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CHAPTER 4
Prepared by:
Fernando Quijano and Yvonn Quijano
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M $Y L(i)
d
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Clearly some currency was held by firms rather than by households. And
some was held by those involved in the underground economy or in illegal
activities. However, this leaves 66% of the total unaccounted for. The
balance of which is abroad and held by foreigners.
The fact that foreigners hold such a high proportion of the dollar bills in
circulation has two main macroeconomic implications.
First, the rest of the world, by being willing to hold U.S. currency, is making
in effect an interest-free loan to the United States of $500 billion.
Second, while we shall think of money demand as being determined by
the interest rate and the level of transactions in the country, it is clear that
U.S. money demand also depends on other factors.
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M $Y L(i)
This equilibrium relation is called the LM relation.
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$100 $ PB
i
$ PB
$100
$ PB
1 i
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Figure 4 - 4
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The assets of the central bank are the bonds it holds. The
liabilities of the central bank are the money it has issued,
central bank money. The new feature is that not all of central
bank money is held as currency by the public. Some of it is
held as reserves by banks.
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Lets think in terms of the supply and the demand for central
bank money.
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Determinants of the
Demand and the Supply
of Central Bank Money
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Bank Runs
Rumors that a bank is not doing well and some loans will
not be repaid, will lead people to close their accounts at
that bank. If enough people do so, the bank will run out
of reservesa bank run.
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CU c M
D d (1 c) M d
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R D
The demand for reserves by banks is given by:
R d 1 c M d
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H d CU d R d
H d cM d 1 c M d c 1 c M d
Finally, replace the overall demand for money, M ,d
with its expression from equation (4.3) to get:
H d c 1 c $Y L i
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H Hd
Or restated as:
H d c 1 c $Y L i
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Equilibrium in the
Market for Central Bank
Money and the
Determination of the
Interest Rate
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H CU d R d
The federal funds market is a market for bank reserves.
In equilibrium, demand (Rd) must equal supply (H-CUd).
The interest rate determined in the market is called the
federal funds rate.
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1
H $Y L(i)
[c (1 c)]
Supply of money = Demand for money
1/ c 1 c
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Key Terms
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