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Chapter 18: Money Supply & Money Demand

Chapter 18: 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%)

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Chapter 18: Money Supply & Money Demand

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  1. 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

  3. Money Supply M = C + D C = Currency: coins & bills (25%) D = Demand Deposits: checking account deposits (75%)

  4. 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

  6. 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

  7. 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

  8. 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.

  9. 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

  10. 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

  11. 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

  12. 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: FED’s purchases and sales of government bonds • By purchasing bonds and paying the sellers, the FED increases the money supply

  14. 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

  15. 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)

  16. 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

  17. Money Market Equilibrium Interest Rate (%) (M/P)s 5 (M/P)d 80 Quantity of Money

  18. Expansionary Monetary Policy Interest Rate (%) (M2/P)s (M1/P)s 5 4 (M/P)d 85 80 Quantity of Money

  19. 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

  20. 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

  21. 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

  22. Optimal Conditions Cost Total cost of bank withdrawal Cost of bank trips = FN Foregone interest = iY/2N Number of trip to bank, N N*

  23. 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

  24. 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)

  25. Actual vs. Taylor’sRule

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