Quantity of Money Demanded The Money Market Potential Confusion: Money and Income Differ. Conceptual Definition of Money: The medium of exchange. The financial assets that you own that can be used to purchase goods and services. Operational Definition of Money: M1 = Cash + Checking Deposits M2 = M1 + Savings Deposits Income: How much you earn over the course of a year. i (%) MS Preview of the Money Market Demand Curve for Money: How much money would be demanded if the nominal interest rate were ______, given that everything else relevant to the demand for money remains the same? i* The demand curve for money is downward sloping. MD Supply Curve for Money M The supply curve for money is vertical. Notation: r = Real interest rate The Federal Reserve Board (the Fed) fixes the quantity of money. i = Nominal interest rate  = Inflation rate Equilibrium Nominal Interest Rate (i*) Real Nominal Rate interest = interest  of rate rate inflation r = i   Quantity of Money Demanded Quantity of Money Supplied =

Ginny’s Gift Ginny’s uncle deposited $10,000 in her checking account but stipulated that Ginny could not spend the money until she graduates; that is, she can’t spend it for one year. Ginny’s checking account pays no interest. Purchasing a CD requires Ginny to miss two hours of work. Ginny earns $20 per hour. Suppose that the CD’s nominal interest rate is 0.1 percent. How much interest would the CD earn in one year? 10,0000.1% = 10,000 0.001 = $10 How much income would Ginny lose by missing work? 220 = $40 Would expect Ginny to missing work to buy the CD? No Instead, suppose that the CD’s nominal interest rate is 10 percent. How much interest would the CD earn in one year? 10,00010% = 10,000 0.1 = $1,000 How much income would Ginny lose by missing work? 220 = $40 Would expect Ginny to missing work to buy the CD? Yes Generalize. As the nominal interest rate increases: What happens to the number of CD’s individuals purchase? Increase. What happens to the checking account balances of individuals? Decrease Do individuals hold more or less money? Less Conceptual (Webster’s) definition of money: Money is the medium of exchange. Operational definition of money: M1 = Cash + Checking Deposits M2 = M1 + Savings Deposits

Ginny’s checking account pays no interest. Ginny’s Gift Ginny’s uncle deposited $10,000 in her checking account but stipulated that Ginny could not spend the money until she graduates; that is, she can’t spend it for one year. Ginny’s checking account pays no interest. Purchasing a CD requires Ginny to miss two hours of work. Ginny earns $20 per hour. Suppose that the CD’s nominal interest rate is 0.1 percent. Instead, suppose that the CD’s nominal interest rate is 10 percent. How much interest would the CD earn in one year? 10,0000.1% = 10,000 0.001 = $10 10,00010% = 10,000 0.1 = $1,000 How much income would Ginny lose by missing work? 220 = $40 220 = $40 Would expect Ginny to miss work to buy the CD? No Yes Generalize. As the nominal interest rate increases: What happens to the number of CD’s individuals purchase? Increase. What happens to the checking account balances of individuals? Decrease Do individuals hold more or less money? Less Conceptual (Webster’s) definition of money: Money is the medium of exchange. Operational definition of money: M1 = Cash + Checking Deposits M2 = M1 + Savings Deposits

The Demand Curve for Money Downward Sloping Demand Curve for Money: How much money would be held if the nominal interest rate were ______, given that everything else relevant to the demand for money remains the same? NB: Money earns no (or nearly no) interest. i (%) The nominal interest (i) rate rises: The demand curve for money is downward sloping  Interest earning assets (CD’s, Treasury bonds, corporate bonds, etc.) become more attractive because they are earning more interest.  Individuals seek to hold more interest earning assets. MD M  To hold more interest earning assets individuals hold less money. i (%) MS Supply Curve for Money: Vertical Claim: The supply curve for money is vertical. The Federal Reserve Board (the Fed) fixes the quantity of money. Strategy: To explain this, we will study the banking system by introducing a tool of the accountant, balance sheets. M

Required reserve ratio Banks Balance Sheet: Your Balance Sheet: Assets: Everything you own and everything others owe you Assets: Everything the bank owns and everything others owe the bank Liabilities: Everything you owe to others Liabilities: Everything the bank owe to others Banking System Balance Sheet: October 15, 2015 Assets Liabilities Billion Dollars (Bank’s) Cash Assets 2,770 (Customers’) Deposits at Bank 10,930 (Bank’s) Securities 3,040 (Bank’s) Loans to Customers 8,460 (Bank’s) Borrowing 1,890 (Bank’s) Other Assets 1,300 (Bank’s) Other Liabilities 1,060 Cash Assets 2,770 Deposits 10,930 Securities 3,040 Borrowing 1,890 Loans 8,460 Other Liabilities 1,060 Other Assets 1,300 Bank Assets = 2,270 + 3.040 + 8,460 + 1,300 = 15,570 Bank Liabilities = 10,930 + 1,890 + 1,060 = 13,880 Bank Net Worth = Assets  Liabilities = 15,570  13,880 = 1,690 The Federal Reserve Board (Fed) and the Fractional Reserve Banking System The Fed is the banks’ bank: Banks borrow funds from the Fed – this is part of the Borrowing balance sheet entry. Banks deposit funds from the Fed – this is part of the Cash Assets balance sheet entry. The Fed regulates banks: Note that banks do not have enough cash assets to cover all of their customers’ deposits. The Fed requires banks to keep a fraction of its deposits as reserves: (Actual) Reserves = Vault Cash + Deposits at Fed NB: A bank’s (actual) reserves cannot fall short of its required reserves. Required reserves Required reserve ratio = × Deposits

Required reserve ratio Banking System Balance Sheet: October 15, 2015 Conceptual (Webster’s) definition of money: Money is the medium of exchange. Assets Liabilities Cash Assets 2,770 Deposits 10,930 Operational definition of money: Securities 3,040 Borrowing 1,890 M1 = Cash + Checking Deposits Loans 8,460 Other Liabilities 1,060 Other Assets 1,300 M2 = M1 + Savings Deposits Question: Which balance sheet item generates profits for banks? Answer: Loans. Question: Which balance sheet entry counts as money? Answer: Deposits. We can purchase goods and services by writing as long as our checking account balance is sufficient. Also, in the age of smart phones we can transfer funds from our saving accounts to our checking accounts in seconds. So, effectively our savings account deposits also constitute money. i (%) MS By regulating banks, the Fed does fixes the money supply. Required reserves play the critical role: Required reserves Required reserve ratio = × Deposits M

 Lab 5.1 “Nuts and Bolts” of the Fractional Reserve Banking System Simplified Banking System Liabilities Assets Vault cash 30 Deposits at Fed 20 Securities 60 Loans 380 Deposits 400 Borrowing from Fed 10 Required reserve ratio 10% RES 50 DEP 500 410 400 Vault Cash 30 Dep at Fed 20 SEC 60 LOANS 480 390 380 BOR 10 Required reserves = Required reserve ratio  Deposits Excess reserves = Actual reserves  Required reserves Bank Assets: Everything the banks own and everything others owe the banks. Bank Liabilities: Everything the banks owe others. = 50  50 40 41 = 0 = 10 = 9 = 10%  410 400 500 = 41 = 40 = 50 Question: Is the bank loaned up? Answer: No. Answer: Yes. NB: When a bank has excess reserves, it can issue more loans. When a bank issues a new loan: How many more loans? LOANS and DEP increase by the amount of the new loan. Answer: 90 Let’s try 10. RES are unaffected.  Lab 5.1 Key Questions to Pose With actual reserves of _______ and a required reserve ratio of _______%, how many deposits can banks be liable for? _______ 50 10 500 Why 500? Because 10%  500 = 50 Since loans and deposits increase by the same amount when a bank issues a new loan and reserves are unaffected, how many ____________ loans can banks issue? _________ more 90