Download Chapter 18: Money, Supply and Money Demand

Money Supply & Money Demand
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
Money Supply
M=C+D
C = Currency: coins & bills (25%)
D = Demand Deposits: checking account deposits
(75%)
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
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
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
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
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.
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
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
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
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
Tools of Monetary Policy
 Open Market Operations: FED’s purchases and sales of
government bonds
 By purchasing bonds and paying the sellers, the FED increases
the money supply
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
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)
Money Demand Line
M/P = L(Y, i)
Y = income
i = interest rate
Interest Rate (%)
10
5
(M/P)d
80
100
Quantity of Money
Money Market Equilibrium
Interest Rate (%)
(M/P)s
5
(M/P)d
80
Quantity of Money
Expansionary Monetary Policy
Interest Rate (%)
(M1/P)s
(M2/P)s
5
4
(M/P)d
80 85
Quantity of Money
Portfolio Theory of Money Demand
(M/P)d = L(rs, rb, πe, W)
M/P = real money balances
rs = expected real rate of return on stocks
rb = expected real rate of return on bonds
πe = expected rate of inflation
W = real wealth
(M/P)d is positively related to W and negatively
affected by rs, rb, πe
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
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
Optimal Conditions
Cost
Total cost of bank withdrawal
Cost of bank trips = FN
Foregone interest = iY/2N
N*
Number of trip to bank, N
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
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
 Taylor’s rule for the determination of the nominal federal
funds rate:
Inflation rate + 2 + 0.5(Inflation rate + 2) – 0.5(GDP gap)
Actual vs. Taylor’s Rule