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%)

D = Demand Deposits: checking account

deposits (75%)
 Money Supply Line

The quantity of money in circulation is controlled

by the central bank in real value
Interest Rate (%)

(M/P)s
10

80 Quantity of Money
 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
 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
 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
 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.
 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
 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
 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
 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
 Tools of Monetary Policy

Open Market Operations: FEDs purchases and

sales of government bonds

By purchasing bonds and paying the sellers, the

FED increases the money supply
 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

 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)
 Money Demand Line

Interest Rate (%) M/P = L(Y, i)

Y = income
10 i = interest rate

5
(M/P)d
80 100
Quantity of Money
 Money Market Equilibrium
Interest Rate (%)

(M/P)s

(M/P)d
80 Quantity of Money
 Expansionary Monetary Policy

Interest Rate (%)

(M1/P)s (M2/P)s

5
4

(M/P)d

80 85 Quantity of Money
 Portfolio Theory of Money Demand

(M/P)d = L(rs, rb, e, W)

M/P = real money balances
rs = expected real rate of return on stocks
rb = expected real rate of return on bonds
e = expected rate of inflation
W = real wealth
(M/P)d is positively related to W and negatively
affected by rs, rb, e
 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
 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
 Optimal Conditions
Cost
Total cost of bank withdrawal

Cost of bank trips = FN

Foregone interest = iY/2N

N* Number of trip to bank, N

 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
 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

Taylors rule for the determination of the nominal federal

funds rate:

Inflation rate + 2 + 0.5(Inflation rate + 2) 0.5(GDP gap)

Actual vs. Taylors Rule