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  1. 1. Chapter 18: Money Supply& Money Demand
  2. 2. Federal Reserve System, FEDThe central bank of the U.S.Independent decision making unit with regionalbanksIn charge of money supply management andeconomic stabilization
  3. 3. Money Supply M=C+DC = Currency: coins & bills (25%)D = Demand Deposits: checking account deposits (75%)
  4. 4. Money Supply LineThe quantity of money in circulation is controlledby the central bank in real value Interest Rate (%) (M/P)s 10 5 80 Quantity of Money
  5. 5. Fractional Banking SystemBanks are required by law to hold a percentage of alldeposits 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
  6. 6. Fractional Banking System R = RR + ER RR = rr R ER = (1 – rr)RBanks’ lending and investing ER will create moneythrough a multiplier effect
  7. 7. A Model of Money SupplyThe monetary base (B) is money held by thepublic in currency and by banks as reserves R B=C+RThe currency-deposit ratio (cr) is the amount ofcurrency people hold as a fraction of their demanddeposits cr = C / D
  8. 8. 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 increasesby $m.
  9. 9. A Model of Money SupplyExample: 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
  10. 10. 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 banksmake and the higher is the money multiplierThe lower the currency deposit ratio, the fewer dollars ofthe monetary base the public holds as currency and thelower is the money multiplier
  11. 11. Tools of Monetary PolicyReserve-deposit ratio: ratio of cash reserves todeposits that banks are required to maintainBy lowering the ratio, banks will have morereserves to lend and invest, increasing the moneysupply
  12. 12. Tools of Monetary PolicyDiscount rate: rate of interest the FED charges onloans to banksBy lowering the rate, banks encourage borrowingfrom the FED and lending to the public, increasingthe money supply
  13. 13. Tools of Monetary PolicyOpen Market Operations: FED’s purchases andsales of government bondsBy purchasing bonds and paying the sellers, theFED increases the money supply
  14. 14. Expansionary Monetary PolicyIncrease the money supply by any one orcombination of the above toolsReduce the interest rate to encourage investmentIncrease employment & income
  15. 15. Money DemandThe amount of money demanded for transactionand speculative purposes depends: personalincome and interest rateAt any level of personal income, quantitydemanded of money is a negative function ofinterest rate; (M/P)d = L(i, Y)
  16. 16. Money Demand LineInterest Rate (%) M/P = L(Y, i) Y = income 10 i = interest rate 5 (M/P)d 80 100 Quantity of Money
  17. 17. Money Market EquilibriumInterest Rate (%) (M/P)s 5 (M/P)d 80 Quantity of Money
  18. 18. Expansionary Monetary PolicyInterest Rate (%) (M1/P)s (M2/P)s 5 4 (M/P)d 80 85 Quantity of Money
  19. 19. Portfolio Theory of Money Demand (M/P)d = L(rs, rb, πe, W)M/P = real money balancesrs = expected real rate of return on stocksrb = expected real rate of return on bondsπe = expected rate of inflationW = real wealth(M/P)d is positively related to W and negatively affected by rs, rb, πe
  20. 20. The Baumol-Tobin ModelDefine– 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
  21. 21. Optimal ConditionsTotal cost of money withdrawal = Foregoneinterest + Cost of trips TC = iY/2N + FNThe annual number of trips that minimizes the totalcost of bank trips is N* = (iY/2F)1/2Average transactionary money holding is MH = Y /2N* = (YF/2i)1/2
  22. 22. Optimal ConditionsCost Total cost of bank withdrawal Cost of bank trips = FN Foregone interest = iY/2N N* Number of trip to bank, N
  23. 23. Speculative Demand for MoneyMoney individuals hold for investment in thefinancial marketNear money consists of non-monetary, interest-bearing assets such as stocks and bonds
  24. 24. The Federal Funds RateThe short-term interest rate at which banks make loans toeach otherThe FED uses this rate as the basis for its interest ratepolicyTaylor’s rule for the determination of the nominal federalfunds rate: Inflation rate + 2 + 0.5(Inflation rate + 2) – 0.5(GDP gap)
  25. 25. Actual vs. Taylor’s Rule