Chapter 18: Money Supply & Money Demand

Federal Reserve System, FEDThe 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 LineThe quantity of money in circulation is controlled by the central bank in real value Quantity of MoneyInterest Rate (%)(M/P)s80510

Fractional Banking SystemBanks are required by law to hold a percentage of all deposits with the FED to be able to return the deposits:

R = reserves: depositsRR = 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 SystemR = RR + ERRR = rr RER = (1 rr)R

Banks lending and investing ER will create money through a multiplier effect

A Model of Money SupplyThe monetary base (B) is money held by the public in currency and by banks as reserves RB = C + RThe 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 SupplyDivide 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 BDefine 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 SupplyExample: B = $500 billion, cr = 0.6 and rr = 0.1:

m=(0.6 + 1) / (0.6 +0.1) = 2.3M = 2.3(500) = $1,150 billion

Change in Money SupplyThe 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 PolicyReserve-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 PolicyDiscount 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 PolicyOpen Market Operations: FEDs purchases and sales of government bonds

By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary PolicyIncrease the money supply by any one or combination of the above tools

Reduce the interest rate to encourage investment

Increase employment & income

Money DemandThe 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 LineQuantity of MoneyInterest Rate (%) (M/P)d10510080M/P = L(Y, i)Y = incomei = interest rate

Money Market EquilibriumQuantity of MoneyInterest Rate (%) (M/P)d580(M/P)s

Expansionary Monetary PolicyQuantity of MoneyInterest Rate (%) (M/P)d580(M1/P)s(M2/P)s485

Portfolio Theory of Money Demand

(M/P)d = L(rs, rb, e, W)M/P = real money balancesrs = expected real rate of return on stocksrb = expected real rate of return on bondse = expected rate of inflationW = real wealth (M/P)d is positively related to W and negatively affected by rs, rb, e

The Baumol-Tobin ModelDefine Y = transactionary money an individual holds in bank N = annual number of trips to bank an individual makes to withdraw moneyF = cost of a trip to the banki = nominal interest rate

Optimal ConditionsTotal cost of money withdrawal = Foregone interest + Cost of trips TC = iY/2N + FNThe annual number of trips that minimizes the total cost of bank trips isN* = (iY/2F)1/2Average transactionary money holding isMH = Y /2N* = (YF/2i)1/2

Optimal ConditionsCostNumber of trip to bank, NForegone interest = iY/2NCost of bank trips = FNTotal cost of bank withdrawalN*

Speculative Demand for MoneyMoney 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 RateThe 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)

Actual vs. Taylors Rule