Chapter Eighteen 1

A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

Mannig J. Simidian

®

CHAPTER EIGHTEENMoney Supply and Money Demand

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M = C + D

Money Supply Currency Demand Deposits

In this chapter, we’ll see that the money supply is determined not onlyby the Federal Reserve, but also by the behavior of households(which hold money) and banks (where money is held).

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The deposits that banks have received but have not lent out are calledreserves. Consider the case where all deposits are held as reserves: banks accept deposits, place the money in reserve, and leave the money there until the depositor makes a withdrawal or writes a check against the balance.

The deposits that banks have received but have not lent out are calledreserves. Consider the case where all deposits are held as reserves: banks accept deposits, place the money in reserve, and leave the money there until the depositor makes a withdrawal or writes a check against the balance.

In a 100% reserve banking system, all deposits are held in reserve and thus the banking system does not affect the supply of money.

In a 100% reserve banking system, all deposits are held in reserve and thus the banking system does not affect the supply of money.

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As long as the amount of new deposits approximately equals theamount of withdrawals, a bank need not keep all its deposits inreserves. Note: a reserve-deposit ratio is the fraction of deposits kept in reserve. Excess reserves are reserves above the reserve requirement.

As long as the amount of new deposits approximately equals theamount of withdrawals, a bank need not keep all its deposits inreserves. Note: a reserve-deposit ratio is the fraction of deposits kept in reserve. Excess reserves are reserves above the reserve requirement.

Fractional-reserve banking, a system under which banks keep only a fraction of their deposits in reserve. In a system of fractional reserve banking, banks create money.

Fractional-reserve banking, a system under which banks keep only a fraction of their deposits in reserve. In a system of fractional reserve banking, banks create money.

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FirstbankBalance Sheet

SecondbankBalance Sheet

ThirdbankBalance Sheet

Assets Liabilities Assets Liabilities Assets LiabilitiesReserves $200 Deposits $1,000Loans $800

Reserves $128 Deposits $640Loans $512

Reserves $160 Deposits $800Loans $640

Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.

Mathematically, the amount of money the original $1000 deposit creates is:Original Deposit =$1000Firstbank Lending = (1-rr) $1000Secondbank Lending = (1-rr)2 $1000Thirdbank Lending = (1-rr)3 $1000Fourthbank Lending = (1-rr)4 $1000

Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] $1000 = (1/rr) $1000 = (1/.2) $1000 = $5000 Money and Liquidity CreationMoney and Liquidity Creation

...

The process of transferring fundsfrom savers to borrowers is calledfinancial intermediation.

The process of transferring fundsfrom savers to borrowers is calledfinancial intermediation.

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Three exogenous variables:The monetary base B is the total number of dollars held by thepublic as currency C and by the banks as reserves R. The reserve-deposit ratio rr is the fraction of deposits D that bankshold in reserve R.The currency-deposit ratio cr is the amount of currency C people hold as a fraction of their holdings of demand deposits D.

Definitions of the money supply and the monetary base:M=C+DB =C+RSolving for M as a function of the 3 exogenous variables:M/B = C/D + 1

C/D + R/DMaking the substitutions for the fractions above, we obtain: cr + 1 cr + rr

BM = Let’s call this the money multiplier, m.

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M = m BM = m B

Money Supply Money multiplier Monetary Base

Because the monetary base has a multiplied effect on the money supply,the monetary base is sometimes called high-powered money.

Because the monetary base has a multiplied effect on the money supply,the monetary base is sometimes called high-powered money.

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Let’s go back to our three exogenous variables to see how their changes cause the money supply to change:

The money supply M is proportional to the monetary base B. So, an increase in the monetary base increases the money supply by the same percentage.

The lower the reserve-deposit ratio rr (R/D), the more loans banks make, and the more money banks create from every dollar of reserves.

The lower the currency-deposit ratio cr (C/D) , the fewer dollars of the monetary base the public holds as currency, the more base dollars banks hold in reserves, and the more money banks can create. Thus a decrease in the currency-deposit ratio raises the money multiplier and the money supply.

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How does the Fed control the money supply?

1) Open Market Operations

(buying and selling U.S. Treasury bonds).

2) Reserve Requirements

(never really used).

3) Discount rate at which member banks (not meeting the reserve requirements) can borrow from the Fed.

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According to the Quantity Theory of Money, (M/P)d = kY, where k is a constant measuring how much people want to hold for every dollar of income.

Later we adopted a more realistic money demand function where the demand for real money balances depends on i and Y: (M/P)d = L(i, Y).

They emphasize the role of money as a store of value; people hold money as a part of their portfolio of assets. Key insight: money offers a different risk and return than other assets. Money offers a safe nominal return, while other investments may fall in both real and nominal terms.

They emphasize the role of money as a medium of exchange; they acknowledgethat money is a dominated asset and stress that people hold money, unlike other assets, to make purchases. They explain why people hold narrow measures of money like currency or checking accounts.

Classical Theory of Money Demand

Keynesian Theory of Money Demand

Portfolio Theories of Money Demand

Transactions Theories of Money Demand

Let’s examine one transaction theory called the Baumol-Tobin model.

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Total Cost = Forgone Interest + Cost of TripsTotal Cost = iY/(2N) + FN

interestincome

# of trips # of tripstravelcost

There is only one value of N that minimizes total cost. The optimal value of N is denoted N*.

N* = iY/2FAverage Money Holding is = Y/2(N*)

= YF/2i

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N*

Cost of trips to bank (FN)

Forgone interest (iY/(2N))

Total cost = iY/(2N) + FN

One implication of the Baumol-Tobin model is that any changein the fixed cost of going to the bank F alters the money demandfunction-- that is, it it changes the quantity of money demanded for agiven interest rate and income.

Number of trips to bank

Cost

The cost of money holding: forgone interest, the cost of trips to thebank, and total cost depend on the number of trips N. One value ofN denoted N*, minimizes total cost.

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The Baumol-Tobin model’s square root formula implies that theincome elasticity of money demand is ½: a 10% increase in incomeshould lead to a 5% increase in the demand for real balances.

In reality, however, most people have income elasticities that arelarger than ½ and interest elasticities smaller than ½.

But, if you imagine a world in which there are two kinds of people: Baumol-Tobins with elasticities of ½. The others have a fixed N, so they have an income elasticity of 1 and an interest elasticity of 0.In this case, the overall demand looks like a weighted average of thedemands for both groups. Income elasticity will be between ½ and 1, and the interest elasticity will be between ½ and 0– just as the empirical evidence shows.

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Near money consists of assets that have acquired the liquidity of money (e.g. checks that can be written against mutual fund accounts).

Near money causes instability in money demand and can give faultysignals about aggregate demand.

One response to this problem is to use a broad definition of money thatincludes near money– however, it is hard to choose what kinds of assetsshould grouped together.

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Reserves100-percent-reserve bankingBalance sheetFractional-reserve bankingFinancial intermediationMonetary baseReserve-deposit ratioCurrency-deposit ratioMoney multiplierHigh-powered money

Open-market operationsReserve requirementsDiscount rateExcess reservesPortfolio theoriesDominated assetTransactions theoriesBaumol-Tobin modelNear money