Chapter Nineteen 1

CHAPTER 19Money Supply, Money Demand

and the Banking System

®

A PowerPointTutorial

To Accompany

MACROECONOMICS, 7th. EditionN. Gregory Mankiw

Tutorial written by:

Mannig J. SimidianB.A. in Economics with Distinction, Duke University

M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of

Management

Chapter Nineteen 2

To understand the money supply, we must understand the interactionbetween currency and demand deposits and how the Fed policyinfluences these two components of the money supply.

Chapter Nineteen 3

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).

Chapter Nineteen 4

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-percent-reserve banking system, all deposits are held in reserve; thus the banking system does not affect the supply of money.

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

A Sample 100-Percent-Reserve Bank Balance SheetAssets LiabilitiesReserves $1,000

Deposits $1,000

Chapter Nineteen 5

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.

A Sample Fractional-Reserve Bank Balance SheetAssets Liabilities

Reserves $200Loans $800

Deposits $1,000Let’s lookat how money creation works…

Chapter Nineteen 6

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 percent and that the initial deposit is $1,000.

Mathematically, the amount of money the original $1000 deposit creates is:Original Deposit =$1,000Firstbank Lending = (1- rr) $1,000Secondbank Lending = (1- rr)2 $1,000Thirdbank Lending = (1- rr)3 $1,000Fourthbank Lending = (1- rr)4 $1,000

Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] $,1000 = (1/rr) $1,000 = (1/.2) $1,000 = $5,000

Money and Liquidity Creation (but not wealth creation)

Money and Liquidity Creation (but not wealth creation)

...

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

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

Chapter Nineteen 7

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.

Chapter Nineteen 8

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.

Chapter Nineteen 9

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 percent.

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.

Chapter Nineteen 10

How the Fed controls the money supply

How the Fed controls the money supply

1) Open-market operations (buying and selling U.S. Treasury

bonds).

Reserve requirements (least frequently used instrument).

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

Chapter Nineteen 11

Bank Capital, Leverage and Capital Requirements

Starting a bank requires financial resources to get the bankstarted; the equity of the bank’s owners is called bank capital.

Here is what a bank’s balance sheet would look like:

Assets Liabilities and Owners’ Equity_________________________________________________

Reserves $200 Deposits $750

Loans $500 Debt $200

Securities $300 Capital (Owner’s Equity) $50

Chapter Nineteen 12

On the balance sheet on the previous slide, the reserves, loans, andSecurities are on the left side of the balance sheet must equal, intotal, the deposits, debt, and capital on the right side of the balance sheet.

This business strategy relies on a phenomenon called leverage,which is the use of borrowed money to supplement existing fundsfor purposes of investment. The leverage ratio is the ratio of thebank’s total assets (the left side of the balance sheet) to bankcapital (the one item on the right side of the balance sheet that represents the owner’s equity.

The implication of leverage is that, in bad times, a bank can losemuch its capital very quickly. The fear that bank capital may berunning out, and thus that depositors may not be fully repaid istypically what generates bank runs when there is no deposit insurance.

Chapter Nineteen 13

One of the restrictions that bank regulators put on banks is that thebanks must hold sufficient capital. The goal of such a capitalrequirement is to ensure that banks will be able to pay off theirdepositors. The amount of capital required depends on the kind ofassets a bank holds. If the bank holds safe assets such as governmentBonds, regulators require less capital than if the bank holds risky assetssuch as loans to borrowers whose credit is of dubious quality.

In 2008 and 2009, many banks found themselves with too littlecapital after they incurred losses on mortgage loans and mortgage-backed securities. The shortage of bank capital reduced banklending, contributing to a severe economic downturn. In responseto this problem, the U.S. Treasury, working together with theFederal Reserve started putting public funds into the banking system,increasing the amount of bank capital and making the U.S. taxpayera part owner of many banks. The goal of this unusual policy was torecapitalize the banking system so bank lending could return to normal.

Chapter Nineteen 14

Chapter Nineteen 15

Classical Theory of Money DemandAccording 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.

Keynesian Theory of Money DemandLater 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).

Portfolio Theories of Money DemandThey 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. (M/P)d= L (rs, rb, E, W), where rs is the expected return in the stock market, rb is the expected return on bonds, E is the

expected inflation rate, and W is real wealth.

Transactions Theories of Money DemandThey 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.

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

Chapter Nineteen 16

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

income# of trips # of trips

travelcost

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

N* = iY/2F

Average Money Holding is = Y/2(N*) = YF/2i

Chapter Nineteen 17

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 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.

Chapter Nineteen 18

The Baumol-Tobin model’s square root formula implies that theincome elasticity of money demand is ½: a 10-percent-increase in incomeshould lead to a 5-percent 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 zero.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 zero– just as the empirical evidence shows.

Chapter Nineteen 19

Assets are grouped into two categories:1) MONEY: Assets used as a medium of exchange as well as a store of currency (currency, checking accounts)2) NEAR MONEY: Assets used a store of value (stocks, bonds, and savings accounts).

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, but it’s hard to choose what kinds of assetsshould be grouped together.

Chapter Nineteen 20

The instability of money demand has been a political issue forThe Federal Reserve. In 1993, Fed chairman Alan Greenspan saidthat the aggregates “do not appear to be giving reliable indications of economic developments and price pressures.”

Over the previous year, M1 had grown at 12 percent, while M2 had grown 0.5 percent. Depending on the weight given to each measure, monetary policy was either very loose, very tight, or somewhere in the middle.

Since then, the Fed has set a target for the federal funds rate, the short-term interest rate at which banks make loans to one another. Itadjusts the target interest rate in response to changing economic conditions.

Chapter Nineteen 21

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

Open-market operationsReserve requirementsDiscount rateExcess reservesBank capitalLeverageCapital requirementPortfolio theoriesDominated assetTransactions theoriesBaumol-Tobin modelNear money