Chapter 18: Money Supply & Money Demand

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Chapter 18 Money Supply Money Demand
2
Federal Reserve System, FED

• The central bank of the U.S.
• Independent decision making unit with regional
  banks
• In charge of money supply management and economic
  stabilization

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Money Supply

• M C D
• C Currency coins bills (25)
• D Demand Deposits checking account deposits
  (75)

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Money Supply Line

• The quantity of money in circulation is
  controlled by the central bank in real value

Interest Rate ()
(M/P)s
10
5
80
Quantity of Money
5
Fractional Banking System

• Banks are required by law to hold a percentage of
  all deposits with the FED to be able to return
  the deposits
• R reserves deposits
• RR required reserves reserves held by the FED
• rr reserve-deposit ratio percentage
  determined by the FED (rr R/D)
• ER excess reserves reserves used by banks to
  lend or investment

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Fractional Banking System

• R RR ER
• RR rr R
• ER (1 rr)R
• Banks lending and investing ER will create money
  through a multiplier effect

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A Model of Money Supply

• The monetary base (B) is money held by the public
  in currency and by banks as reserves R
• B C R
• The currency-deposit ratio (cr) is the amount of
  currency people hold as a fraction of their
  demand deposits
• cr C / D

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A Model of Money Supply

• Divide M C D by B C R
• M/B (C D) / (C R)
• Divide the numerator and denominator by D
• M/B (C/D 1) / (C/D R/D)
• M/B (cr 1) / (cr rr)
• M (cr 1) / (cr rr)B m ? B
• Define money multiplier m (cr 1) / (cr
  rr),so far any 1 increase in the monetary base,
  money supply increases by m.

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A Model of Money Supply

• Example B 500 billion, cr 0.6 and rr 0.1
• m(0.6 1) / (0.6 0.1) 2.3
• M 2.3(500) 1,150 billion

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Change in Money Supply

• The money supply is proportional to the monetary
  base. So, an increase in B increases M m-fold.
• The lower the reserve-deposit ratio, the more
  loans banks make and the higher is the money
  multiplier
• The lower the currency deposit ratio, the fewer
  dollars of the monetary base the public holds as
  currency and the lower is the money multiplier

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Tools of Monetary Policy

• Reserve-deposit ratio ratio of cash reserves to
  deposits that banks are required to maintain
• By lowering the ratio, banks will have more
  reserves to lend and invest, increasing the money
  supply

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Tools of Monetary Policy

• Discount rate rate of interest the FED charges
  on loans to banks
• By lowering the rate, banks encourage borrowing
  from the FED and lending to the public,
  increasing the money supply

13
Tools of Monetary Policy

• Open Market Operations FEDs purchases and sales
  of government bonds
• By purchasing bonds and paying the sellers, the
  FED increases the money supply

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Expansionary Monetary Policy

• Increase the money supply by any one or
  combination of the above tools
• Reduce the interest rate to encourage investment
• Increase employment income

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Money Demand

• The amount of money demanded for transaction and
  speculative purposes depends personal income and
  interest rate
• At any level of personal income, quantity
  demanded of money is a negative function of
  interest rate (M/P)d L(i, Y)

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Money Demand Line
M/P L(Y, i) Y income i interest rate
Interest Rate ()
10
5
(M/P)d
100
80
Quantity of Money
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Money Market Equilibrium
Interest Rate ()
(M/P)s
5
(M/P)d
80
Quantity of Money
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Expansionary Monetary Policy
Interest Rate ()
(M2/P)s
(M1/P)s
5
4
(M/P)d
85
80
Quantity of Money
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Portfolio Theory of Money Demand

• (M/P)d L(rs, rb, pe, W)
• M/P real money balances
• rs expected real rate of return on stocks
• rb expected real rate of return on bonds
• pe expected rate of inflation
• W real wealth
• (M/P)d is positively related to W and
  negatively
• affected by rs, rb, pe

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The Baumol-Tobin Model

• Define
• Y transactionary money an individual holds in
  bank
• N annual number of trips to bank an individual
  makes to withdraw money
• F cost of a trip to the bank
• i nominal interest rate

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Optimal Conditions

• Total cost of money withdrawal Foregone
  interest Cost of trips
• TC iY/2N FN
• The annual number of trips that minimizes the
  total cost of bank trips is
• N (iY/2F)1/2
• Average transactionary money holding is
• MH Y /2N (YF/2i)1/2

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Optimal Conditions
Cost
Total cost of bank withdrawal
Cost of bank trips FN
Foregone interest iY/2N
Number of trip to bank, N
N
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Speculative Demand for Money

• Money individuals hold for investment in the
  financial market
• Near money consists of non-monetary,
  interest-bearing assets such as stocks and bonds

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The Federal Funds Rate

• The short-term interest rate at which banks make
  loans to each other
• The FED uses this rate as the basis for its
  interest rate policy
• Taylors rule for the determination of the
  nominal federal funds rate
• Inflation rate 2 0.5(Inflation rate 2)
  0.5(GDP gap)

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Actual vs. Taylors Rule