1500
per month and you spend 50 per day on the 30 days
of the month. You could at one extreme keep all
of your money in cash in your mattress and spend
as you like or you could keep it all in the bank
and make 30 trips to the ATM machine. Let's
model this a little bit more abstractly. Let Y be
your monthly income. Let tc be the cost of a trip
to the bank. If you keep your money entirely in
cash, your cash holdings look like the figure.
If you make two trips, they are drawn down to
zero at mid-month, go back up to 750 and are
drawn down to 0 again.
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Trips to the Bank
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Average Cash Holdings
M represents your cash holdings, and n
represents your trips to the bank. What is your
average cash balance holding. For n1, Y/2. For
n2, Y/4. In general, average cash balances
MY/2n. How might interest bearing checking
accounts effect your analysis? How now do we
determine your optimal number of trips to the
bank?
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Example
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Transactions Cost Function
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Mathematical Approach (opt.)
To verify that this is indeed the minimum, we
must check the second derivative
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Avg. Money Holdings
The so-called square root formula above tells us
that the income elasticity (k?Q/?Y) of the
demand for money is 1/2
Similarly, the interest elasticity is 1/2.