mankiw's macroeconomics modules A PowerPointTutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw Mannig J. Simidian ® CHAPTER EIGHTEEN Money Supply and Money Demand

Money Supply & Money Demand

M = C + D Money Supply Money Supply Demand Deposits Currency In this chapter, we’ll see that the money supply is determined not only by the Federal Reserve, but also by the behavior of households (which hold money) and banks (where money is held).

100-Percent-Reserve Banking The deposits that banks have received but have not lent out are called reserves. 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.

Fractional-Reserve Banking As long as the amount of new deposits approximately equals the amount of withdrawals, a bank need not keep all its deposits in reserves. 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.

Money and Liquidity Creation A closer look at money creation... Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000. Firstbank Balance Sheet Secondbank Balance Sheet Thirdbank Balance Sheet Assets Liabilities Assets Liabilities Assets Liabilities Reserves $200 Deposits $1,000 Loans $800 Reserves $160 Deposits $800 Loans $640 Reserves $128 Deposits $640 Loans $512 Mathematically, the amount of money the original $1000 deposit creates is: Original Deposit =$1000 Firstbank Lending = (1-rr)  $1000 Secondbank Lending = (1-rr)2  $1000 Thirdbank Lending = (1-rr)3  $1000 Fourthbank Lending = (1-rr)4  $1000 The process of transferring funds from savers to borrowers is called financial intermediation. . . . Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …]  $1000 = (1/rr)  $1000 = (1/.2)  $1000 = $5000 Money and Liquidity Creation

A Model of the Money Supply Three exogenous variables: The monetary base B is the total number of dollars held by the public as currency C and by the banks as reserves R. The reserve-deposit ratio rr is the fraction of deposits D that banks hold 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+D B =C+R Solving for M as a function of the 3 exogenous variables: M/B = C/D + 1 C/D + R/D Making the substitutions for the fractions above, we obtain: cr + 1 cr + rr Let’s call this the money multiplier, m. M =  B

M = m  B The Money Multiplier Money Supply Monetary Base Because the monetary base has a multiplied effect on the money supply, the monetary base is sometimes called high-powered money.

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.

How does the Fed control the money supply? Open Market Operations (buying and selling U.S. Treasury bonds). 2) D Reserve Requirements 3) D Discount rate at which member banks (not meeting the reserve requirements) can borrow from the Fed.

Money Demand Classical Theory of Money Demand 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 acknowledge that 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. 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.

Baumol-Tobin Model of Cash Managment Total Cost = Forgone Interest + Cost of Trips Total Cost = iY/(2N) + FN # of trips interest # of trips income travel cost 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

The cost of money holding: forgone interest, the cost of trips to the bank, and total cost depend on the number of trips N. One value of N denoted N*, minimizes total cost. Cost Total cost = iY/(2N) + FN Cost of trips to bank (FN) Forgone interest (iY/(2N)) N* Number of trips to bank One implication of the Baumol-Tobin model is that any change in the fixed cost of going to the bank F alters the money demand function-- that is, it it changes the quantity of money demanded for a given interest rate and income.

Conclusions The Baumol-Tobin model’s square root formula implies that the income elasticity of money demand is ½: a 10% increase in income should lead to a 5% increase in the demand for real balances. In reality, however, most people have income elasticities that are larger 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 the demands 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.

Financial Innovation and the Rise of Near Money 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 faulty signals about aggregate demand. One response to this problem is to use a broad definition of money that includes near money– however, it is hard to choose what kinds of assets should grouped together.

Key Concepts of Ch. 18 Reserves Open-market operations 100-percent-reserve banking Balance sheet Fractional-reserve banking Financial intermediation Monetary base Reserve-deposit ratio Currency-deposit ratio Money multiplier High-powered money Open-market operations Reserve requirements Discount rate Excess reserves Portfolio theories Dominated asset Transactions theories Baumol-Tobin model Near money